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Underground Economy

Updated on February 1, 2024
Article byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Underground Economy?

The underground economy is a part of a country’s economy that deals in illegal transactions. The prime reason for its existence is that individuals can access products and services otherwise banned by the economy. 

Underground Economy

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It is also known as the shadow economy, informal economy, and black economy or black market. Although shadow economy transactions do not hold any part in the Gross Domestic Product (GDP) calculation, they contribute to the income of a few entities. Thus, it provides an alternative source to the economy. Moreover, goods sold under this economy attract no taxes. So, it also brings parallel cons like tax losses and high debts

Key Takeaways

  • An underground economy, or shadow economy, is where illegal transactions occur. It is also known as the informal economy, black market, and black economy. 
  • The early evidence of underground economies dates back to the 15th century in Egypt. However, Adam Smith popularized the concept in the book “Wealth of Nations” in 1776. 
  • The shadow economy’s factors include high prices, strict regulations, excessive control, and others. 
  • For example, in 2021, Bulgaria had the highest black market at 32.41% of the GDP. In contrast, the United States black market was 6.56% of the GDP. 

Underground Economy Explained

The underground economy is where few economic entities carry out illegal financial transactions. These transactions get an escape from taxes and statistics. However, not all in the shadow economy are unlawful; some are smaller. The black market includes smuggling drugs and alcohol, gambling, tax evasion (avoiding taxes), prostitution, barter exchange, and similar things. 

The first usage of the underground economy concept dates back to the 15th century. During that time, sellers sold illegal products like censored books across European borders. In the 1600s, France, England, Turkey, and the United States banned tobacco. Later, in 1776, the Father of economics, Adam Smith, described the underground economy in his book Wealth of Nations. According to Smith, when people’s ability to exchange is limited, they attempt to bypass the restrictions, thus finding new ways to gain that benefit. However, the black market concept got popularized after World War I and the United States Civil War. 

Similar stances occurred with the illegal trade of cotton in 1862. Official records reported several illegal practices during the War of the Rebellion in 1865. They sold salt, food, weapons, coffee, leather, and shoes to the Confederate army units. However, in the mid-19th century, the Union and the Confederacy restricted the liquor trade. Likewise, in 1931, the U.S. also banned the trade of marijuana plants. By 1974, the U.S. underground economy had made $120 to $180 billion, which is 10-15% of the U.S.’s total income.  

The shadow economy exists because of the underlying cause of restrictions, as discussed by Adam Smith. If trade had no restrictions, such an economy would not exist. Excessive control over certain activities forces people to engage in illegal activities. For example, control over drugs and liquor is necessary. Yet, people prefer buying them. Thus, giving rise to the informal economy.

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Causes

Let us look at the causes of underground economy and its influence on the economy:

Causes of underground economy

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#1 – Political And Economic Reasons 

One of the significant causes of underground economy is the political and economic factors. When uneven income distribution occurs, labor finds an alternative to earn more. As a result, they indulge in illegal practices. For example, riches escape taxes, and poorer people slip into poverty. Also, economic crises like inflation and unemployment contribute to the shadow economy. 

#2 – Fiscal Policies

Fiscal policies drafted by the government can lead to a shadow economy. For example, if strict customs and duties get imposed on trade, people will find a way out, thus creating a new economy. Likewise, bans on harmful substances encourage people to turn into smugglers. Other fiscal factors include high taxes, improper audit practices, and others. 

The country’s judiciary system plays a vital role in the black market. Unclear laws and regulations can lead to illegal practices and crime. Likewise, frequent changes in laws can create a loophole in the system, thus benefiting the offenders. Organizational factors like incomplete business data and misleading reports can cause a black market. 

#4 – Social And Psychological Traits

It refers to the social behavior of the consumer. So put, it is the psychological behavior of a person toward the restrictions. For example, someone who has dealt with drugs or any banned item will try to hide the evidence. Likewise, citizens might show fewer profits to escape taxes. 

Effects 

Let us look at the effects of underground economy on the country:

#1 – Constant Fluctuations In Prices

As people continue trading in the shadow economy, their prices fluctuate. For example, a person sells high-priced marijuana on the black market. Since it is a legal crime, there are high chances of getting caught. Thus, the prices are always high and low depending on the demand and supply. 

#2 – Disruptive Economic Structure

Because of the shadow economy, the statistics of an economy are never correct. There are many missing figures and wrong income calculations. The GDP (Gross domestic product) levels are also reported as low. In addition, the unemployment and inflation rates get hyped. As a result, investors and economists find it hard to trust the data. 

#3 – Instability In Money Supply

Since the transactions continuously occur in the informal economy, there are high mortgages. People tend to borrow and lend money. However, it does not get reflected in the system. As a result, the central banks irregulate the money supply in the economy.

Examples of Underground Economy

Let us look at the examples of underground economy to comprehend the concept better:

Example #1

Suppose Canada notices a rise in the trade of drugs in its country, so they announce a ban on it. Almost 21% of the Canadian population has an addiction to drugs. However, they realize the ban imposed by the government. If they try to trade it, they will commit a legal offense. As a result, these people will continue to consume it no matter what.

Some dealers try to sell it secretly at a higher price without revealing the transactions. Likewise, the company producing it will do the same. Therefore, they will continue dealing in it with secret dealers. Also, the drug company will hide the transactions in their balance sheets to escape the taxes. Thus, contributing to the effects of underground economy. 

Example #2

China tops the underground economy by country in terms of human transplants. The global underground economy country-wise had dropped from 16.48% to 16.07% in 2021. Of it, $7 billion includes illegal logging. Only Iran is the sole owner to make it legal. However, other countries cannot perform it but donate them. As a result, many smugglers are illegally buying human organs. 

Another case study is about African racketeer Stephanie St. Clair. In 1917, she invested $10000 in a shadow lottery and made millions out of it. However, she donated the money back to the black community. In the first week of September 2022, the Council of Europe hosted the underground economy conference. The conference aimed at reducing the black market all across the continent.  

Advantages And Disadvantages

The shadow economy has a significant role to play in the global market. It brings competition to the surface and increases employment opportunities. Also, they provide an additional source of income for the country.

However, there are similar disadvantages to the underground economy. The economy slips into a debt crisis. There is inflation attacking the country. Also, a country’s GDP is wrong, leading to substantial tax losses. As a result, the statistical data obtained comes out wrong. However, some European countries conduct an underground economy conference to reduce their size. 

AdvantagesDisadvantages
Increased employment opportunitiesDebt crisis
Increased total revenuesRise in Inflation
Competition risesWrong statistical data
 Huge tax losses

Frequently Asked Questions (FAQs)

Can the underground economy lead to recession?

No, it cannot cause a recession because the share of the shadow economy is relatively smaller. And the underground transactions cannot cause a shortage in the whole economy. However, some shadow economies might hide their income in a recession. 

How does the underground economy affect the GDP?

Both GDP and the shadow economy have an interrelation. GDP is the total amount of gross products sold within the economy. In contrast, the shadow economy does not reveal the number of goods sold. So, while calculating, the real economy will consider only transparent transactions, leaving behind illegal ones. As the GDP shown does not include all products, the GDP will be inaccurate (or low). 

What jobs are likely part of the underground economy?

The following jobs are a part of underground economies:
– Human trafficking
– Dealing with drugs and harmful substances
– Gambling
– Smuggling endangered species, human organs, and others.

Why is it difficult to suppress the underground economy?

The main reason it is difficult to compress the shadow economy is restrictions. Until restrictions are strict, underground economies will tend to grow. People will continue indulging in illegal practices. 

This article has been a guide to what is Underground Economy. We explain its causes, effects, examples, advantages, and disadvantages. You can learn more about it from the following articles –

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