Europe’s underground economies

One significant issue arising in the crisis has been the size of some European underground economies. Politicians seek measures to increase public revenues as public budgets come under strain. As large segments of European, and especially southern European, economies are hidden in the underground, large amounts of otherwise taxable incomes are likewise hidden.

Chapter 4 my new edited collection, Institutions in Crisis: European Perspectives on the Recession, grapples with the issue of these underground economies. With over a quarter of Greek economic activity only unofficially undertaken, we see that in some countries the issue is significant. Indeed, the average underground economy for the PIGS (the PIIGS excluding Ireland) is 21.7 percent of GDP, almost three times the size of America’s, and double that of Germany’s.

Two important questions must be answered. First, what explains the size of these underground economies? Second, how can we integrate them into the official economy?

There are two general reasons why economic activity seeks to be underground rather than official. On the one hand high, tax rates prohibit otherwise mutually beneficial economic activities from occurring. Movements into the underground try to evade these taxes and thus allow trades to be made (for those of you who can remember your first-year economics class, this is a way to reduce those triangular deadweight losses of taxation). On the other hand, regulations add a potentially complex and costly web of rules that entrepreneurs must abide by. In some cases it is only possible, or at least easier, for a firm to operate in the underground instead of the official regulation-abiding economy.

When looking at the general range of underground economies in Europe it does not take long to discern which effect is stronger. Europe is well known for its plethora of taxes, as well as its high marginal tax rates, but there is no clear relationship between taxes and the size of the underground economy. High tax Scandinavian countries, for example, seem to enjoy relatively small undergrounds. Some southern European countries, Spain for example, have relatively low tax rates and large undergrounds.

The answer lies in the distinction between different interventions that Murray Rothbard made in this economic treatise, Man, Economy and State. Binary interventions are those where one party becomes subordinate to the intervener in the transaction. Labor taxes, for example, cause a firm to hire labor at a different price than it originally would have, and under the constraints placed on it by the government imposing the tax. Triangular interventions, in distinction, are those that place both parties to a transaction subordinate to the intervener simultaneously. Testing requirements on drugs subordinate both drug producers and consumers to the government imposing the regulation – no transaction can take place regardless of the desires of the relevant parties.

Northern European countries, despite their high tax rates (a form of binary intervention) enjoy relatively low levels of triangular interventions. Low levels of simple regulations make entrepreneurial undertakings relatively pain free. Business owners can comprehend the binary interventions as an additional cost of business, and proceed cognizant of the fact that they face a minimal level of complex and uncertain regulatory burdens. Consequently, there is not much reason to operate in the unofficial section of the economy. (Keep in mind that although one can save on taxes by doing so, there are costs – the lack of a clearly defined and enforceable rule of law being the foremost.)

Southern European countries, in distinction, are well known for the bureaucratic boondoggles they are. Triangular interventions abound. Complex and uncertain labor laws make firing (and subsequently, hiring) employees a costly or impossible ordeal. Unable to navigate the regulatory burdens endemic in these economies, entrepreneurs hide in the underground. By saving on the expense of the difficulties of complying with complex regulations, entrepreneurs are able to outweigh the added costs by working in less official conditions.

As this problem is most acute in the PIGS countries, it has become an issue as politicians search for means to bolster government revenues. By reallocating economic activity to the official sector, taxes will be able to be collected and government coffers replenished. Calls for more frequent auditing and increased fines have come to the fore. Such solutions are misplaced at best, and will exacerbate the problem at worst.

Increased audits and fines for the “guilty” will doubtlessly decrease the size of the underground economies. This added risk and cost of underground business will incentivize some entrepreneurs to withdraw, or at least curtail, such economic activity. It is doubtful that this will translate into increased official economic activity. Entrepreneurs in the underground are there because the conditions in the official economy are not conducive to business. High taxes and complex regulatory structures drove them out in the first place. Without a change to either of these two facets (primarily the latter), we should not expect any increase in official economic activity.

In my book I spell out one additional reason why EU politicians should not be overly keen on minimizing the size of their underground economies. As unemployment rates have increased, the various undergrounds have been able to cushion part of the blow. Working conditions in the underground economies are certainly not as desirable as in the official one, but the unemployed have few choices. Lacking growing employment opportunities in the official economy, a lack that I stress is caused by excessive and uncertain regulatory burdens, removing the underground options available will only serve to further impoverish the burgeoning unemployed masses.