UNDERGROUND ECONOMY

The term "underground economy" refers to the part of the economy that generates income, but goes untaxed. According to Tibbett Speer in American Demographics, each year as much as $1 trillion of income goes unreported to the Internal Revenue Service. Moreover, the unreported amount appears to be growing, due partly to a rapid increase in small service companies and a large influx of illegal immigrants, according to Speer. Roughly 83 percent of the taxes Americans owe the government are paid voluntarily. Audits and other enforcement methods generate an additional 4 percent. However, the remaining 13 percent of potential tax revenue slips through the cracks.

A number of hypotheses have been advanced to explain the increasing practice of tax evasion. Some academic economists have studied the relationship between the tax rate and tax revenue collected. Young H. Jung, et al Arthur Snow, and Gregory Trandel suggest in the Journal of Public Economics that under certain assumptions regarding the risk-taking behavior of individuals, a rise in the tax rate increases the number of individuals who avoid paying taxes in that sector of the economy in which tax evasion is possible. The tax rate level, consequently, also affects the total amount of tax revenue evaded. Thus, Jung et al suggest that the design of tax policy itself sows seeds of the inevitability of tax evasion. Therefore, tax policy makers have to take care to craft a tax system that provides incentives to pay taxes and severely discourages the avoidance of tax payments.

One cannot put all the blame of underground economy on illegal immigrants or the design of the tax structure, however. The structure of the economy is itself to blame to a great extent. As mentioned earlier, the rapid growth of small service companies has contributed to the growing size of the underground economy. Some sections of the underground economy are truly "underground," i.e., their activities are considered illegal. Thus, one does not pay taxes on what one cannot admit to doing. David Fettig points out in Fedgazette that illegal income is part of the underground economy in the United States. This hidden sector includes illegal drug dealing, illegal prostitution, unlawful gambling, and other criminal activity. Fettig argues that while the amount of money involved in criminal activity, and the subsequent tax revenue lost, is of interest to economists and policymakers, it is largely considered unrecoverable. Thus, if one considers the underground economy to be comprised of legal and illegal segments, policymakers realize that they can recover taxes only from the legal segment of the underground economy. Therefore, policymakers' attention is focused more towards the size of the underground economy as it relates to otherwise legal enterprises, like "off-the-books" hiring or unrecorded retail sales. These are activities that normally appear above ground and part of normal business activities, but sometimes go unreported or unrecorded—most often to avoid tax payments or the costs of meeting regulatory requirements. Fettig emphasizes that the underground economy's impact on economic statistics and on government programs are foremost in policymakers' minds when they think about this, because the goals of new policies may be thwarted in some way if they fail to consider the underground section of the economy.