How Deep Is the Shadow Economy? A New Freakonomics Radio Podcast

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Our latest Freakonomics Radio podcast is called “How Deep Is the Shadow Economy?” It addresses what we know — and don’t know — about the gazillions of dollars that never show up on anyone’s books.

(You can download/subscribe at iTunes, get the RSS feed, listen via the media player above, or read the transcript below.)

The conversation ranges from the macro to the micro — that is, from worldwide estimates of the size of the shadow economy to the actual off-the-books transactions (from drug dealing to freelance hair-cutting) that make those dollars flow.

We touch on research by the Turkish economists Ceyhun Elgin and Oguz Oztunali, who estimate that off-the-books transactions account for roughly 23 percent of world GDP (short versionfull paper); and a similar World Bank study by the economist Friedrich Schneider, who has studied shadow economies — and the attendant tax evasion —  for the past quarter century.  

But the star of this podcast is Sudhir Venkatesh, the Columbia sociologist who is a regular Freakonomics contributor. Venkatesh has studied, up close and personal, the working lives of prostitutes, home cooks, drug kingpins, sidewalk auto-repairmen, and many others whose labor — licit and illicit — constitutes the shadow economy. If you are even a little bit interested in this subject, you should definitely read Venkatesh’s Off the Books: The Underground Economy of the Urban Poor (as well as his later book Gang Leader for a Day: A Rogue Sociologist Takes to the Streets).

Here’s Venkatesh from the podcast:

You have to be pretty creative if you’re going to try to measure the shadow economy. Many social scientists, particularly those that want to see what percentage of the shadow economy is in the country overall, they want big estimates, they’ll often do surveys. So they might ask people very directly, “Hey, how much did you work illegally in the U.S.?” Well there’s a problem — people might not be telling the truth. Other economists might say, you know, to avoid the truth-telling issue we’re just going to take careful estimates. And so they construct very elaborate models. Sociologists like me who don’t trust people at all and believe that we generally don’t tell the truth at all have to go and see someone perform something illegally. So that means we’ll go and watch them. And in my case I’ll spend years watching them. The problem is I might only end up watching two dozen people. It’s hard to figure out what the country is doing as a whole by watching two dozen people, let alone your neighborhood. So it’s a problem. And as creative as we want to be in trying to measure it, we often fall short. 

One agency with particular interest in the shadow economy is the I.R.S., which estimates the annual U.S. “tax gap” — the difference between taxes paid and taxes owed — is about $345 billion. We’ve written about the tax gap before, and unless it magically disappears (ha!), probably will again.


frankenduf

no mention of shadow banking?- i would think this would dwarf the shadow transactions of the little fish- when Brooksley Bourne tried to shine a regulatory light on the shadow banking sector, her federal powers were eviscerated by congress- reading between the lines, we may then infer that there are very powerful forces lurking in those shadows, power backed by a high volume of cash

Eric M. Jones.

Shhhhhhhhhhhhhhhhhhhhhhhhhhh..................

Jacob

Should internet sales be included in the shadow economy? I know I spend a large amount on Amazon, and while they do pay federal tax on it, my state is missing out on that sales tax. I'm sure there are many Ebay sellers, who don't report that income. Is this perhaps a twilight economy, reported federally, but not on the state level?

Enter your name...

Then there's the question of whether that "income" is really income.

I just sold a book online. I had accidentally bought two, and by the time I realized it, I couldn't return either. I sold the spare for less than I paid for it. My "net income" is a loss of about $10. I'm sure that I could declare myself to have a "small business" that lost $10 this year, but since this isn't an ongoing activity, it would make more sense for me to just skip it. (The hassle of filing the forms will exceed the $2 or $3 reduction in income taxes.) That means that this transaction isn't being "reported", but it's not really part of the "untaxed shadow economy", because no income taxes were owed on it in the first place.

I suspect that my situation is not unusual among small sellers on eBay, especially among hobbyists and people selling small numbers of books and music.

James

Seems like one problem, and not the least of them, is deciding just how deep to drill for the shadow economy. When does just plain neighborliness become part of the shadow economy? Take gardening, for instance. Like most of my neighbors, I garden for pleasure, and often wind up with an excess of this or that, which I give to friends & neighbors, sometimes getting some of their excess in turn.

For instance, the other day I gave my neighbor a basket of peaches from my tree, next week she might give me some of her peppers. Obviously, it's possible to see these as economic transactions: she might otherwise have bought peaches at the store, as I would buy peppers. But on the other hand, there's no price: I don't say "I'll swap 10 lbs of peaches for the same amount of peppers", because I have far more peaches than I can eat this year, and likewise with her peppers.

These sorts of transactions go on all the time, and at all levels, between my neighbors, as I imagine they do in most rural places, and probably add up to a significant fraction of our total produce consumption. So it's economic in the sense that it's depriving the grocery chain of transactions, but is it properly part of the economy?

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Matt

It could possibly fall under gift taxation provisions of the tax code, which allows you to "gift" $13,000 worth of assets (or services?) to individuals without being federally taxable. I'm not an expert on this. Maybe another person with more knowledge on the subject can clarify.

Julie

Two thoughts--having spent some time in a South American country where little to no income was ever reported to the government, I doubt than most people in said country making ordinary transactions would even consider their economic activity as part of a "shadow economy." They'd wonder why on earth the government would need to get between them and their corner bodega or a between them and their hair dresser. Some of them, who view their government as little more than an organized crime gang, would see it almost as paying protection money.

Second thought--where does hiring the neighbor kid to mow your lawn or babysit your kids fit in with the shadow economy? Should teenaged babysitters be required to report their income? Are these transactions legal, sublegal, or illegal?

MW

What about time taken caring for your own kids? After all, this is denying babysitters income. Maybe it is only part of the shadow economy when you're not enjoying it? Does it make a difference whether you're expecting your kids to care for you in old age (in which case your current 'work' is an 'investment')?

It seems to me that defining the boundary of the shadow economy is very nearly as problematic as measuring it.

Jim Fisher

For many the shadow economy is the only way the can afford to start a business, working sans licenses and permits until they accumulate the capital to "go legit." It's not a matter of criminal activity, it's the reality of the expense of starting a business.

TravisZ

Very interesting podcast.

Shadow economy actually makes me feel better, a big percentage of shadow economy means people are have a better life than what it appears on paper.

Another thing is I am not sure how reliable the paper is on the numbers. Paper says in my home country China, the shadow economy is about 12%, which I find hard to believe. I am thinking more like 25-30%.

Retro

Enjoyed this one; it makes one stop and think.

eBay was always very interesting to me because it enabled large scale movement of second-hand merchandise. Let's take for example, things that people have in their basement, like say a collectors' edition LP, or a collection of baseball cards, or some vintage electronic game still in the box (e.g. say a video game from 20 years ago or something).

When you're small-time, and you start selling off these collectable items, often for more money than was paid in the first place (let's say you paid $20 for it, and now, years later, for whatever reason, it's worth $200 to die-hard fans, which is a huge mark up even accounting for inflation) some interesting things happen. eBay the business collects its commission and listing fees. So the activity has SOME interaction with the regular economy. The post office does the business of shipping the goods to the buyer. But the majority of the value of the transaction, which if it was an antiques shop, would show on the books as a business sale, is being done by amateurs. There's no sales tax payable on the sale. Now if you were selling it in person, behind closed doors, it's a private transaction. But the likelihood of finding the buyer without eBay would have been quite remote. The auction service both facilitated a buyer finding a seller of a good that has value only to those people and nobody else (random Joe on the street wouldn't pay that much money for some old collectible knicknack, he'd say you were crazy) but took a piece of the action and reported that as legitimate business income for services rendered.

It's only if you start relying on this mechanism as a major source of your income that you have to report it as yourself running a business; until then it's just a creative form of re-using something old.

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SEAN

Great episode. Interesting as always. My question is about something unrelated to the actual episode. I really like the outro music. That guitar lick was killer. Who is that? Does anyone know?

tom

Does anyone know the name of the outro music please? 9:04?