Understanding the Shadow Economy

Assistant Professor of Economics Emily Marshall

Photo by Carl Socolow '77.

Assistant Professor of Economics Emily Marshall parses the links between unemployment, crime and the shadow economy

by Tony Moore

Everyone knows about the shadow economy, even if they don't know that's the name for it. Simply, per the Wall Street Journal, "The shadow economy is perhaps best described by the activities of those operating in it: work done for cash, where taxes aren’t paid, and regulations aren’t strictly followed." Most of us might call it "working under the table." For Dickinson College Assistant Professor of Economics Emily Marshall, it's the subject of a recent paper she co-authored called "Revisiting the Relationship Between the Economy and Crime: The Role of the Shadow Economy." Below are some questions that came to mind upon reading a subsequent article the three authors wrote on the subject.

What got you interested in the connections among unemployment, crime and the shadow economy?

When I was a visiting instructor at Bates College, my office was next to a sociologist who specializes in criminology. At some point during the semester, one of my classmates from graduate school came to give a talk on the shadow economy and corruption. The three of us had a conversation following the presentation about ways to integrate our research interests. I'm a macroeconomist with a focus on business cycle theory, so the significance of the relationship between unemployment and crime is extremely important, and we had a theory that this relationship could be confounded by the presence and size of the shadow economy.

The article mentions that some think that in the U.S. alone the shadow economy could be as large as $2 trillion. If people paid taxes on all that shadow income, how might that effect the national debt?

This is a great question. To attach some quick figures, at the end of 2017, U.S. gross domestic product (GDP) was around $17.3 trillion. So the shadow economy is approximated to be around 11 to 12 percent of overall economic activity. Total federal debt was around 20.5 trillion, over 100 percent of GDP. Assuming a marginal tax rate of around 25 percent, we can approximate (very roughly) that about $.5 trillion of that could go to tax revenue if those activities were part of the legitimate economy. Some of that, of course, would go to paying off the national debt, but some would go to other federal programs. So, in the big picture, the overall effect on the national debt may not be that large—it would still be over 100 percent of GDP, even after adding that additional $2 trillion to the GDP figure. It could help close the gap, but not dramatically. There are, of course, other considerations. Moving these activities to the legitimate economy could reduce the ability of these individuals to receive welfare, with favorable effects on the federal budget.

How does one measure shadow economic activity?

The shadow economy is extremely difficult to measure, partly because the intention is to not be tracked or traced. Therefore, most of the measures of the shadow economy are imputed through latent variable techniques—meaning we econometrically estimate the size of an unknown variable using observable variables that are correlated with the shadow economy. This is the measure that we choose to use in our paper, because it's the most consistent with our theory. However, there are other techniques for estimating the size of the economy, including calculating the amount of money circulating in the economy and electricity usage. The shadow economy can be imputed from these figures by subtracting off the proportion that can be attributed to official economic activity.

The article asks, “Do unemployed individuals choose to enter the shadow economy to supplement their income rather than resort to criminal activity?” Generally I don’t see someone who might rob a liquor store taking up babysitting or landscaping instead. Or is that actually the case (babysitting aside)? Can you explain the way that all might work?

First, it should be clear that when we say this, we are referring only to instrumental crimes, or those intended to improve a person’s financial position. Thus, when individuals become unemployed, for example, due to a recession, and need to earn income to survive and support their families, they may rob the local liquor store or seek employment underground. Our hypothesis is that the latter is a more attractive alternative to most individuals. However, in areas where there is not a vibrant shadow sector, individuals may have no choice but to commit crimes to make ends meet. Alternatively, people with criminal backgrounds who are classified as unemployed may find it difficult to seek employment in the official sector, and without a shadow economy they may choose to revert to criminal activities to earn income.

The article also says, “We considered the possibility that the link between unemployment and crime would be less strong in places and times when there is a robust shadow economy.” This seems to imply that the shadow economy comes first. I.e., When unemployment strikes, the existing shadow economy is what will keep people from committing crimes. So is it a “shadow economy infrastructure” that keeps crime at bay in a sense? Or does a shadow economy develop as an overall economy begins to tank?

Again, great point. One thing to mention is that the shadow economy has been shown to be counter-cyclical. In other words, as the official economy is booming the shadow economy is depressed, but as the official economy slips into a recession both demand and supply for the shadow activities increase. At the same time, the motivation perspective of crime tells us that people will seek the resources they need in the most efficient way possible: either the shadow economy or crime if someone is unemployed. While previous studies ignored the underground sector, we show that the relationship between unemployment and crime depends on the shadow economy.

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Published April 26, 2018