Going Underground: America's Shadow EconomyBy: Jim McTague
Baron's | Thursday, January 06, 2005
America has two economies, and one is flourishing at the expense of the other. First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the fast-growing underground economy, where millions of nannies, construction workers and others are paid off-the-books, their incomes largely untaxed. The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It should soon pass $1 trillion.
What is largely fueling the underground economy, experts say, is the nation's swelling ranks of low-wage illegal immigrants. The government puts this population at 8.5 million, but that may represent a serious undercount.
Robert Justich, a senior managing director at Bear Stearns Asset Management in New York, makes a persuasive case in a forthcoming paper, "The Underground Labor Force Is Rising to the Surface," that illegal immigrants actually number 18 million to 20 million. If true, the economic implications are profound and could help shape debates slated in Washington this year over both immigration policies and tax reform.
Measuring the size of the underground economy is, of course, more art than science, since most of its denizens seek to remain anonymous. But convincing anecdotal evidence and a number of credible academic studies suggest that it is expanding briskly -- probably by an average of 5.6% a year since the early 1990s, edging out the real economy.
In the process, the underground economy is undermining the effectiveness of the Internal Revenue Service, which is highly dependent on employees' withholding taxes. If the IRS could collect all the taxes it says that it is owed from the underground economy in a given year, then the current budget deficit would disappear overnight. And if the IRS could collect these taxes every year, then the nation would have surpluses as far as the eye can see.
The IRS has estimated that its tax gap -- the estimated amount of taxes owed minus the amount collected -- is around $311 billion in any given year. The agency will produce a new estimate in 2005, and it could be as high as $400 billion, says former IRS Commissioner Donald Alexander. Now a lawyer in Washington, he cites a rise in private contracting and the opportunities it affords for not reporting income.
The gap number measures only a portion of the underground economy. Because the number is extrapolated from audited returns, it makes no allowances for criminal enterprises that report no income, and it even fails to capture some garden varieties of non-reporting. The unreported wages of illegal immigrants alone could be costing the government another $50 billion a year, says Justich.
Growth of the underground economy is partly a result of corporate downsizing, which has forced many former employees to go out on their own.
"We have had an 85% taxpayer compliance rate," says Nina Olson, the IRS's taxpayer advocate. "I expect the number to decline," because the portion of employees subject to withholding is on the wane. Such employees are 99% compliant with tax laws, she says, but in the 21st-century economy, "More and more people are being treated as independent contractors. We are losing people from the withholding environment."
Entrepreneurs often are stymied by the complexity of estimating their taxes and making quarterly payments, which leads to mistakes or out-and-out avoidance. The growth of online commerce may be exacerbating the situation.
There were over 40 million regular users of eBay alone in 2003, up from 23 million in 2002. The sellers are responsible for paying taxes. Some of them set up a business and get a taxpayer ID number; others don't. (An eBay spokesman says the company isn't a tax adviser -- it's up to members to report their taxes.)
Most unsettling to IRS bureaucrats, taxpayers as a group appear to have become less honest. Former New York City Police Commissioner Bernard Kerik is the latest poster boy for the phenomenon. He had to drop his bid to become secretary of homeland security because he failed to pay Social Security taxes for his children's illegal-immigrant nanny.
Kerik is hardly alone: Any homeowner who has been offered two prices by a handyman or a gardener -- a higher one for a payment by check, a lower one for all cash -- knows how quickly the savings can add up. In one twist on off-the-books business, the New York Times recently reported on a rise in mechanics who repair cars at curbside for untraceable cash payments. They are not in want of customers. In some cities, including Boston, owners of battered cars get similar offers from itinerant body-repair "experts."
In speeches, IRS Commissioner Mark Everson is fond of citing a survey by his agency showing that the number of Americans who consider tax-cheating acceptable rose from 11% in 1999 to 17% in 2003.