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Paying the Fare for the Underground Economy

Mary-Jo Kranacher, MBA, CPA/CFF, CFE

Discussion of the underground economy usually evokes thoughts of illegal immigrants working off the books, thieves trading in stolen goods, and drug dealers and prostitutes soliciting customers. But there is another side of the underground economy—unreported and underreported cash payments for in-home repair services, tutoring, snow removal, landscaping, construction, babysitting, and housecleaning services—that is widely tolerated and accepted in our society. in its latest update to the tax gap, the IRS confirmed that the gap due to income underreporting grew by 32% in five years (based on 2006 data). Some individuals and businesses operate underground to evade paying taxes, others to avoid government regulation.

Research has shown that if taxpayers perceive the system to be fair, they are more likely to comply with the tax laws. But in recent years, taxpayers have witnessed their political leaders—for example, U.S. Treasury Secretary Timothy F. Geithner and former chairman of the U.S. House Committee on Ways and Means Charles B. Rangel—preach about the responsibility of every member of society to pay his fair share of taxes, while those same individuals flouted the tax laws. Predictably, compliance is highest in areas where there is third-party withholding and reporting; but corporate downsizing has taken its toll in this regard, as many laid-off workers have gone out on their own.

Avoiding government regulations may also motivate individuals and businesses to join the underground economy. For example, unlicensed childcare services circumvent legal facilities requirements while meeting a much-needed demand. New York City's unlicensed livery cabs are another example: Restrictions on the number of available taxicab medallions and the prohibitively high cost of these medallions left a void that, historically, has been filled by illegal livery cabs. in late December, Governor Andrew M. Cuomo signed a bill that allows a new class of licensed livery cabs to pick up street hails in the outer boroughs of New York City and upper Manhattan. Legislation like this is intended to encourage individuals to move from the shadow economy to the official one.

Economic Effects

When a business operates in the underground economy, it gains an unfair competitive advantage over those that comply with the various laws by illegally reducing its operating costs, such as licenses, insurance, payroll taxes, and employee benefits. in turn, it's able to offer goods or services at reduced prices while remaining profitable. The economic downturn has pressed consumers and businesses to seek out lower cost goods and services; so it's not surprising that the underground economy is thriving. Yet it can have both positive and negative effects on the official economy.

The good

Undocumented workers hold millions of U.S. jobs that, if reported, would significantly improve our nation's employment numbers. In addition, a substantial portion of the income earned in the underground economy is promptly spent in the official economy and thus contributes to economic growth.

The bad

The underground economy takes place beyond the scrutiny of the iRS and government policy makers, so it is difficult to estimate its size and extent. And like any other fraud, participants conceal their activities to avoid detection. But it is clear that the underground economy affects a wide range of constituents:

  • Consumers face a greater risk of substandard quality of goods and services.

  • Workers suffer from a loss of benefits and other protections as provided by law.

  • Law-abiding businesses face unfair competition and subsequently higher taxes and expenses.

  • There are also broader costs to society in the form of inefficient government policies that are based on inaccurate data (i.e., unemployment, official labor force, income, consumption), as well as reduced tax revenues that lead to greater budget constraints in the public sector.

The ugly

Corporate layoffs have led some workers to accept jobs in the underground economy that pay less, offer irregular hours or less job stability, and provide few, if any, benefits. Working off the books and not paying taxes or continuing to collect unemployment benefits provide a compensatory trade-off for the lower wages and the lack of benefits. in fact, those who receive unemployment benefits have a significant disincentive to work “on the books.”

Seeking a Solution

Although the underground economy has long been a fact of life, governments must attempt to control these activities because of the broad ramifications they have on the official economy. Raising rates to compensate for lost tax revenue only increases the incentives to go off the books. A fairer tax system would be a good start: There is something inherently wrong about a system in which middle income wage earners may pay a higher marginal tax rate than very wealthy investors.

The inclination to promulgate more regulations as a solution to this problem should be tempered by research that has shown that having fewer regulations—strictly and consistently enforced—is a more effective way to curb our expanding underground economy.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA/CFF, CFE. Editor-in-Chief. ACFE Endowed Professor of Fraud Examination, York College, The City University of New York (CUNY), mkranacher@nysscpa.org.

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