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East: The Black Economy -- How Can You Measure What Is Hidden? (Part 2)

  • Mark Baker

In some countries, the "black," or underground, economy rivals the size of the official economy. It has flourished particularly in the transition countries of Eastern Europe and the former Soviet Union. Yet because these transactions are hidden, their impact remains poorly understood. In this second of a two-part series, RFE/RL's Mark Baker looks at some of the innovative techniques economists have developed to measure the black economy.

Prague, 11 June 2004 (RFE/RL) -- Every year, in countries around the world, billions of dollars change hands in payments that are never recorded or taxed.

This is the black economy -- the "underground" or "off-the-books" economy -- where payments are made in cash and banks are scrupulously avoided.

The term "black economy" usually conjures up images of illegal or illicit activities -- like drug-dealing or prostitution. But in fact, most "black" transactions are for activities that are legal but concealed to avoid tax or other government regulations. Economists say this "legal" black economy may be three to four times bigger than the illegal one.

National governments have a strong interest in knowing the size of the black economy -- if only to gauge how much revenue they are losing to tax evasion. But since these transactions are hidden there's no easy way to measure them.

In the absence of reliable statistics, economists have come up with clever and unorthodox methods for calculating the black economy. Friedrich Schneider at Austria's University of Linz is one of a few dozen economists around the world at the forefront of efforts to measure the underground economy.

"Measuring the shadow economy is a [very, very] difficult problem. It's not easy to define the shadow economy. In many countries, there are different definitions that are given," Schneider says.

He says that one popular method measures the amount of cash in circulation in a given society and then subtracts the cash that is assumed to be needed to carry out legitimate, open transactions. This method is based on an assumption that most black economy transactions are conducted in cash, since it leaves no trace.

Schneider explains: "Another method to estimate the shadow economy is the 'currency demand' method, in which you analyze the amount of cash people have in their pockets and separate from this the amount of cash people have for all legal activities -- like buying cigarettes or newspapers. And then [you] try to analyze this amount of cash they use to pay shadow economy workers."

The "cash demand" method has been criticized for several reasons. It tends to work better in developed countries where cash is not the sole means of payment and cash flows can be measured more easily. It's seen as less accurate in poorer countries, where nearly all transactions -- hidden, open, legal, illegal -- are conducted in cash.

The black economy is prevalent to some degree in all countries -- as people everywhere fight a temptation to hide income from tax authorities. But the problem is particularly severe in the transition countries of Eastern Europe and the former Soviet Union. There, in the past, huge parallel economies often arose to fill needs not provided by the state-run sector.

These parallel structures are still in place in many areas, and countries like Georgia, Azerbaijan, Ukraine, and Belarus rank among world leaders in the size of their underground economies as a percentage of GDP. But measuring the size of the black economy there is particularly hard. The economies are largely cash-based and the currency-demand method may not be accurate for measuring the black economy.

Schneider says one alternative method involves measuring the total consumption of electricity in a country -- and then subtracting the amount that is assumed to be needed for legitimate uses. The difference, he says, indicates the size of the shadow economy.

"Quite often such a measurement is done with the 'electricity consumption' approach, which is only partly reliable in a scientific sense because even when you succeed to isolate the amount of electricity that is used for shadow economic activities, you do not need electricity for all shadow economy activities, and much more important, even if you succeed in measuring all of these millions of kilowatt hours [of electricity] used for the shadow economy, you still have the problem to convert it into value added figures," Schneider says.

Economists themselves concede the findings are only approximations. Schneider admits his error margin is plus or minus 10 percent.

More important than the actual size of the black economy may be the general trends -- and these appear similar regardless of how the underground economy is measured. The black economy appears to thrive in countries where populations distrust the authorities and where corruption is rife. In place like Georgia, Nigeria, Bolivia and Azerbaijan the black economy approaches two-thirds of GDP.

Invariably, it appears, the black economy diminishes where transparency increases and the faith of citizens in the authorities and tax policies rises.

For Part 1 of this report, please click here