under ground final

8/3/2019 Under Ground Final

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I. Introduction:

The history of academic research in the field of underground economy is more

than thirty years old, yet to date, there has not been a common viewpoint on the use of

the term underground economy; furthermore, the conclusions that have been drawnare debatable with regard to the consequences produced by underground economy,

and possibly with respect to remedies proposed by public policy for decreasing it. One

of the reasons for insufficient attention to the academic research of the underground

economys consequences is a lack of systematically and by single methodology

collected information concerning the size and importance of underground economy in a

given economy.

There is widespread belief that underground economies arise due to high

statutory tax rates and excessive regulation imposed by governments that lack the

capability to enforce compliance. The presence of underground economies, however,

can hinder macroeconomic management and damage economic growth in several

ways.

First, the loss of government tax revenues can result in larger budget deficits,

which by leading to higher public borrowing requirements can crowd out private

investment. Lower tax revenues can also compromise the quality and quantity of publicgoods provided, thereby impairing economic growth. Second, firms operating

underground cannot make use of market-supporting institutions like the judicial system

and courts and, as a result, may invest too little. For instance, the inability to enforce

legally binding contracts can limit their access to formal capital markets. In addition,

efforts to avoid detection can generate distortions, resulting in a misallocation of

resources in the economy

Therefore, to make states economic policys implementation more effective a

more sophisticated academic research of the underground economys sector must be

undertaken. National policy that is set on information, where real causes of growth of

the underground economy have not been taken into account, can change the balance of

a stable economy to an unstable one, and the chief consequence of that would be

stagflation. If there is a growing underground economys sector, which is not

adequately reflected in statistics, incorrect interpretation of the situation could produce

political solutions that in time could bring on much more serious economic

consequences.


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Similarly, theoretical conclusions on the underground economys effects have

not produced a common viewpoint. On the one hand, the underground economy

damages the social equality principle by redistributing income more beneficially toward

one of the smaller groups of population, thus distorting market competition; on the

other hand, the underground economy sector could become the choice of certain

entrepreneurs in situations, where state transparently interferes excessively in the

individuals activities.

1.1 Background of the study

There is no agreement on how to define the underground economy, or even what

to call it. informal, shadow, black, unofficial, unrecorded, hidden, parallel,

concealed and second economy are all used by researchers to describe roughly the

same phenomenon. The underground economy(or illegal economy) covers market

production ofgoods and services, legal and illegal,which are sold or purchased

illegally. Itis composed of both the irregular economy,where legal goods and services

areproduced and exchanged under illegalconditions, and (productive) black markets,

the preserve of goods and servicesthat are illegal but satisfy all the partiesinvolved.

From table 1, it becomes clear that the underground economy includes

unreported income from the production of legal goods and services either from

monetary or barter transactions hence, all economic activities which would generally

be taxable were they reported to the state (tax) authorities. In general, a precise

definition seems quite difficult, if not impossible, as what Mogensen said that the

shadow economy develops all the time according to the principle of running water: it

adjusts to changes in taxes, to sanctions from the tax authorities and to general moral

attitudes, etc.See, for instance, the feature Controversy: On the Hidden Economy in the

Economic Journal, vol. 109, no. 456,


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It is widespread in time and in space. To some extent this phenomenon is so

deeply rooted that one can think about the existence of a natural rate of underground

economy. Despite improvements and efforts, national accounts are still biased by the

underground activities and this can mislead the policymakers; the shadow economy

affects the design of national tax systems and triggers links between legal and illegal

activities; the hidden economy may impose constraints to public revenues generation

and, therefore, limit the provision of public goods. Thus, in spite of the difficulty of

obtaining reliable statistics of the underground economy, it is important to gather

information about it.

History presents us with a largenumber of prohibition and taxation events that

gaverise to contraband. However, smuggling and otherforms of underground markets

are not only a historicalphenomenon, but an everyday fixture of contemporary

economies: drugs, alcohol, fuel, tobacco, etc.

One should not think of the underground economy as only black markets or

smuggling on irregular markets. The irregular economy mainly includes otherwise legal

services sold under the table like labour services sold to businesses or individuals (in

residential construction and renovation, for example).


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The underground economy must be distinguished clearly and unmistakably from

the criminal activities of the underworld. Government officials and agents are ever

eager to lump both together, the criminals andtheir organization with the producers in

the underground. Both groups areknowingly violating laws and regulations and defying

political authority.But they differ radically in the role they play in society.

The underworldcomprises criminals who are committing acts of bribery, fraud,

and racketeering, and wilfully inflicting wrongs on society. The undergroundeconomy

involves otherwise law-abiding citizens who are seeking refugefrom the wrongs

inflicted on them by government. They are employersand employees who are

rendering valuable services without a license orinspection sticker, or failing to report

their productive activities to thepolitical authorities.

Underground activities can be grouped into four main categories:

1. Economic activity yielding income that is not reported to the tax authorities.

2. Economic production that violates one or several other mandates, such as

compulsory government licensing and rate making, inspection and label laws,labor laws, government regulations of agriculture, export and import controls,

government control over money and banking, governmental control of energy

production and distribution, and countless others. Violators may or may not

evade taxes, but they all work illegally, hiding from swarms of government

inspectors.

3. Productive activity by transfer beneficiaries who draw Social Security benefits or

receive public assistance. Their freedom to work is severely restricted.

4. Productive activity by illegal aliens without residence status. They may pay

income taxes and other taxes, but must remain underground for fear of

deportation.

The underlying cause of the underground economy is found in Adam Smiths

Wealth ofNations. Smith saw the foundation of modern society in the division of labor.


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Every time the propensity to exchange is constrained, individuals try to evade the

constraints in order to obtain what they perceive as the benefits of exchange.

The main impediments to exchange that push individuals to the underground

economy are taxes, excessive regulations, efficiency of the bureaucracy and

corruption. Empirical research shows that the underground economy is larger in the

countries where these impediments are more consequential.

TRENDS AND CURRENT DEVELOPMENT:

The existence of informal activities of underground economy is a fact of life

around the world. As some economists point out, there are also strong indications that

the size of the informal economy is increasing. Some present several hypotheses to

explain this growth. They suggest the expansion of the informal economy is:

Part of the process of economic restructuring following the structural crisis of the

1970sspecifically, the reaction of firms and individual workers to the power of

organized labor;

A reaction against the states regulation of the economy, both in terms of taxes andsocial legislation;

The result of increasing international competition, particularly in labor-intensive

industries;

The process of industrialization in many developing countries, characterized by social

and economic conditions that limit standards previously established by the state.

The result of poverty in which millions of people subject to harsh living conditions are

forced to accept any solution to their misery.

In a more recent survey, people with knowledge about it argue that the most

important and often cited reasons for the growth of the underground economy are the

rise of the burden of taxes and social security contributions; increased regulation in the

official economy, especially of labor markets; forced reduction of weekly working time;


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earlier retirement; unemployment; and the decline of civic virtue and loyalty towards

public institutions combined with decreasing tax ethic.

At the microeconomic level it is important to understand the rationale behind

engaging in informal or illegal activities or transactions. Using a cost-benefit approach,

it was been pointed out that Economic units choose to be partially or completely

informal by weighing the costs and benefits that a legal status entails and considering

their particular institutional and resource constraints. In this sense, the choice to be

illegal is a rational one, a fact which does not imply that some firms are not forced by

their constraints to be either legal or illegal. The price of formality includes costs to

access the formal sector which is the time and monetary costs for obtaining licenses

and registrations and costs to remain in it which is the taxes, regulations and

bureaucratic requirements.

ISSUES:

Many millions of elderly people have gone into retirement consuming their

savings and idling their days away searching for fun and play. They have flocked to

resort and retirement centers in some countries where they support successfulentertainment and amusement industries and promote uncontrolled real estate booms.

In reaction to ever-rising levels of taxation, younger workers may choose to work fewer

hours and take longer vacations. Many may seek to reduce the number of weekly hours

from forty to thirty-five, or even to thirty. Others may seek benefits that are tax-

exempt, such as expense accounts, stock purchase options, club memberships, health

care and insurance benefits, and countless other gratuities. They all are seeking escape

and shelter from the tax collector.

In recent years millions of law-abiding American workers escaped by illegal

methods; they joined the underground economy. High tax rates, soaring inflation, and a

growing doubt of government led them to take this desperate step. No one can know

with certainty just how many workers actually participate in the underground. Yet it is

common knowledge that huge amounts of goods and services are produced without

being reported to government authorities, that the unemployment rate is a lot lower

than the official rates of the Labor Department, and that the actual savings rate is

much higher that commonly thought.


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I.2 Review on related Literature

Theoretical and conceptual framework

Looking at the USA experience, in the 1970ies by utilizing economic prognoses

based on macroeconomic models a marked increase in prognoses errors occurred. This

generated an increased interest in the influence of the unofficial economic activities on

the US economy as a whole and what portion of the prognoses errors were attributable

to the underground economys sector.

Statistics bureaus, administrations, agencies and etc. disseminated information

give signs and promote the economic analyses and the politics. The increasing and

information system avoiding underground economy sector, in circumstances, when

government policy is oriented on full time job policy, can cause the stagflation

syndrome, that accord the changes equally turned against of unemployment rate and

inflation. On the contrary, if the policy is oriented on price stability, increasing

underground economy sector can cause budget deficit in the mentioned situation.

In the context of the fiscal economy, the observed sector refers to the amount of

income that is reported to the fiscal authority. Non-compliance with tax law

generates unreported income, i.e., the difference between the amounts of income

that have to be reported to the tax authority and the amount actually is reported. A

growth of unreported income reduces the ability of the fiscal authority to generate

revenues and, ceteris paribus, generates budget deficits.

Moreover, since the income recorded in the National Accounts system relies on

the data reported to the tax authorities, a growth of unreported income can also lead to

a growth of unrecorded income. In short, a large and growing unobserved sector

reallocates resources away from the sphere of the observation and control. It affects

perception of economic reality and the reality itself. Its allocation and distribution con-

sequences have an important implication for macroeconomic stabilization policy and

tax policy.

The history of academic research in underground economy is more than thirty

years old, but even now, in literature there is still missing unified approach to term use

underground economy. For indicating the phenomenon, underground economythere is called such notions as secret work economy, unofficial, hidden, grey,


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black, parallel, tax free. The use of different terms depends on context which

researchers choose for accenting.

It is possible to classify the underground economy by kind of activity in two ways.

Firstly, by legal transaction: legal (it is not forbidden by law, but for concrete individual itis much better not to declare this transaction) or illegal (those economic activities and

transactions, which are in contradiction with local laws and regulations); Secondly, is

money used as exchange leverage in those transactions.

The relation of economic activity to official sector in the underground economy can be

divided into three parts:

1) Parallel economy (in literature also referred to as white collar)

2) grey economy (informal);

3) Black economy ( secret work).

Table 1 Taxonomy of underground economy relation to official sector

Parallel and black economy induces benefits only for narrow group of individuals,

in the same time making loss to other individuals. On the contrary, grey economy could

induce benefits for all the society by being as an alternative, for example, in economy

with high bureaucracy and different restriction level. From the society and state

administration point of view, there are interesting questions on factors, which could

parallel economic gray economic black economic

subjects

objects

relation to

official

sector

employees in legal

sector

income distribution

without production

do not exist without

official sector

illegal employees

production of legal

goods and services

relatively independent

Criminal

production of illegal

and unlawful goods

and services

independent


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encourage in grey economy involved individuals to complete transition into official

sector. Parallel and black economy sectors have to be not integrated, but

exterminated, and that is why those sectors are analyzed separately from the grey

sector.

Relevant Literature

There is a vast literature on the determinants and consequences of underground

economies. The benefits of operating partially or completely in an underground

economy generally relate to firms desire to evade taxes, regulations or other

institutional distortions.

For instance, higher effective tax rates and other onerous regulations can make

operating in the underground economy more attractive by imposing high entry costs to

legality (de Soto (1987), Loayza (1996), Rauch (1991)). In many developing countries,

taxes on formal firms constitute a major source of government revenues, and narrow

tax bases for formal firms have often resulted in governments imposing very high

marginal tax rates.

Cutting taxes and red tape are, according to this view, the main ways of bringing

firms into the official economy. A related view is that the unofficial economy may arise

due to predatory behavior of corrupt officials, seeking bribes from anyone engaging in

officially registered economic activity (Shliefer and Vishny (1997), Kaufman (1994),

Johnson et al (1998)). In this view, the problem that needs to be addressed is

bureaucratic corruption.

In reality, it may be difficult to determine the direction of this causality asenterprises may be able to profitably avoid paying taxes by bribing officials, resulting in

higher level of corruption in the economy. However, informality can impose significant

costs to firms operating in the underground economy. If, for instance, penalties for tax

evasion increase with the amount of unpaid taxes, higher tax rates may not create an

incentive to hide (Andreoni, Erard, and Feinstein (1998)).

In addition, firms in the underground economy may face higher bribes to avoid

detection. An important cost of operating in the underground economy is the inabilityto enforce contracts. For example, firms may have to deal with a restricted set of


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trading partners; foregoing gains from trade arise from a broader set of potential

trading partners (Johnson, Mc Millan, and Woodruff (1999)). It may also be difficult to

raise equity capital or to borrow from capital markets because to do so would require

official documentation (Loayza (1996)). As a result, firms may face higher borrowing

rates, thereby reducing incentives to invest.

Relevant Studies

Most of the studies discuss about the size and impact of the underground

economy instead of its various names and phenomenon (Frey and Pommerehne, 1984;

Thomas, 1992; Loayza, 1996; Pozo, 1996; Lippert and Walker, 1997; Schneider, 1994a,

1994b, 1997, 1998a; Johnson, Kaufmann, and Shleifer, 1997; and Johnson, Kaufmannand Zoido- Lobatn, 1998a).

For an overall survey of the global evidence of its size in terms of value added

was done by Schneider and Enste (2000). A range of literatures depicts about the size

of underground economy which the academicians came out with various

measurements based on the underground activities. The impact of the underground

economy is differing towards developed and developing countries.

Hubbard and OBrien (2006) state that few economists explain the underground

economy in the United States amounts to more than 10 percent of measured GDP.

However, the underground economy in some developing countries may be more than

50 percent of measured GDP. They added that one of the reasons of the high rate of

the underground economy in the developing countries is due to the high taxes and

extensive government regulations.

When the governments calculate the size of their economies, a lot of activities is

not captured (Kasipillai, 1998). These activities are not necessarily involving illegal

goods or services perhaps we may be closer with them than we think. The current

economic slowdown may increase the underground economy activities. Kasipillai

(1998) states that in Malaysia construction is likely to be the sector in Malaysia that

generates the highest hidden income. This is due to this building industry number ones

position is due to its heavy reliance on foreign labor. The legal procedures of recruiting

foreigners are complicated and costly. So, hiring illegal foreign workers is to be anotherunlawful cost advantage. The other sectors are prostitution, unlicensed money lending,


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cuts and kickbacks from contracts, and smuggling. As such, smuggling activity will be

the focused because of the scarce study in the underground economy perspective.

According to Park (2003), the average size of underground economy for eight

Asia countries (e.g Bangladesh, Cambodia, Hong Kong, Indonesia, Korea, Malaysia,

Thailand and Singapore) in percentage of official GDP increased from year 1992 to

2003. His study shows that Thailand has the highest size of underground economy in

2003 while Singapore is the lowest with 54.1% and 13.7% respectively while Malaysia

recorded 32.2% officially. (See Table 2).

On the other hand, smuggling has various effects towards our economy. It can

caused losses in government revenues, bad impact towards internal structure of

society by promoting illegal institution besides changing the patterns of consumption

(Dominguez, 1975). Hence, the GDP and income distribution will also be effected.

(Farzanegan, 2008). By definition, smuggling can be explained as the clandestine

import of goods from one jurisdiction to another (Deflem and Henry, 2001). Merriman

(2003) states smuggling as the evasion of taxes on goods circumvention of border

controls.

In theory, the magnitude of supply and demand could create smuggling.Farzanegan (2008) corroborates that when the state intervention brings a wedge

between international and domestic prices through customs and excise duties and

trade restrictions, there is a chance for the underground economy to develop. By

earning income from importing goods through the state border as violating the rules,

smugglers could earn a handsome profit. Smugglers obtained their income by avoiding

state control, regulations and related costs ((Lithuanian Free Market Institure, 2004).

Since smuggling is part of the underground economy, there is a scarce study on it with

limitations in measuring this kind of activity.


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Theoretical aspects of underground economy

Within National Account system, unregistered economy activities are

divided into five groups: underground work, illegal, unofficial, household

production for own use and production, which is not accounted as a result of

incomplete data compile program.

Obviously, the forms of underground economy typology are not

eliminating each other. For example, organized crime income from drug

producing and trade (black economy; illegal production), or collected duties from

illegal producers, are legalized by using official enterprises. It is the reason for

using general definition of the underground economy in this research work,

which is mainly used also in other research works on underground economyvaluation by modelling method:

Underground economy is the gross domestic product, which in the result

of being unreported and/ or underreported is not accounted for in the official

statistics.

Motives of individual, which encourage them to operate in underground

economy transactions, could be divided into two groups: structural and

economic. The structural motives has no influence on individuals tendency to

operate in underground economy transactions in short time period, it is invariant

against concrete

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governments political decisions, but it could change individuals attitude in me-

dium or long time period. The economic motives influence individuals tendency

involve into underground economy transactions in short time of period, it canchange with concrete changes in governments policy.

Structural motives can be examined in three sections:

1) Governments rules (restrictions);

2) Governments perception;

3) individuals discretion.


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Figure 1: Corruption perception index and underground economy (2000)

[vertical axes underground economy size (% GDP); horizontal axes

corruption perception index]

Source: Schneider, Klinglmair(2004)

Transparency International Releases, The Year 2000 Corruption Perceptions Index

For estimating in cross section of Europe Economic Area state, how close is the

connection between structural motives and underground economy segment,

there were analysed data of 22 EU countries and Norway (except Malta, Cyprus

and Luxemburg).

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As the indicator of structural motives in 2000 there were chosen Transparency

International organizations calculated corruption perception indexes in the

cross-section of countries. After developed methodology, interviews andquestionnaires results are standardized in the scale from 0 to 10. The bigger is

index, the smaller is the influence of corruption by the opinion of business

leaders (the structure is not obstructing the entrepreneurship). Data on the

underground economy amount for year 2000 are taken from the research of F.

Shneider and R. Klinglmair in which the underground economy estimation are

acquired by money demand model in the crosscut of countries (Figure 1).

From acquired correlation it is possible to make the conclusion: in the context of

Europe Economic area in effect is the statement as the structural motives less

direct to waste recourses and promotes production, as smaller is the under-

ground economy amount. Consequently, for decreasing the underground

economy amount, it is necessary to improve the economics structure.

There are four economic motives which could encourage individual to operate in

underground economy:

1) friends or relatives;2) for avoiding from tax payments;

3) for not losing any of state benefits;

4) inflation.

The motive to operate in the underground economy could be individuals

awareness of the fact that relatives works in the underground economy. By

knowing the fact that other individuals does not declare all their revenues or

does not declare it at all, and usually they avoid of control institutions, others

also are motivated to involve in the underground economy operations. This

motive is closely connected to structures motives examined before especially

with government regulations, but also there is necessary to remember the

influence of local traditions on operations in economics.

By increasing taxes and social security payment burden, it is influenced work

leisure option. The bigger is labour costs in official economy and disposable

income difference, the bigger is tendency to avoid this difference and to operate

in the underground economy.


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However Latvias tax burden comparing to EU, candidate countries and European

economic area countries is rather low, separately examining tax burden of

individuals with low income, it is possible to make a conclusion that in Latvia it is

the highest among all examined countries (41.4%). On the contrary, expenses on

social protection in Latvia (by Eurostat data 15.3% of GDP in 2000) are one of the

lowest (expenses on social protection: social benefits, which includes money or

cash transfers; for households and individuals to protect from getting into

definite risk group; administrative expenses).

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Examining in the context of mentioned 23 countries united expenses on social

protection relation to individuals tax rate with low incomes correlation with the

underground economy amount, it is possible to make a conclusion that for thedecreasing the underground economy amount, there must be balanced budget

of expenses on social protection and tax burden level to individuals with low

income.

By increasing the high cost of living, the real tax burden can increase and

wherewith, probably, can increase motivation to operate in the underground

economy. Especially, if incomes are not indexed in official economy or tax

system is not indexed at all, then, when high cost of living increases, the

underground economy incomes becomes relatively attractive in comparison with

real after tax incomes in official sector.

The relative income level in Latvia is one of the lowest in EU, but one of the

highest income level increase rate. According to economic growth theory, real

growth rate should decrease by getting closer to EU average level. One of the

ways in as long time period as it is possible to keep high real growth rate, is to

restrain and decrease inflation level. Thereby, it is possible to make a conclusion:

to decrease or at least to restrain the underground economy amount is possible

by ensuring bigger real income level increase as much as possible, or at least

decreasing inflation level.

Theoretically, the effect of the underground economy is not possible to rate

unequivocally. The underground economy distorts social equality principle by

redistributing incomes in favour of one of the smaller group of population and

distorts market competition. In the same way, it distorts the standard of ethics. It

distorts state economic policy, as basing on false official statistics it is possible to

make an improper decision; for example, existing of illegal employment leads to

governments decision to promote new work place formation, and it will not de-

crease supposed unemployment rate, but budget deficit will increase.

It is usually the case that the economy is better off if, ceteris paribus, an activity

is done officially, than when it is carried out in the underground economy.

However, it is much less obvious, that it is better that the activity has not be

rather done at all than has be done in the underground. This presents a majordifficulty to the policy analysis, since the simple fact that we observe a large


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underground economy does not reveal what there were alternatives to the

underground.

The underground economic activity is combined with various negative welfare

effects. The main problem is the distortion of competition between the twosectors.

Lower capital intensity in the underground economy can be explained by the

assumption that unregistered workers cannot use credit markets, except at a

high cost. Thus, they have no incentive to use them at all. If the probability of

being detected is relatively high then it is equal to a high risk of losing the

capital. As a result, capital is relatively cheaper in the official economy and

thereby firms utilise

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it more intensively than it could be sensible for scarcity reasons. The capital

coefficient in the regular sector is too high, as the labour factor is done more

expensive artificially due to state and collective agreements. This implies thatproduction in the unregistered sector is too labour-intensive, as this factor is

relatively cheaper than capital.

As all the accumulated knowledge that the individual has gathered in the un-

registered sector becomes worthless, when this person is discovered, their

training or on-the-job education is not profitable. This slows down economic

growth even further and, in the long run, could increase long-term

unemployment, as it becomes harder for unregistered workers to obtain a

regular job, due to lack of education. However, unregistered workers on the side

(works underground parallel to official work) do not have this problem.

Furthermore, weak intellectual property rights on real capital, prevents even the

most innovative firms from developing new and better products or services. In

the long-run scarce human resources lead to decreased growth potential as the

development and application of modern technologies, increasingly fail due to the

lack of the workers knowledge. Nor can productivity be augmented with more

capital input.

Higher labour intensity in the underground economy can be explained by in-

creased service concentration. The service sector is more labour-intensive and

unregistered work covers services in general. The effect is that labour becomes

more expensive in the official economy as result of rationalisation and capital-

intensive production.

The official economy can much deviate from perfect competition by regulations.

In the underground economy, many of these state and collective agreement

interventions do not exist, resulting in a higher amount of consumer sovereignty,

individual freedom, and price fl exibility, where the latter can function as

indicators of scarcity. This is an important presupposition for the efficient input of

resources. Price equalises supply and demand, and as well coordinates the

individual decisions of households and firms. Thus, the underground economy has

almost ideal conditions for an optimal resource allocation. The economy is not

burdened by over-regulation and administration, as in the official sector, which

holds back economic growth considerably. From an allocation point of view, the


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underground sector is cheaper alternative for small enterprises in urban

surroundings, particularly in transition and developing countries.

In the long-run, the pressure from underground economic activity can help to

transform legal regulations as well as social and economic institutions. If thestate budget situation becomes poorer, market reforms are anticipated by

government.

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2. Methods to estimate the underground economy

There are three kinds of methods which are most widely used to estimate the

size of the underground economy: direct approaches, indirect approaches and

modelling.

In direct approaches are used designed surveys or/and samples based on vol-

untary replies or fiscal auditing. The main disadvantage of surveys is that the

average precision and results depend greatly on the respondents willingness to

cooperate, and the results from these kinds of surveys depend on the way the

questionnaire is formulated. Since fiscal auditing programs are designed to

measure the amount of undeclared taxable income, they have been effective to

calculate the underground economy. Estimates based on fiscal audits disclose

only that part of income generated in the underground economy which the tax

authorities succeed to uncover. A further disadvantage of the direct approaches

is that it only leads to point estimates, but the purpose of this study is to attain

estimates of the growth of the underground economy over the period 1995

2003.

The number of respondent has to be sufficient for the interpretations of regressionresults. Further, there have to take into account the problem of heteroscedas-

tity.

In such open and democratic societies as in Canada and Norway, the level of

respondence is 63-74%. In other economic countries which are not so open, the

level of respondence is seemed to be much lower. It is the reason why for

acquiring valid results, from the very beginning, it is necessary to provide com-

paratively much bigger representative sample to population when in Canada orNorway. And it turns to the fact, that it is necessary to provide the research

budget big enough. First of all for having the possibility to attract researchers,

who could develop qualitative questionnaire. Secondly, for the having the

possibility to pay for the social research company service representative

selection developing and mediatising/interviewing organizing, responses

database forming. And thirdly, for attracting researchers to result analyses.

Because of big costs, direct methods in underground economy researches,

mainly are done by support of state institutions or society organisations.


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Indirect approaches, which are also called indicator approaches, are mostly

macroeconomic ones and in it there are used various economic and other indica-

tors that contain information about the development of the underground

economy. Currently there are five indicators that leave some traces of the

underground economy:

(1) The Discrepancy between National Expenditure and Income Statistics;

(2) The Discrepancy between the Official and Actual Labour Force;

(3) The Transactions Approach;

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(4) The Physical Input (Electricity Consumption) Method;

(5) The Currency Demand Approach.

All these methods are designed to estimate the size and development of theunderground economy by considering that just one indicator must capture all

effects of the underground economy.

It is obvious that underground economy effects are shown up simultaneously in

production, labour, and money markets. And even more important critique is

that the causes that determine the size of the underground economy are taken

into account only in some of approaches. For example, in currency demand

approach studies it is considered one cause the burden of taxation. The mostwidely used methods to get underground economy time series are currency

demand method and electricity consumption method.

In (household) electricity consumption method there are questionable two basic

assumptions. Firstly, electricity is not necessary used in all economic activities,

moreover, it is possible to use alternative source of energy. Secondly, there are

economic activities which are not related to sector of households. As information

about household electricity consumption is restricted, more attention is paid for

analysing currency demand model. Money indicators are more available than

electricity indicators, and linkage is clearer between underground economy and

money indicators than between underground economy and electricity indicators.

The model approach considers that multiple causes are leading to the existence

and growth of the underground economy, as well as the multiple effects of the

underground economy over time. The econometric method is based on the theory

of unobserved variables. The dynamic Multiple Indicators Multiple Causes

Figure 2: The size of the underground economy as unobserved variable


24/32

model allows to get a time series indexes of the unrecorded vs. recorded output

of the state.


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54

The method is based on the factor analytic approach, where is assumed that the

underground economy is an unobserved variable over time. The unknown

coefficients are estimated in a set of structural equations within which the un-observed variable cannot be measured directly. The MIMIC (multiple-indicators

multiple causes) model in general consists of two parts, with the measurement

model linking the unobserved variables to observed indicators. The structural

equations model specifies causal relationships among the unobserved variables.

In this case, there is only one unobserved variable the size of the underground

economy. There is assumed that the underground economy could be influenced

by a set of exogenous determinants (causes). The second set consists of

indicators for the underground economy, which are capturing the effects of the

underground economy. The relation between causes Di(i =1,2,...,n), the

underground economy H, and indicators Ij(j=1,2,...,m) are shown in Figure 2.

This is an inappropriate approach for estimating the size of the underground

economy in Latvia due to the time series shortage and/or absence of some

causes data. As further, for converting this index into percentage units there is

necessary to have a benchmark the long-run average value of unrecorded vs.

recorded output. To obtain this benchmark there could be used any of theindirect approaches.

By reposing on underground economy estimation method analyses done in

research work, it is possible to make a conclusion, that for Latvia the most

suitable is money demand method. Direct method is eliminated because of it

gives assessment only for concrete time period; moreover, it is very expensive

method, mainly because of the fact that Latvias respondence level could be very

low. To convert by the model approach acquired indicators to ratio ofunobserved and observed sector, it is a priori necessary to have information

about this relation in a long time period. That is why more logically to begin the

underground economy assessment by indirect methods especially with

developing money demand method.

A general currency ratio model contains the following specifications:

= Cu+Co and (1)

D = Du + Do (2)


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where C currency stock in circulation and D actual stock of demand deposit

are decomposed by unobserved sector (subscript u) and observed sector

(subscript o).

Currency and demand deposit ratios:

(3)

Brekis_promocijas.indd 54 6/8/2007 4:06:04

PM

,o

o

oD

Ck =


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55

(3)

can be viewed either as functions of constants, according to assumptions of

money demand approach.

Assumes that Youn Yuare observed and unobserved income, accordingly, then:

and (5)

(6)

are income velocity in observed and unobserved sectors. To solve the model for

Yu, we must evaluate (6) in terms of the models observable variables, namely, C,

D, and Yo. Repeated substitution and rearrangement of terms yields the general

solution for unregistrered income as:

(7)

u

u

u

D

Ck =

oo

o

o

DC

Y

+

=

uu

u

u

DC

Y

+

=

,))(1(

))(1(1

CDkk

DkCkYY

uo

ou

ou +

+=

u

o

=


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where

Equation (7) expresses the unreported sector as a function of three observable

variables -observed income Yo, actual currency stock C, actual stock of demand

deposit D, and three parameters or functions , ku, un ko .

The simple Simple Currency - Ratio Method employs the following restrictive

assumptions:

(1) Currency is the exclusive medium of exchange in unreported

transactions

(Du > 0; ku ). Assumption implies that unreported transactions are never paid by

check.

(2) The ratio of currency to demand deposits remains constant except

for changes induced by the growth of unreported income (k0 = const).

(3) The amount of unreported income produced by currency unit

transacted in the unreported sector is the same as the amount of reported

income produced by

Brekis_promocija

s.indd 55

6/8/2007

4:06:04 PM


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56

currency unit transacted in the reported economy. Assumption implies that

income velocity is equal in both sectors.

Imposing these restrictions on the general model presented as (7) produce the

restrictive form (set =1 and examines limit when ku ):

Dk

DkCYY

o

oou

)1( +

= (8)

which represents the simple currency - ratio method.

In the model (8) retained assumption that =1, namely, the income velocities

for reported and unreported income are identical. If unreported income is mainly

concentrates in the service sector, which requires much few intermediate

transactions, then income velocity in unoffi cial sector could be greater than in

offi cial sector, so 1. If1, the estimates are too

high.

The foregoing simulation of the currency - ratio model assumes that the

benchmark estimate for this ratio is constant (k0 = const).The currency ratio, kot

may be regarded as a stable function of other economic variables.

The currency -deposit ratio:

uo

u

uo

o

uo

uo

DD

C

DD

C

DD

CC

D

C

+

+

+

=

+

+= (9)

is assuming that Du 0 (assumes that actual and official deposit stocks are close

D D0) could be rewrite as follows:

if Du 0 (10)

or if use (3).

,D

C

D

C

D

Cu

o

o+


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D

Ck

D

Cu

o+ if Du 0 (11)

So, for estimating currency ratio by using econometric methods, equation (11)

items could be described with two functions:

(12)

Brekis romoci as.indd 56 6/8/2007 4:06:04

=

=

)(

),,(

2

1

fD

C

w sryfk

u

o


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57

where

y reported income;

r rate of interests;

ws income share of wages and salaries;

average effective marginal tax rate.

First function is described by factors which have an effect on official currency

demand. To describe second function, as the most important factor which has an

effect on currency demand in unofficial sector, is used tax index.

According to these assumptions, actual currency and deposit ratio is defined as

follows:

(13)

Equation (13) can be estimated to obtain a forecast of currency ratio C/D.

Method based on assumption that currency demand created by unrecorded

sector exclusively is produced by taxes. So to obtine estimates of function ko, the

tax rates are set to zero in the model (13)

)(),,( 21 fwsryfD

C+=


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under ground final

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