Light on the 'subterranean economy' exposes US policy problems

For some economists, there's something fascinating about the "subterranean economy." It's shadowy and mysterious. It involves prostitution, gambling and drug trafficking, the Mafia, the moonlighter who fails to report his or her income to the Internal Revenue Service, the businessman who skims cash from his till and all sorts of other illegal or legal moneymaking activity that is not reported to the tax authorities. This small group of economists plays detective, trying to ferret out facts when the participants in the subterranean economy are usually trying to hide the facts. They estimate the size when no one really knows its magnitude precisely.

Whatever, the subterranean economy is huge. Peter M. Gutmann, a professor of economics at Bernard Baruch College, New York City, has pioneered in this field and he guesses that the fast-growing subterranean economy will reach $420 billion this year, or about 14 percent of the expected gross national product reported by the Department of Commerce.

Whether smaller, as estimated by the IRS in 1979, or larger, as figured by some other economists, the subterranean economy is so big it now has important policy implications.

Professor Gutmann spelled out some of these for a seminar held last month in New York by Wertheim & Co., a New York Stock Exchange brokerage house. Some implications are obvious; others more of a surprise:

* National output is greater than statistics indicate, possibly 14 percent more than the $2.9 trillion GNP anticipated this year for the United States.

* Living standards are higher than the official statistics show. Since the census misses counting some undocumented aliens, however, living standards may not be quite 14 percent greater.

* The labor force is greater than the nearly 100 million reckoned by the Department of Labor -- perhaps 5 or 6 percent more. These are people who may be working in the classical illegal activities -- numbers running, etc. Or they could be the carpenter who's considered out of work by the unemployment insurance office but is actually busy renovating houses to make some unreported income.

* Productivity per worker is greater than the government estimates. The understatement of national output is substantially greater than the understatement in the national labor force.

* Productivity per man-hour is probably also greater. That's controversial among the economists studying the subterranean economy. But Mr. Gutmann figures there is so much skimming in retailing, services, and construction (taking cash out of the till without reporting it to the government) that national output is considerably understated.

* The economic growth rate is faster than reported. That is so because the subterranean sector has been growing more rapidly than the statistically measured economy -- perhaps twice as fast during the past decade, Mr. Gutmann figures.

* True inflation is a little greater than the statistics indicate. The cost of "black" construction, retailing, or services may be less than that offered by firms paying their full taxes. But the productivity improvement in these sectors has been historically poor.So, if the subterranean economy was added to the regular one, prices would go up faster.

* The unemployment rate is less than the Department of Labor states. Mr. Gutmann guesses that the May unemployment rate of 7.6 percent should really be about 5.9 to 6.1 percent.

One reason is that some of those quizzed during the Census Bureau's monthly household survey do not always "tell the Gospel truth." They may say they are jobless, but are actually working "off the books." Or they may say they are looking for work because this is necessary to collect welfare or food stamps; but actually they are not really wanting a job and shouldn't be counted in the labor force. And hundreds of thousands of full-time students are included amongst the unemployed, even if only looking for part-time work.

* Savings and investment are bigger than measured by the government. That's because participants in the subterranean economy don't spend all their illicit income. Some of the production of this subterranean economy consists of investment goods. That's particularly true of home improvements done on the sly.

* Poverty in the US is less than the official figure. That's because people often don't report their subterranean income during government household surveys.

Professor Gutmann warns that because the subterranean economy results in misleading data, policymakers may take "inappropriate actions which are injurious to the nation's economy." For instance, because unemployment is overstated and GNP growth understated, they may stimulate the economy too much. This can lead to more inflation.

Another problem is that the subterranean economy perverts the allocation of economic resources. People may invest too much money and effort in such areas as retailing, services, or construction where tax evasion can be relatively easy. These areas have experienced low productivity gains.

What's to be done to reduce the dishonesty implied by the growth in the subterranean economy?

Professor Gutmann suggests that a reduction in marginal tax rates -- as proposed by the Reagan administration -- might help. It wouldn't then be so profitable to be dishonest on taxes. Also, a strengthening of the IRS enforcement ability could scare people into reporting more subterranean income, though it might hurt the small-business sector and be politically unpopular, he says.

Whatever, the growth of the subterranean economy will at some point deman d more government attention.