The Black Economy and Its Impact

How the Shadow Economy Secretly Affects You

cyber criminal
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Photo by Ralf Hiemisch/Getty Images

The black economy is a commercial activity that operates outside of laws, regulations, and taxes. It's also called the shadow economy, the underground economy, or the informal economy.

Key Takeaways

  • A black economy is any income not legally reported to tax authorities
  • Cash or cryptocurrency is the preferred payment mode
  • It usually involves money laundering
  • Underground economic activities are unrecorded and untaxed
  • The U.S. black market economy is the largest in the world

Three Characteristics

There are three characteristics that describe the black economy. First, some aspect of it is illegal. It may provide goods or services that are prohibited by law. It could provide legal goods or services that avoid taxes. Often, it does both.

Second, cash is preferred. That way, payments avoid detection by law enforcement, bank compliance officers, or tax authorities. About $72 billion of illegal activities used Bitcoin. That's 46% of all Bitcoin transactions.

Third, the black economy uses money laundering to convert payments to a legitimate form. Money laundering has three steps:

  1. Deposit funds into a legitimate bank. Cash deposits less than $10,000 don't attract federal attention. For larger sums, shadow businesses comingle the illegal gains with funds from a cash-heavy legal business.
  2. The layering of transactions to disguise the source, ownership, and location of the funds. They may create overseas shell companies that are only used to launder the cash.
  3. Integrate the funds into society in the form of holdings that appear legitimate. Many use funds to buy real estate.

The goal of money laundering is to move the money from the illicit business through many transactions to obscure the money trail. It prevents bank compliance officers and federal officials from recognizing the signs of an underground business.

Motivation

Sellers want to engage in the black economy to make more money than they could legally. They may also do it to gain prestige, power, and self-esteem. Most are in an environment where it is socially acceptable, if not encouraged, by their peers. Some others have been socially conditioned to believe this is the only way they can get ahead.

Buyers have three motivations. For many, the shadow economy is the only way to obtain an illegal good or service.

Others want to obtain a legal good or service at a lower price or faster delivery. For example, the cost of stolen or smuggled goods is lower than the cost of manufacturing these goods. There are no taxes paid. You just pay for transportation, plus a fee to cover the seller's risk. Often they are sold on the street corner.

Some want to obtain a legal good or service that's in short supply. In these instances, the good or service will cost more in the black market, but it's more readily available.

Examples

Examples of illegal services include illegal gambling, human trafficking, and prostitution. In 2016, trafficking affected 40 million people. Of those, 15.4 million have been trafficked into forced marriages.

Around 10 million children are sold into slavery each year.

Another 24.9 million are sold into forced labor. Of those, 16 million are forced into factory or farm labor and domestic servitude. Another 5 million are sexually exploited, and 4 million are in forced labor to the state. Women and girls comprise 99% of those enslaved in the sex industry. They are 58% of the other sectors.

The book "Human Trafficking, Human Misery" explains that trafficking also includes human organs, child soldiers, mail-order brides, and adoption. The United Nations Office on Drugs and Crime also includes forced begging.

In 2012, forced labor generated $150 billion in profits. Two-thirds are from sexual exploitation. Sex traffickers make $21,800 in profits each year from each of their victims.

A growing illegal service is the digital black economy and cybercrime.

Examples include stolen personal and financial information. It's used to gain access to bank accounts and credit cards or to establish new lines of credit. Cybercriminals are highly skilled, under the age of 25, and often recruited from universities. Europol estimates it costs corporations 750 billion euros a year.

Illegal goods include street drugs, weapons, human organs, endangered species, and counterfeit money. Other examples include pirated movies and CDs, ticket scalping, and many goods sold on the street.

Global Financial Integrity estimated the maximum that illegal international trade made in the top 10 sectors.

  • Counterfeiting: $1.13 trillion
  • Drug Trafficking: $652 billion
  • Illegal Logging: $157 billion
  • Illegal Mining: $48 billion
  • Illegal Fishing: $36.4 billion
  • Illegal Wildlife Trade: $23 billion
  • Crude Oil Theft: $11.9 billion.
  • Light Weapons Trafficking: $3.5 billion.
  • Organ Trafficking: $1.7 billion.
  • Trafficking in Cultural Property: $1.6 billion.

When added to human trafficking, the total is $2.2 trillion.

A third example of the black economy is legal goods and services that are shielded from taxes. It includes any work done "under the table." It includes any income that isn't reported to tax authorities. For example, a construction worker engages in the black economy if he takes a cash payment and doesn't report it on his taxes. The work is legal, but his tax avoidance isn't.

The Internal Revenue Service estimates that 16.4% of taxes owed are not paid. As a result, tax evasion cost the federal government $441 billion per year from 2011-2013. The IRS recovers $60 billion, reducing the tax gap to $381 billion annually. Not all of these are black market participants, but the IRS estimate does give a ballpark idea of how much is lost to these illegal activities.

Advantages

The shadow economy provides jobs and income to people who might not have good options in the legitimate economy. For example, a street market allows dozens of entrepreneurs selling similar products to compete.

It allows people to afford medicine, health services, and other essential products they could never obtain otherwise. For example, a doctor in a country illegally can provide low-cost health care on a cash basis because he doesn't pay taxes.

It also helps countries survive economic downturns. When people lose jobs, they turn to the shadow economy to survive until the recession is over.

Disadvantages

The shadow economy drives out legitimate industries that can't compete with the lower costs of illegal operations. Some black market players deliberately create shortages in legal goods to force people to purchase from them.

The tax-free nature of the black market means the government loses revenue. These funds could have been used to provide services to the country's citizens. The underground market economic activity is not counted in government statistics. As a result, the country underestimates its gross domestic product.

Workers don't receive benefits or legal protection. As a result, many are exploited.

These workers aren't included in the nation's count of employment and unemployment. They aren't counted in the labor force.

For example, increased drug use is one reason why the labor force participation rate has declined since 1999. Yale professor Alan Krueger did a study of prime-aged men who weren't in the labor force. Professor Krueger found that 20% of the LFPR decline for these men was caused by increased use of opioid medication between 1999 and 2015. Almost half of them take pain medication daily to treat chronic health conditions. One third were forced to take illegal heroin when their prescriptions ran out and they became addicted.

Another study found that 1 million people are heavy users of opioid drugs. That's 0.5% of the labor force. It cost the economy $44 billion  a year and slowed economic growth by 0.2%. 

Risks to Those Involved in the Transaction

Both buyers and sellers risk punishment, including fines and jail time, for engaging in illegal activity. If the good or service itself isn't illegal, then the tax evasion or theft is.

Buyers have no recourse if the product isn't satisfactory. There are no receipts, warranties, or guarantees. For example, the product could be counterfeit. They could become a victim of crime themselves. They can't appeal to the government for any protection.

Buyers and sellers could be exposing themselves to violent consequences. Since the activity is illegal, the strongest survive. That includes the threat of force when necessary.

Pros

  • Provides jobs

  • Often offers goods and services at a lower price

  • Helps countries weather recessions

Cons

  • Exploits workers, especially women and children.

  • Encourages violence and drug abuse

  • Government loses revenue and miscounts employment estimates

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Article Sources

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  2. Review of Financial Studies. “Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies?” Accessed March 12, 2020.

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