The Underground Economy and Its Role in the World

The submerged economy or informal economy is that economic activity that is outside the regulated economy, and therefore, the State cannot exercise its entire tax system against this economic activity.

The statistics around the submerged economy are usually diffuse because they are small-scale operations, although numerous, and therefore, they are estimates through surveys or indirect indicators such as the demand for money in an economy.

On a global scale, the size of the submerged economy is reduced

In the following graph, we can see how the size of the informal economy has evolved compared to the global economy in each of the economic territories from 1990 to the present day.

In all of them, a clear pattern is perceived and that the informal economy has lost relative weight, which means that the activities that were developed in the informal economy have been passed to the formal economy.

This has been possible thanks to the improvement of countries with greater growth in their GDP, a rapid accumulation of physical capital and great improvements in governance, and a fruitful business climate to develop economic activity.

Today, those regions that have a greater proportion of the submerged economy are found in sub-Saharan Africa and Latin America and the Caribbean. Both show an unregulated activity that has a weight of 34% of GDP.

Therefore, informal activity represents approximately one-third of GDP, but the most significant is that it implies 70% of employment in emerging markets and developing economies.

Informality is more widespread in less developed economies, with large agricultural sectors and a greater proportion of unskilled workers. Although it sometimes provides the short-term advantage of flexibility and employment, a broader informal sector is associated with lower productivity, lower tax revenues, and greater poverty.

There is high heterogeneity in the size of informal economies in sub-Saharan Africa, ranging from a minimum of 20 to 25% in Mauritius, South Africa, and Namibia to a maximum of 50 to 65% in Tanzania and Nigeria.

In comparison, the submerged economy of North America has a weight of 9% on GDP and, if we take into account the global number of countries within the OECD, the relative weight scales up to almost 15% on GDP.

Why is the economy submerged?

The submerged economy arises when the formal economy prevents the economic development of a particular business activity in which two parties agree on the exchange of a good or service.

This impediment can be caused mainly for three essential reasons. The first would be given by a sufficiently demanding regulation so that there are incentives to undertake this activity outside the formal economy, obtaining an economic premium for that legal risk assumed by the parties.

Informal workers make up the vast majority of employment in the agricultural sector in developing countries, in part because they set high compliance costs to discourage the activity of the formal sector of small agricultural enterprises.

From another point of view and with close examples, we see it in the Criminal Code in the prohibition and trafficking of certain drugs. Also, in the imposition of a minimum wage by a government that prevents less productive workers from accessing the regulated labor market, and they are engaged in the submerged economy.

Another reason would be a tax scheme high enough so that the perception of both producers and consumers is to try to avoid fiscal greed so that the transaction can be facilitated. And it is that in Spain, with a general rate on the consumption of 21%, a clear incentive arises to avoid a strong increase in the bill.

The most common example of how taxes hurt is the hiring of independent professionals “without invoice” to save the payment of excise taxes, even if this implies fewer guarantees in the provision of services. Also, with the tax avoidance of assets through tax havens and screen companies to avoid paying corporate tax.

Ultimately, the lack of strong institutions – a characteristic of developing economies – that do not protect private property motivates the rise of the submerged economy. We speak of a lack of legal certainty leading to an ineffective application of the law.

The dysfunctional law, in its enforcement mechanism, together with institutions that dominate corruption, leads companies to prefer the black market because of the lack of guarantees in the formal economy.

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