The U.S. Underground Economy

Seminar Paper, 2008

15 Pages, Grade: 2,0


Table of contents

1. Introduction

2. Causes and motivators
2.1 The legal framework and institutional quality
2.2 Globalization and additional motivation

3. Affected sectors
3.1 Underground immigrants in New York
3.2 Contraband trade and money laundering
3.3 The service sector

4. Results and effects
4.1 Consequences
4.2 The "gray area phenomenon" (GAP)

5. Options and solutions
5.1 Measurement and estimates
5.2 Policy implementation

6. Conclusion



1. Introduction

The phenomenon of underground economy can be observed all around the world, regardless of a country´s state of development. It has been studied and discussed in literature for several decades. In the 1980s the size of the underground economy in the United States was higher than during World War II for the first time, and it continued to grow due to tax increases in the 1990s. In addition, globalization and the resulting greater competition as well as the increasing number of unregistered immigrants give rise to unrecorded activities.

In this paper I will focus on the causes and effects of the underground economy in the United States. Therefore, I will first explain the main motivators for individuals to take action in the unofficial economy, such as a legal framework consisting of high tax schemes and social security burdens as well as the institutional quality in terms of bureaucracy and regulatory discretion.

Second, I will examine some of the most affected sectors. In this context I will especially concentrate on underground immigrants, contraband trade, and money laundering as well as labor-intense services undertaken by not-registered workers.

Finally, I will address the results and effects of the underground economy on the recorded one and its labor and money markets. In this section of the paper I will also show how the U.S. underground economy is related to other phenomena such as the budget deficit, the “gray area phenomenon” and corruption.

In the final part of the paper I will focus on possible solutions to reduce the extent of underground activities. I will especially emphasize some methods to measure and estimate invisible economic action on the one hand and on the implementation of policy engagement on the other.

A brief conclusion in the end sums up the main points and provides an overview of the aspects developed in this paper.

2. Causes and motivators

People might decide to operate in the unofficial economy for various reasons. These can basically be classified into two categories. There are external causes such as the legal business environment and institutional quality, as well as globalization and personal motivators that influence the decision of whether to engage in underground activities or not.

2.1 The legal framework and institutional quality

The most important reasons for the growth of the shadow economy are “costly regulation, rising tax rates and growing distrust of government” (Feige 1994: 24). The National Center for Policy Analysis (1998) also confirms “as tax rates rise, hiding income becomes more profitable”.

In this context, Dreher and his colleagues (2008) mention the burden of high taxation and social security contributions on the one hand, and institutional quality on the other, as the primary causes for underground activity. As individuals seek to keep their profits, they avoid participation in the official system. The latter aspect, institutional quality, refers to bureaucracy, regulation, a weak legal system, and corruption. The authors conclude that there is a positive relation between bureaucracy and the underground economy.

In the U.S., an increase in underground activities is also a consequence of downsizing staff in many business establishments, that led many jobless persons to go underground, as well as a result of rising online commerce, where the taxation is basically the sellers´ responsibility (McTague, 2005).

2.2 Globalization and additional motivation

In contrast to the causes mentioned above, Karlinger (2008: 1-2) identified some aspects of globalization in the late 1990s that finally increased underground activities. These include the reduction of trade barriers, market liberalization, and the improvement of communication and transportation. The result of such developments was an increase of competition in the legitimate economy as well as the unregistered one, driving more individuals underground. Competition forces economic agents to reduce their input costs, and especially labor is much cheaper without taxation and safety or health standards.

According to Frey and Schneider (2000: 5-6), there are also personal considerations responsible for the decision of participation in the underground sector. First, they mention working time restrictions in terms of few hours, long vacation, and early retirement as reasons for additional employment in the unregistered economy. Second, there is an incentive for self- employed persons and illegal immigrants, as in their case, the expectation and the expected extent of punishment for underground activities is quite low, especially compared to their possible gains. Third, there is a relationship between engagement in the shadow economy and its morale costs, which constitutes the individual component influencing the decision.

3. Affected sectors

3.1 Underground immigrants in New York

The problem regarding illegal immigrants and immigrant underground activities are a specific problem of the United States, due to its “enormous border area, high quality of life, and tradition of civil liberties” (Zagaris, 1997). In this section of the paper I will especially focus on illegal immigrants in New York. However, according to McHugh (2005), other highimmigration states are Arizona, California, and Texas.

Smuggling aliens is a relatively profitable underground activity. The Census Bureau estimates that there are about 400.000 illegal immigrants living in New York City, which accounts for approximately 5% of the city´s population, and the number is increasing by about 25.000 every year. The majority comes from Latin America, Korea, the Dominican Republic, China, Sicily, Nigeria and Russia and engages in illegitimate businesses such as prostitution, distribution of drugs and arms, smuggling, gambling, and fraud. They sell handbags, ties, perfumes, watches, and jewelry from briefcases on the sidewalks or wait there for construction or gardening jobs (Zagaris, 1997).

3.2 Contraband trade and money laundering

Zagaris (1997) points out that the largest share of U.S. contraband traffic is made up of illegal drugs and psychotropic substances, enforced by the relationship between drug and arm trafficking, increasing gun violence, and the incarceration of wholesalers. This industry consists of the producers, intermediaries, sellers, and support service suppliers, such as money launderers.

Money laundering forms an important part of the underground economy, as it enables individuals operating there to profit from their criminal activities. It is a complex process, basically consisting of the physical placement of cash proceeds, separation from their criminal origin, and transformation into legitimate assets.

3.3 The service sector

According to McHugh (2005), off-the-books immigrant labor represents the largest element of the underground economy. In addition to illegal immigrants, other unregistered workers such as day laborers and relatives of the entrepreneur, engage primarily in the small businesses in the service sector.

The list of business sectors offering unreported cash-only services is enormous. McTague (2005) mentions several off-the-book workers such as construction workers, mechanics, nannies, carpenters, and plumbers among other self-employed contractors. L.S.M (1997: 186) focuses in his paper on illegal services and lists “prostitution, pornography, the production and distribution of illegal substances, and many types of gambling (…)”.

A marketing survey from the 1980s (McCrohan, Smith 1986: 51, 53-57) found some sectors where the number of informal vendors exceeded that of official suppliers. For instance, 95% of domestic services were undertaken by unregistered providers. Home repair and improvements contributed the largest proportion of underground activities. Other services mentioned include personal care, automobile repair, educational services, cosmetic, laundry, and related services.

4. Results and effects

4.1 Consequences

“America has two economies, and one is flourishing at the expense of the other” (McTague, 2005).

According to Frey and Schneider (2000: 1), a growing underground economy leads to the following three dominant problems. First, official statistics do not validly represent economic and social conditions of the economy, which may cause the implementation of inappropriate macroeconomic and social policies. “A second concern is the loss of tax revenue as underground activities escape taxation” (Frey, Schneider 2000: 1). Third, as more and more taxpayers become dissatisfied with public services, they will also engage in underground activities which could lead to government´s inability to finance the supply of public goods and services.


Excerpt out of 15 pages


The U.S. Underground Economy
Vienna University of Economics and Business
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ISBN (Book)
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Economy, globalization, GAP, contraband trade, money laundering, service sector
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Raffaela C. M. Wallner (Author), 2008, The U.S. Underground Economy, Munich, GRIN Verlag,


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