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Underground Economy

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  • Erik Reuter
    http://online.barrons.com/article/SB110445261525213540.html Going Underground The shadow economy is about to top $1 trillion -- at a great cost to many
    Message 1 of 3 , Jan 1, 2005
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      Going Underground
      The shadow economy is about to top $1 trillion -- at a great cost to many

      Monday, January 3, 2005

      AMERICA HAS TWO ECONOMIES, and one is flourishing at the expense of
      the other. First, there's the legitimate economy, in which craftsmen
      are licensed and employers and employees pay taxes. Then there's
      the fast-growing underground economy, where millions of nannies,
      construction workers and others are paid off-the-books, their incomes
      largely untaxed. The best guess as to the size of the output of this
      shadow economy is about $970 billion, or nearly 9% that of the real
      economy. It should soon pass $1 trillion.

      What is largely fueling the underground economy, experts say, is the
      nation's swelling ranks of low-wage illegal immigrants. The government
      puts this population at 8.5 million, but that may represent a serious
      undercount. Robert Justich, a senior managing director at Bear Stearns
      Asset Management in New York, makes a persuasive case in a forthcoming
      paper, "The Underground Labor Force Is Rising to the Surface," that
      illegal immigrants actually number 18 million to 20 million. If true,
      the economic implications are profound and could help shape debates
      slated in Washington this year over both immigration policies and tax

      Measuring the size of the underground economy is, of course, more art
      than science, since most of its denizens seek to remain anonymous. But
      convincing anecdotal evidence and a number of credible academic studies
      suggest that it is expanding briskly -- probably by an average of 5.6% a
      year since the early 1990s, edging out the real economy.

      In the process, the underground economy is undermining the effectiveness
      of the Internal Revenue Service, which is highly dependent on employees'
      withholding taxes. If the IRS could collect all the taxes it says that
      it is owed from the underground economy in a given year, then the
      current budget deficit would disappear overnight. And if the IRS could
      collect these taxes every year, then the nation would have surpluses as
      far as the eye can see.

      The IRS has estimated that its tax gap -- the estimated amount of taxes
      owed minus the amount collected -- is around $311 billion in any given
      year. The agency will produce a new estimate in 2005, and it could be as
      high as $400 billion, says former IRS Commissioner Donald Alexander. Now
      a lawyer in Washington, he cites a rise in private contracting and the
      opportunities it affords for not reporting income.

      The gap number measures only a portion of the underground
      economy. Because the number is extrapolated from audited returns, it
      makes no allowances for criminal enterprises that report no income, and
      it even fails to capture some garden varieties of nonreporting. The
      unreported wages of illegal immigrants alone could be costing the
      government another $50 billion a year, says Justich.

      Growth of the underground economy is partly a result of corporate
      downsizing, which has forced many former employees to go out on their

      "We have had an 85% taxpayer compliance rate," says Nina Olson, the
      IRS's taxpayer advocate. "I expect the number to decline," because
      the portion of employees subject to withholding is on the wane. Such
      employees are 99% compliant with tax laws, she says, but in the
      21st-century economy, "More and more people are being treated as
      independent contractors. We are losing people from the withholding

      Entrepreneurs often are stymied by the complexity of estimating their
      taxes and making quarterly payments, which leads to mistakes or
      out-and-out avoidance. The growth of online commerce may be exacerbating
      the situation. There were over 40 million regular users of eBay alone in
      2003, up from 23 million in 2002. The sellers are responsible for paying
      taxes. Some of them set up a business and get a taxpayer ID number;
      others don't. (An eBay spokesman says the company isn't a tax adviser --
      it's up to members to report their taxes.)

      Most unsettling to IRS bureaucrats, taxpayers as a group appear to have
      become less honest. Former New York City Police Commissioner Bernard
      Kerik is the latest poster boy for the phenomenon. He had to drop his
      bid to become secretary of homeland security because he failed to pay
      Social Security taxes for his children's illegal-immigrant nanny.

      Kerik is hardly alone: Any homeowner who has been offered two prices by
      a handyman or a gardener -- a higher one for a payment by check, a lower
      one for all cash -- knows how quickly the savings can add up. In one
      twist on off-the-books business, the New York Times recently reported
      on a rise in mechanics who repair cars at curbside for untraceable cash
      payments. They are not in want of customers. In some cities, including
      Boston, owners of battered cars get similar offers from itinerant
      body-repair "experts."

      In speeches, IRS Commissioner Mark Everson is fond of citing a survey
      by his agency showing that the number of Americans who consider
      tax-cheating acceptable rose from 11% in 1999 to 17% in 2003.

      Former Commissioner Alexander, who ran the agency during the Nixon, Ford
      and Carter administrations, said he urged Congress to pass a law making
      customers responsible for withholding some taxes on services provided
      by carpenters, plumbers and other self-employed contractors. Customers
      would have had to hold back 5% of the cost of services and forward it to
      the IRS, but Congress failed to embrace the measure.

      Result: The underground economy has kept growing nearly
      unchecked. Academics accept the work of Austrian Friedrich Schneider
      as the best estimate of the underground economy's size. Using data on
      currency flows and the consumption of electricity, he guessed that in
      1996 it was about 8.8% of the nation's gross domestic product. This
      estimate was made before the flood of immigration from South America, so
      it might be conservative if used today, when the nation's GDP stands at
      $11 trillion.

      To be sure, the U.S. underground economy, as a percentage of GDP,
      is smaller than those of some other countries. In a 2000 paper in
      a publication of the Independent Institute, a nonprofit research
      organization, Schneider found that Greece, as of 1998, had the largest
      underground economy, at 29% of its GDP, followed by Italy at 27.8% and
      Spain at 23.4%. Countries with high tax burdens and high social security
      costs lead the list.

      But the sheer growth of the underground economy in the U.S. is cause
      for concern. If Justich's estimate of illegal immigrant workers is
      correct, the underground economy may now be growing at a markedly faster
      rate than the legitimate economy. Justich, working with Bear Stearns
      colleague Betty Ng, an emerging- markets economist, says he's found
      evidence of a larger illegal immigrant population by analyzing data on
      construction and on remittances sent from the U.S. to Mexico and other
      countries. He also had conversations with over 100 immigrants from
      Mexico, Brazil, the Dominican Republic, Guinea, China and Tibet. And he
      interviewed local business owners, real-estate sales people and police.

      Justich, a veteran securities analyst, currently specializes in
      fixed-income strategies at Bear Stearns Asset Management, which oversees
      some $29 billion in investments. He began digging into the underground
      economy because of its broad ramifications for the real economy. In his
      spare time, he has been exploring the immigrant communities of northern
      New Jersey for his work as executive producer of a documentary film
      about immigrants and the importance of their former national anthems in
      their lives.

      >From all this, Justich concludes that Fed Chairman Alan Greenspan's
      estimates of productivity gains are overly rosy. "The productivity
      miracle may be slightly overstated because they are counting the output
      of millions of illegal immigrants but not counting the input," he
      says. Likewise, long-term budget projections could be overstating the
      potential growth of the legitimate U.S. economy or underestimating
      the need for high illegal immigrant flows to hit the forecast growth

      Ideas like that could well become food for thought for House Ways and
      Means Committee Chairman Bill Thomas of California. He wants to push
      ahead with tax reform this year, including the creation of a national
      sales tax and reduction of income taxes. In theory, a sales tax would
      capture the underground economy, since all wage earners have to spend
      money to live.

      A larger number of illegal immigrants also would have a profound
      impact on coming discussions on immigration reform. President Bush
      proposes temporary amnesty for illegal aliens already in the country,
      allowing them to obtain permits to work legally for three years and
      stay longer if their jobs otherwise can't be filled by native-born
      workers. But if there are, in fact, 20 million illegal aliens, the Bush
      proposal could engender a situation not unlike the German unification
      of the 1990s, which triggered huge demand for social services in East
      Germany. Unanticipated costs here could be enormous.

      Steven Camarota of the privately funded Center for Immigration Studies
      in Washington asserts that the net cost to the government for amnesty,
      based on a population size of 10 million, would have been $10 billion if
      carried out in 2002. The total cost would be $26.3 billion minus about
      $16 billion in new taxes from the immigrants. The costs would arise
      because the illegal immigrants, most of whom are poorly educated, would
      begin to become heavier users of government services like food stamps,
      schools and Medicare.

      Camarota, who does contract work for the Census Bureau, doesn't think
      that U.S. birth and death records support Justich's claim of 15 million
      to 20 million illegal immigrants. But Camarota says that he isn't
      suggesting that the debate is settled. There are other statistics, like
      unemployment data, that might suggest slightly larger numbers.

      JUSTICH CERTAINLY HAS DUG DEEPER for data at the local level than most
      researchers when preparing his report for his company's investors. He
      has unearthed data on building permits that show construction of
      multifamily dwelling units is up six-fold in immigrant communities while
      census data show just a small percentage increase in population in those
      same communities.

      Justich's analysis of remittances from the U.S. to Mexico also
      indicates a larger population of immigrants than the official numbers
      show. According to a study by a Georgetown University professor, Manuel
      Orozco, for the Pew Hispanic Center, remittances to Mexico tripled to
      $13.2 billion between 1995 and 2000. Yet the official tally of Mexicans
      in the U.S. rose 56% and the estimate of their weekly wages rose 10%.

      Similarly, a California official told Barron's of an anecdote that
      calls official numbers into real question. Bill Leonard, a member
      of California's Board of Equalization, said he was involved in
      redistricting his state's congressional districts in 2001. Some areas
      that were the same size in population as others, based on census data,
      ended up having five times as many unregistered voters. Most of the
      extra people were noncitizens, he says. Leonard also says that the
      number of active retail permits in the state has been stable for several
      years at one million -- a sign, he asserts, that stiff competition from
      unlicensed businesses may be keeping new entrants out of the retail

      Leonard estimates that California loses $100 million in sales taxes each
      year to the underground economy.

      The IRS's Olson, who operates as Joe Taxpayer's ombudsman, says that tax
      collectors and cops enthusiastically pursue two groups of tax evaders
      -- the underpayers and the crooks. But she says there's little effort
      at the federal level to capture the sidewalk vendor who's hiding most
      of his income or to ferret out which of the many lawn-care services
      operating in suburban neighborhoods is skipping taxes. The authorities
      just don't perceive a big enough bang for the enforcement costs.

      The truth is, employers hiring illegal workers have little to fear from
      the government right now. Data from the U.S. Citizenship and Immigration
      Services, as the old Immigration and Naturalization Service has been
      dubbed since being shifted to the Department of Homeland Security, show
      that enforcement actions against employers and illegal workers have
      dropped sharply since 1997. Back then, there were about 18,000 arrests
      a year resulting from investigations of employers using illegal alien
      workers, but in 2002 there were fewer than 1,000 arrests. Instead,
      agents are trying to catch workers at border-crossing points. Opponents
      argue that cracking down on employers would be more effective. If
      immigrants couldn't get work, the argument goes, they wouldn't bother to

      THE DECLINE IN ARRESTS COINCIDES with a broader easing of enforcement
      actions by the IRS -- following criticism of overzealous collections
      in the early 1990s. Audits of individuals dropped from three for every
      thousand tax returns in 1998 to two in 1,000 in 2003, according to
      Syracuse University's Transactional Records Access Clearinghouse. And
      audits of corporations dropped 26% in the first six months of 2004 from
      the same period a year earlier. [Lengthening Shadows]

      There are signs that tide may be turning. The IRS last year added
      2,200 enforcement employees. Olson, for her part, favors more spot
      audits of even the smallest small businesses because, she says, word of
      enforcement actions spread like wildfire and make others think twice
      about cheating. And Sen. Kent Conrad, a Democrat from North Dakota, has
      been calling vociferously for an increase in the IRS budget to allow for
      more aggressive enforcement.

      In the meantime, however, employment of illegal immigrants is
      flourishing. Justich believes that undocumented workers now hold 12
      million to 15 million jobs in the U.S. If those showed up in official
      data, the Bush administration's job-creation record would look
      significantly better. In fact, four million to six million of these
      positions have moved from the legitimate economy into the underground
      economy in recent years, he says.

      While exploring northern New Jersey for the documentary -- he's
      producing it with Gary Dial of the Manhattan School of Music and singer
      Terre Roche -- Justich was struck by the economic impact of Brazilian
      immigrants on a neighborhood of Newark adjacent to the city's Penn
      Station. Sidewalks and stores are packed with shoppers. Restaurants are
      filled with diners. New three-family housing units are popping up block
      after block.

      Justich began doing some detective work. He and his colleague Ng
      compared housing permits in the gateway communities with census data
      and were shocked at the results. The census data indicate that the
      populations of Newark, New Brunswick and Elizabeth grew by 5.6% between
      1990 and 2003, and less than the 9% growth in their three corresponding
      counties. Yet housing permits in the three cities were up six-fold
      versus a three-fold increase for the counties; and 80% of the permits
      in the cities were for multifamily dwellings. That struck him as a huge
      disconnect, suggesting the immigrant populations are larger than shown
      by the census.

      Leonard of California holds a seminar on the state's underground
      economy every year for officials and legitimate businessmen. They
      brainstorm ways to bring entrepreneurs out of the shadows and onto the
      tax roles. Leonard says the state has tried tax amnesty programs: "We
      had a 60-day window and waived a 10% penalty for nonpayment," he
      recalls. But the accumulated interest on the unpaid taxes for many
      people was more than their back taxes, so the program didn't go far
      enough to get more people to come out, he says.

      A state amnesty program in 2004 netted $1.4 billion in back taxes from
      857 individuals and 340 businesses. For the most part, these were
      wealthy people who had become involved with questionable offshore tax
      shelters. Most of the illegal immigrant businesses gross less than
      $100,000 a year, but there are so many, they probably owe even more.

      Los Angeles, Barron's found, is the most aggressive and successful
      jurisdiction in the country in moving people from the shadow economy
      into the light. The reason for this may be that that the state's amnesty
      program is mostly carrot: Small businessmen have more to gain by going
      legal than they do by remaining in the shadows.

      One piece of the L.A. program provides an exemption from the business
      tax for two years for new licensees with under $100,000 in annual
      gross receipts. For bigger businesses that owe back taxes, the city
      offers flexible repayment plans. Penalties, but not interest, are
      forgiven. Renata Simril, Los Angeles' deputy mayor for economic
      development, says the city spent $2 million to advertise the most
      recent amnesty project, begun in 2002. It was money well-spent. L.A.
      collected business-tax revenues of $21.7 million and added 47,000 new
      tax accounts.

      As Olson points out, it's hard work for someone to stay submerged in the
      underground economy in the 21st century. At some point, perhaps when the
      tax evader wants to buy, say, a house and encounter lenders who demand
      tax returns, the incentive to turn legal can become great. Besides more
      aggressive audits, simpler forms might make the transition from shadow
      to light more attractive, Oslon says.

      One thing is certain: The rest of America is subsidizing the other
      half's free ride, and the costs will only grow if authorities continue
      to underestimate the scope of the problem.


    • Alberto Monteiro
      ... Doublespeak is very funny. Why not blame also the gays or the muslims? What fuels the underground economy are high taxes and bureaucracy. Alberto Monteiro
      Message 2 of 3 , Jan 2, 2005
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        > What is largely fueling the underground economy, experts say, is the
        > nation's swelling ranks of low-wage illegal immigrants.


        Doublespeak is very funny. Why not blame also the gays or the muslims?
        What fuels the underground economy are high taxes and bureaucracy.

        Alberto Monteiro

      • Erik Reuter
        ... Because they aren t largely fueling the underground economy. ... In your expert opinion? Did you get past the second paragraph? -- Erik Reuter
        Message 3 of 3 , Jan 2, 2005
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          On Sun, Jan 02, 2005 at 02:49:43PM +0000, Alberto Monteiro wrote:
          > > What is largely fueling the underground economy, experts say, is the
          > > nation's swelling ranks of low-wage illegal immigrants.
          > :-))))))))))))))))))))))))))
          > Doublespeak is very funny. Why not blame also the gays or the muslims?

          Because they aren't largely fueling the underground economy.

          > What fuels the underground economy are high taxes and bureaucracy.

          In your expert opinion? Did you get past the second paragraph?

          Erik Reuter http://www.erikreuter.net/
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