A recent GFI study estimated that the size of India?s underground economy is now at least 50% of the official economy, as measured by GDP. The growth of the underground economy since Independence was found to be an important determinant of the cross-border transfer of illicit capital from the country.
While the underground economy plays a significant role in the generation and transmission of black money, there are no hard numbers on its size. That?s the nature of the animal?the estimation of illegal and unaccounted income and assets necessarily implies that one cannot accurately estimate their magnitude. Hence, all methods of estimation are subject to errors in measurement. Moreover, the size of the underground economy obviously depends on the type of activities or transactions included in the study. This means researchers cannot simply compare estimates of the underground economy obtained through various methods to check for consistency. For example, an estimate of the underground economy that only includes legal work not reported for the collection of income taxes cannot be compared to another that covers all sorts of illegal activities such as trafficking of drugs and humans. The implications for the tax policy are significant. If the revenue department is concerned about widening the tax base then it would look at the former narrower definition and not the broader underground economy where the question of payment of taxes on illegal activities does not even arise.
The estimate of the underground economy used in the GFI study is based on the monetary approach, which is essentially a broader estimate. This approach makes use of the fact that the demand for high-denomination cash transactions is significantly higher in illegal transactions, compared to legal ones. This is because cash transactions do not leave a paper trail that can be used to trace illegal transactions to the parties that carry them out. The higher demand for cash transactions is then used to calculate the size of the underground economy. Such an approach would typically cover illegal activities that are not subject to taxation as well as legal activities that happen to fall outside the tax net due to deficiencies in tax collection and administration. Clearly, the argument that estimates of the underground economy are not based on ?hard evidence? is a non sequitur.
That settled, what about arguments that the underground economy in India is actually contributing to economic growth and that it has enabled India to cushion the impact of the global economic slowdown? A recent study by the World Bank (Shadow economies all over the world: New estimates for 162 countries from 1999 to 2007) clearly shows that the size of the underground economy is inversely related to the strength of overall governance?countries where the underground economy is small relative to GDP also tend to be much better governed. If the history of developed countries and the ongoing turmoil in North Africa is any guide, stronger overall governance not only fosters a better investment climate, it provides the bedrock for political and economic stability.
The author, formerly the senior economist at IMF, is lead economist at Global Financial Integrity at the Center for International Policy, Washington, DC