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The Black Economy In Ireland


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The Black Economy In Ireland

  1. 1. THE BLACK ECONOMY IN IRELAND The present paper aims to shed some light on this issue by reviewing international evidence and examining some of the existing evidence for the Irish case. In addition, a new updated estimate is presented of the scale of the black economy in Ireland which allows one to assess both the current level and the development of the sector overtime. While numerous approaches, of varying degrees of ingenuity, have been put forward to estimate this quantity, the fact that a major objective of black economy While there is a general perception that an extensive black participants is to conceal their activities from public, view means economy exists In Ireland, quantitative estimates of its size that measuring the black economy can only be carried out by are more difficult to obtain, which is not surprising in view of the desire of participants in the sector to conceal their indirect means and that any such estimates must inevitably be activities from public view The present paper seeks to make a treated with caution. Thus, at this stage, no particular contribution in this respect by reviewing existing evidence measurement approach can be considered fully satisfactory, and both internationally and in the Irish context, and by presenting new estimates of the size of the black economy in the results presented here, as with all other results, must be Ireland. Depending on the technique employed, estimates regarded as highly tentative. suggest that the black economy, amounts to at least 3% of GNP (about £1 billion) and could be as high as 10-11% of GN(3.6’b.iliión). In addition, the relative importance of the The paper is structured as follows. Section 2 provides a review of black economy appears to have increased over time as a the definitional issues arising in connection with the black consequence of the substantial rise in the tax burden which economy. Section 3 reviews the alternative approaches which have occurred since the early 1960s. been employed in the international literature and refers, where relevant, to the existing evidence for the Irish case. Section 4 INTRODUCTION presents an updated estimate of the size of the black economy in It is widely believed that there is an extensive black economy in Ireland using a monetary technique based on trends in currency Ireland. Numerous media reports highlight cases of tax evasion, holding. Section 5 presents the conclusions. social welfare fraud and of spectacular sums earned through various illegal activities. In day-to-day life as consumers or DEFINITION OF ‘BLACK ECONOMY’ producers, it is virtually impossible for individuals to avoid coming The concept of the black economy which is examined here is the into contact with the ‘shadowy figures who inhabit the black one put forward by Smith (1986) and which is illustrated in Chart 1. economy’. Yet while such impressionistic reports are useful, the Total Economic Activity comprises all production of goods and actual quantitative importance of the black economy relative to the services whether sold in markets or not. The formal economy is ‘official economy’ remains a largely unresolved yet important that portion of total economic activity which appears in official question. estimates of national income. It includes both recorded market
  2. 2. activity and non-market activity such as public administration and and various illegal activities such as prostitution, illegal drug sales various imputations (e.g. rent on owner-occupied housing). etc. CHART 1: THE SHADOW ECONOMY, THE FORMAL ECONOMY AND CHART 2: TYPICAL ACTIVITIES IN THE BLACK ECONOMY THE BLACK ECOHOMY A - Activities that should, in principle, be included in measured GDP but urn net because the’ are hidden. B - Activities excluded from GDP by convention. The shadow economy - as defined by Smith - comprises that part of total economic activity which is excluded from the official measurement process. Some items are excluded for conceptual reasons (e.g. home production, DIY and gardening). However, other components are not recorded because of the desire of participants to conceal their activities (e.g. crime or tax evasion). This ALTERNATIVE APPROACHES TO MEASURING THE BLACK ECONOMY component of the shadow economy is defined by Smith as the black economy and is the focus of this study. The sort of activities Clearly, a key objective of participants in the black economy is to which typically occur in this sector are presented in Chart 2. Such conceal their activities from the authorities, in order to evade activities include various components of individual or corporate taxation or prosecution. It is hardly surprising, therefore, that incomes which are not reported to the authorities in order to evade estimation of the scale of the black economy poses a formidable taxation, working while claiming unemployment compensation, challenge. Nonetheless, researchers have developed a range of
  3. 3. techniques to derive estimates of the size of this sector, many of COMPLIANCE METHODS which have already been applied in the Irish context. According to The second approach is based on tax auditing and other compliance Frey and Pommerehne (1984), there are five basic approaches to methods. This relies on data generated in the enforcement of tax estimating the extent of the black economy. laws and in efforts by the tax authorities to uncover hidden income either through understatement or non-tiling of returns. A number SURVEY METHODS of difficulties beset this approach. Firstly, using tax compliance data The first approach is based on voluntary surveys and samples. is equivalent to using a sample of the population. However, since Basically, this involves surveying a sample of the population to the selection of taxpayers for tax audit is not random, in general, determine the extent of the involvement in black economy activity. but based on properties of submitted returns which indicate a This approach has been applied in Norway and Italy, for example. likelihood of evasion, the sample is not a random sample of the One obvious difficulty is the reluctance of black economy population. This factor is likely to bias compliance-based estimates participants to take part in such surveys. This sample selection bias of the black economy upwards. Secondly, estimates based on tax implies that the results of these surveys are likely to underestimate audits reflect that portion of black economy income which the the extent of the black economy. A recent example of this approach authorities succeeded in discovering. This is likely to be only a in the Irish conf ext was a survey of the unemployed carried out by fraction of hidden income. For example, evidence for the US the Central Statistics Office (CSO, 1996), in order to investigate the suggests that tax audits only uncover about a quarter of the income sizeable discrepancies which exist between the Live Register and of taxpayers selected for audit. In this regard, use of tax compliance Labour Force Survey measures of unemployment. According to the data may be like using the number of convictions secured by the results, only about 50% of those surveyed could be classified as police as a measure of the level of crime. In any event, this unemployed on the basis of standard criteria. Of the rest, some approach has not been applied in the Irish context. 11% of respondents admitted to being in full-time employment while claiming unemployment payments, while a further 7% were NATIONAL ACCOUNTS DATA in part-time employment. The remaining 30% were classified as The third approach is based on national accounts data. This has two economically inactive (e.g. students, retired, not seeking aspects. The first is direct estimation by national accounts employment etc.). While the survey suggests a considerable statisticians of undeclared incomes. In this context, statisticians incidence of working and claiming at the same time, it is difficult to attempt to make adjustments for under-coverage of tax returns by, extrapolate from this a quantitative measure of the black economy. for example, comparing the number of employees and self- To do so, one would also need to take into account undeclared employed reporting to the tax authorities with the number incomes of those not claiming unemployment payments and the recorded in other statistical sources such as the Census of distinct possibility that the percentage of those working while Population and the Labour Force Survey. Adjustments are also claiming is higher than indicated by the survey. made for under-reporting of incomes.
  4. 4. This involves comparison of typical declared incomes with GNP in 1992. It was noted that the evidence suggested that the measures available from other sources, e.g. survey data. In the Irish black economy had risen significantly up to the mid-1980s as a case, these two types of adjustments typically amount to around consequence of the rising burden of taxation over the period. 3% of GNP. The second aspect involves a comparison of the estimated national income (allowing for the adjustments just ECONOMETRIC ANALYSIS measured) with independent estimates of total expenditure in the The fifth approach developed by Frey and Weck (1984) is based on national accounts (McAfee, 1980). In theory, total expenditure an econometric analysis on the relationship between determinants should equal total income; to the extent, however, that the former of the black economy, e.g. tax rates, tax morality, et’., and exceeds the latter, it points to a possible understatement of indicators of its size such as participation rates, hours worked etc. incomes. In the Irish case, however, this test has become irrelevant The technique enables the authors to estimate an unobserved since, of tat, the estimated income exceeds expenditure. Thus, hidden economy variable for a number of economies, including information generated in producing the Irish national accounts Ireland. The authors estimate that the Irish black economy suggests a black economy amounting to around 3% of GNP. accounted for 7¼% of GNP in 1978. The methodology has, however been subjected to strong criticism (Helburger and Knepel, 1988). MONETARY METHODS The fourth approach, and perhaps the most popular, is the TABLE 1: INTERNATIONAL ESTIMATES OF THE SIZE OF THE BLACK monetary approach. There are various techniques under this ECONOMY IN 1976 heading, but almost all in some way rely on the idea that, in order to conceal black economy income, currency is the main transactions medium in the black economy. Thus, by deriving estimates of excess currency holdings and tracking the evolution of this variable overtime, it is possible to estimate the trends in black economy activity. The main exponents of the various monetary approaches include Guttman (1977), Feige (1980) and Tanzi (1983). Monetary approaches suffer from a number of difficulties, the most fundamental of which is the fact that demand for currency reflects a number of factors other than the extent of the black economy. In Source: Prey and Pommerhene (1982) and Fege (1989) any event, a number of these approaches have been applied to the Irish case by Boyle (1982 and 1984) and, more recently, by Fagan In order to provide an impression of how the various methods work (1994). In the latter study, various monetary techniques pointed to in practice, estimates of the size of the black economy (as a a black economy amounting to between 8% and 11% of published percentage of GNP) in the US, UK, Germany and Sweden using different approaches are presented in Table 1. For the US,
  5. 5. estimates range from a low of 4% to a high of 28%. For the UK the YB = M B x V range is from 2.5% to 15%; estimates varying from 5% to 12% are reported for Germany while Swedish estimates range from where YB is the amount of income generated in the black economy. 2-6% to 13%. It is clear from this Table that there is considerable This is the central idea behind various monetary methods used. international variation in estimates of the extent of the black economy. It is also very evident that different techniques yield Of course, the main difficulty with this approach lies in estimating strikingly different estimates. In general, estimates based on tax the money holdings of black economy participants (MB). Here the auditing and national accounts discrepancies give rise to standard assumption employed is that their monetary holdings take significantly lower estimates than monetary based estimates. the form of currency holdings rather than deposits, since it is Within the monetary approach, the fixed currency ratio method argued that the anonymity of currency as against bank deposits will and Feige’s transaction method generally give rise to higher make these funds difficult to trace and, therefore, will help to avoid estimates than Tanzi’s currency equation approach. detection by the authorities. Hence, if we can obtain a measure of ‘excess currency holdings’, we can use the quantity equation to A MONETARY ESTIMATE OF IRELAND’S BLACK ECONOMY estimate black economy income. A number of approaches to this question have been put forward and these have been applied to This section presents in more detail the results of applying one of the Irish case by Fagan (1994). The most convincing of these the monetary techniques in order to arrive at an up-to-date methods is that put forward by Tanzi (1983). assessment of the size of the black economy and to assess its evolution overtime. As with all monetary approaches, the starting The Tanzi approach involves the econometric estimation of an point in the measurement is the standard ‘quantity theory of equation for currency holdings which expresses this variable as a money’ relation: function of the usual determinants (income, interest rate, a trend) and, in addition, a measure of the tax burden, which is considered MxV=Y to be the main driving force behind the black economy. Once we have the estimated equation, we can identify the effect of the tax where M is the total money stock, V the velocity of circulation and burden on currency holdings and can calculate that part of currency V is total nominal GNP. This equation, which is an identity that holdings which is due to taxation. Multiplying this by velocity will holds at all points in time, simply states the money stock multiplied provide an estimate of the black economy. by the velocity of circulation equals GNR Now, suppose that an estimate of the money holdings of black economy participants was To be more specific, suppose the following equation is estimated: also available (call this MB). In these circumstances, the total income generated in the black economy could easily be estimated C = a + bY + C R + d T using the quantity equation:
  6. 6. where C is currency holdings by the public, V measured GNP, R an Applying this method to the Irish case[1], yields a measure of the interest rate and T the tax burden (measured by the ratio of tax black economy which is presented in Table 2 and Chart 3. Both revenue to GNP) and a, b, c and d are the estimated parameters. show the implied estimate of the black economy expressed as a Now suppose that in some base year, in which the tax burden was percentage of the official estimate of GNP Note that, in carrying out T0, we assume that the black economy was zero. Then, for any these estimations, a base year black economy amounting to zero other year, the amount of excess currency holdings will be: has been assumed for 1963, in order to ensure compatibility with earlier results reported in Fagan (op. cit.). A number of conclusions C =d (T – T0) are suggested. Using this result, the size of the black economy in that particular Firstly, the method implies that the black economy in Ireland year can be calculated as: amounted to almost 11% of GNP in 1995. This is equivalent to £3.6 billion. Secondly, it is notable that the implied measure of the size YB = CB x V of the black economy has varied significantly overtime. Starting from low levels in the 1960s (recall the base year assumption of a TABLE 2: ESTIMATED SIZE OF THE BLACK ECONOMY IN IRELAND zero black economy in 1963), the implied measure of black economy rose steadily, albeit gradually, as a percentage of published GNP reaching 5.5% of GNP in 1979. Thereafter, this measure of the share of the black economy shot up rapidly in the 1 The calculations presented are based on the following currency demand equation (absolute t-ratios in parentheses): Log(C/M1) = –2.38 + 0.16 Log(GNP) + 0.007 R + 0.019 TAXRATE - 0.024 TREND (8.41) (3.3) (2.8) (4.0) (14.2) R2 = 0.998 DW = 2.4 SER = 0.038 where C/M1 is the ratio of currency to the money stock measure Ml (i.e. currency plus current account deposits), GNP is the published GNP data, R is tong-term Government bond yield, TAXRATE in the ratio of total tax revenue to GNP and TREND is a linear time trend variable. The equation was estimated on annual data covering the period 1960 to 1995. Data on currency holdings, M1 and interest rates are obtained from the IMF International Financial Statistics Yearbook. Data on GNP are obtained from the CSO National Income and Expenditure (various issues) while total tax revenue is obtained from the Budget Publication. In order to assess its adequacy in explaining the data, the equation was subjected to a battery of statistical tests, all of which were passed at the five percent level.
  7. 7. mid-1980s to reach a high of over 13% in 1984, before declining may be influenced by factors not included in our estimated somewhat over the remainder of the period under consideration. equation (e.g. the development of alternative payment media, Note that, by construction, the measure of the black economy credit and debit cards, the introduction of ATMs etc.) which may implied here follows closely the evolution of the tax burden lead to bias in the estimation of the effects of taxes on currency (measured by the ratio of total tax revenue to GNP, which is holdings. Fourthly, the results obtained are highly model- referred to as the average tax rate) over the period. Thus, in the dependent, with the estimated equation parameters exerting a early 1960s the average tax rate was 17%; by the 1990s this rate crucial influence. Thus, although the approach adopted here was had risen to over 33%. the same as in Fagan (1994), the present estimates of the size of the black economy for the year 1992 is some three percentage CHART 3: ESTIMATED SIZE OF THE BLACK ECONOMY 1963-1995 points of GNP higher than the earlier results, reflecting some modification to the equation specification and parameter estimates. Finally, it should be noted that the calculation has been based on the assumption that the black economy amounted to zero in 1963 which, again, is questionable. However, to the extent that this assumption is false, it would imply, in the absence of other problems, that these estimates would provide lower bounds for the size of the black economy, i.e. the black economy would be equal to or greater than the estimates presented here. CONCLUSIONS Given the desire of participants to conceal their activities from the In any event, it is stressed that the estimates presented here are authorities, it is hardly surprising that the measurement of the scale highly tentative since there are a number of limitations which apply of the black economy poses formidable challenges. Nonetheless, to the underlying methodology. Firstly, in line with most monetary various techniques have been developed for this purpose and, in methods, the present approach assumes that currency is the some cases, have been applied in an Irish context. Given the preferred medium for black economy participants. To the extent inherent difficulties, any estimate of this kind must be viewed as that this is not true and other media are employed, e.g. bank highly tentative, since estimates differ markedly depending on the deposits at home and abroad, other assets such as land or particular approach adopted. property, then the method may prove to be inaccurate. Secondly, the calculation is based on the assumption that the velocity of That said, the available evidence points to the existence of a black circulation is the same in the official and black economies, which economy of a significant scale in the Irish case. Discrepancies in the may not be accurate. Thirdly, the evolution of currency holdings
  8. 8. national accounts are consistent with, existence of a black economy Feige, E. (ed.) (1986), The Underground Economies: Tax Evasion and amounting to about 3% of GNP (about £1 billion). In contrast, Information Distortion, Cambridge. the monetary estimate developed in this paper suggests that the black economy could currently be as high as 10-11% of GNP (E3.6 Feige, E. (1986), “A Re-Examination of the Underground Economy billion). in the United States”, IMF Staff Papers, 33 (4). Whatever about the actual level, there are strong grounds for Feige, E. (1979), “How Big is the Irregular Economy?”, Challenge, believing that the importance of the black economy in Ireland has November/December. changed significantly over time. In particular, the substantial of the rise in the tax burden which occurred since the early 1960s appears Frey, B.S. and Pommerhene, W. (1984), ‘The Hidden Economy: to have led to a sizeable increase in the relative importance of the State and Prospects for Measurement ”, Review of Income and black economy. Wealth, March. REFERENCES Frey, B.S. and Weck, H. (1984), “The Hidden Economy as an Boyle, G.E. (1982), “A Glimpse at the Non-accounted Economy”, Unobserved Variable”, European Economic Review, 26 (1), Central Bank of Ireland Technical Paper, No. 2/82, March. October/November. Boyle, G.E. (1984), “In Search of Ireland’s Black Economy”, Irish Gutmann, P.M. (1977), “The Subterranean Economy”, Financial Banking Review, March. Analysts Journal, . November/December. CSO (1987), Labour Force Survey. Helburger, C. and Knepel, H. (1988), “How Big is the Shadow CSO (1990), National Income and Expenditure. Economy: A Re-Analysis Unobserved Variable Approach of Frey and Weck-Hanneman”, European Economic Review, 32. CSO (1996), Unemployment Statistics: Study of the Difference between the Labour Force Survey (LFS) Estimates of Unemployment MacAfee, K. (1980), “A Glimpse at the Hidden Economy in the and the Live Register. National Accounts”, Economic Trends, 316, February. Fagan, G.P. (1994), “Measuring the Size of Ireland’s Black Smith, S. (1986), Britain’s Shadow Economy, Oxford. Economy”, Journal of the Statistical and Social Inquiry Society of Ireland, XXVII (I).