Underground Economy: Term Definition

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According to (Tanzi, 1999) an Underground economy is the market where trade regulations are not followed, and taxes that are supposed to be paid are avoided. It covers various activities which are carried out in large countries with a high rate of corruption and legal monopolies but the rate decreases in countries that have high economic freedom. Goods for trade are acquired through illegal means, which makes them cheaper because suppliers do not pay usual taxes or incur the normal cost of producing those goods. Alternatively, supplies may supply goods at high prices, making them more expensive to buy than legal goods because the traded goods are difficult to obtain, and there is danger in dealing with them and hardly available.

When low prices are charged for illegal goods in the underground market, consumers prefer to purchase legal goods because they prefer promoting suppliers who deal with legal goods for them to obtain them easily and be certain that the products are safe for use. Customers may face legal charges or disciplinary action if they are found possessing illegal goods regardless of where they got them from, which makes them prefer to follow the process of obtaining goods normally instead of through the parallel market. Consumers may have a belief that suppliers are conducting immoral business due to the way suppliers exploit other suppliers and refuse to purchase goods from the underground market. (Tanzi, 1999)

Causes of the underground economy

Taxation causes an underground economy because traders are supposed to pay a certain amount of tax for the goods they trade into the government of the country. Many of the traders in the underground economy may not be willing to surrender the tax and therefore end up evading the tax by operating the parallel market. Corruption causes an underground economy where businessmen bribe in order to imports goods without paying customs duty. This makes the government lose money that is supposed to be generated when goods are imported from outside the country. The government requires all the businesses to be registered for them to commence their activities, but the regulations to be followed may be excessive for people to comply with, which makes them operate in the underground economy in order to avoid following the excessive regulations since they are expensive. There are situations where government efficiency causes underground economy because government officials allow traders to operate without following the rules and principles that are supposed to be followed, and suppliers are able to operate without being caught. When the public sector becomes more efficient, shadow economy occurs because the increase in efficiency of bureaucracy increases the penalty for the people who act as underground agents, which makes them have little benefit from their operations. (Trandel, 1999)

Underground activities originate from incentives, available opportunities, and social contributions. When we consider the case of employees, social contributions need to be paid with incentives, and the employer gets high productivity from social contributions. The elasticity between social tax and wage dynamic in the long run is negative because; relative independence occurs between the behavior of the firm and gross wage from the perspective of social contribution. The rate of income tax has high elasticity due to the stronger incentive it creates for the underground economy to operate because when the tax base of income is hidden, fewer taxes are paid. (Tanzi, 1999)

Consequences of the underground economy

There are negative consequences of the underground economy, such as the government losing a huge amount of revenue it could have generated if all business operations were legal. This affects the debt and capacity of the government to finance programs and provide services to the entire society. People who obey the law are the ones who pay tax for others which makes them have a high burden because they pay more in order to compensate for those who do not pay due to operating in the underground economy.

Employees who are employed in places where the underground economy operates are not covered and do not receive employment benefits they are entitled to from their employers. These employees are not provided with employment cover to compensate them in case they incur a loss for them to be returned back to their original financial position before they incurred the loss, and a pension plan is not available to them. (Trandel, 1999)

The people who operate businesses encounter unfair competition because; those who pay tax compete with those who do not pay. This makes the ones who operate parallel businesses get high net profit from their sales as a result of the profit obtained, which is not taxed at all, and the ones in legal businesses pay a large amount of tax as a percentage of the income generated. Optimizing agents operate in an underground economy where they evade taxes. The consequence is that they are subjected to credit rationing as a cost from banks. When the budget is not flexible for expenses to be adjusted, high tax rates make firms prefer the underground economy in order to reduce the tax base. The economy, in return, lowers aggregate investment due to credit rationing. When the taxes are low, the underground economy is eliminated, making budgets difficult to sustain, and trade deficits occur. (Trandel, 1999)

Compare the underground economy in America and India

According to (Monroe, 2003) India and America are involved in an underground economy where the governments allow transactions to be carried out without being taxed through failing to apply laws of taxation or by legal sanction in some markets. The underground economy does not mean that they steal goods for trade which they also call black market, but transactions involved are cash transactions where traders avoid being traced by the government or deal with financial operations which are complex involving the use of tax havens and multiple subsidiaries.

In India, the underground economy is higher than the gross domestic product of the country, and the parallel economy in American is more than India’s gross domestic product by one trillion dollars. Barter-based and cash transactions are higher because people are aware of it due to the increased size and level of influence on its customers. Customers in India and America are fond of arguing that the underground economy brings about corruption, income is hidden and opportunistic theft. When we compare the payments, transparency of transactions, and billing systems of the United States of America with India’s antiquated systems, America is the way it is due to efficiency in automated systems and honesty in the propensity of Americans.

There are many organizations trading in fraudulent goods and operate businesses through forums that are web-based, leading to online fraud. There is a relationship between specific regions and organizations where indictments and arrests of participants in the underground economy say that the operations are organized where they produce debit and credit cards in large numbers. Groups in North America are loosely organized, consisting of acquaintances who engage in online forums channels that help them communicate with their associates. Credit card information is advertised, and it has a high rank during the reporting period. Financial accounts and information on bank accounts are stolen and advertised to customers in order to inform them that the transactions carried out are legal. This makes advertised goods increase in value and attract many buyers even if they operate in an underground economy. (Monroe, 2003)

Software is pirated in America and India where report shows that computer games are the most pirated and used by the majority. Electronic games have increased in popularity, and the sale of computer games reached $9.5 in the United States in the year 2007, which was a twenty-eight percent increase from the previous year. Medium and small businesses operate in the underground economy such as, information on a credit card which is sold by many traders. Numbers of credit cards are offered for sale, expiry dates for goods, and dumps of credit cards. Credit card numbers help to give verification that transactions are carried out by the owner who possesses the card. (Tanzi, 1982)

What is the government doing to cope with the underground economy?

(Tanzi, 1982) argues that social dialogue brings about many interventions that lead to the development of local systems of production where choices are made in order to solve the problem of the underground economy. Investigations are done by the government to ascertain the legality of the underground economy and measures to be taken in preventing it from operating. The government ensures there is the economic development of production systems at the territorial boundaries so that the underground economy does not operate and the people who engage in it are discouraged from operating.

Instruments are created with the objectives of protecting workers from exploitation by employers and developing them so that they can become self-reliant. The government collaborates with social forces in issuing rules that favor legalized economies so that they may not incur losses due to high competition from the underground economy. Employers have regulations that require them not to exploit workers, and they are supposed to offer insurance cover regardless of the business they are operating. Committees are created by the government to cope with the problem of the underground economy at territorial institutions where they are able to reveal how the underground economy occurs and identify means of reducing it or stopping it completely. The government promotes environmental developments that are sustainable so that people can operate in them legally and never engage in the underground economy. (Tanzi, 1982)

The rights of workers are properly stated so that they can be protected all the time, even if they are in small or large-scale enterprises. The government restores the productive cycle of companies if it is interrupted by underground markets so that it can continue with normal operations without making huge losses due to reduced levels of sales to ensure quality goods and services are produced for customer satisfaction. Government intervenes in favor of workers where they support payment of salary to prevent termination of employment in difficult situations or suspension of workers when work reduces due to underground economy. (Monroe, 2003)

How underground economy affects the economy

The underground economy has become global market with pressures on supply where suppliers have been supplied goods at low price because; they are tax free making demand for those goods to be high because consumers purchase more of commodities when the price is low since they are willing and able to purchase the commodities. This makes the government loose revenue due to inability to collect tax from supplier. Tax is used by government to finance the budget and once the amount of tax collected is low, the government is not able to balance its income and expenditure resulting to budget deficit leading to unstable economy. (Tanzi, 1982)

Advertisement through the media is done for goods traded in parallel markets and it is associated with theft since it is operated by criminals. When customers become aware of such commodities, they doubt its quality and since there are other traders who deal with similar commodity and their businesses are legal, their sales become low because, customers do not differentiate between goods that are legal or illegal. Therefore, the economy fails to grow due to reduced sales and decrease in income generated by its citizens. Safety and control of quality of traded goods becomes difficult leading to the risk of harmful goods being traded without the knowledge of potential customer.


In conclusion, underground economy is carried out by citizens who obey the law but try to seek refuge from the government by trying to benefit more from the activities they engage in. They are employers who offer valuable services that are not inspected and do not have license of their productive activities. The government is supposed to put measures in place so that underground economy is prevented so that the development of economy is not affected for it to achieve economic growth. (Monroe, 2003)


Tanzi V. (1982): The Underground Economy in the United States and Abroad: Free Press pp.25-8.

Monroe K. (2003): The Political Process and Economic Change: Algora Publishing –19-24.

Tanzi V. (1999): Uses and Abuses of Estimates of the Underground Economy: Blackwell Synergy: pp.33-37.

Trandel G. (1999): Progressive income taxation and the underground economy: Elsevier pp.65-69.

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