Institutions & Governance

Off-the-Books Work and a $500 Billion Tax Gap: An Interview with Edgar Feige

July 30, 2013

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You are considered “the father of Underground Economy analysis” but I would think that figuring out the size of the underground economy is very difficult simply because it is underground.

A: People talk about lots of things as the underground economy. For example, the amount of income produced in the economy not represented in GDP, and of course the illegal economy, all those goods and services prohibited by law.

But I am trying to estimate the unreported economy grounded in the IRS’s best estimates of cash in circulation and adjusted gross income. That is the country’s reported tax base. The IRS numbers are a few years old but we’ve updated them by tracing the amount of currency in the U.S. since cash would be the preferred medium of exchange in a shadow economy because it does not leave a paper trail.


Q: Your paper, “America’s Underground Economy: Measuring the Size, Growth and Determinants of Income Tax Evasion in the U.S.,” shows the underground economy reaching record levels. Has the shadow economy been increasing steadily or is something else now at work?

A: There is no question this shadow economy has been increasing dramatically in the last two or three years. But it has also been steadily increasing in the last decade. Basically if you take 1997 as a base it looks as though non-compliance has probably doubled from mid 1997 to 2011.

My estimate is that probably $2 trillion goes unreported each year and that means there is a $400 to $500 billion tax gap, which is the amount of taxes the government could be collecting if there were full compliance.

What’s really important is the estimated non-compliance today approaches what it was during World War II when we had strict price controls and rationing and consequently the largest underground economy on record. (See chart) We are a little bit below that now, but the estimated tax gap has increased in absolute terms.

Ratio of Unreported Income to Reported Income (AGI)

Q: Why is the underground economy increasing so dramatically?

A: The more people view the tax code as inequitable, the more they will try to evade it. The higher the effective tax rate, the higher the incentive to try to evade it. The lower the IRS audit rates, the higher the incentive to evade. And of course the greater the complexity of the tax code and the consequent cost of compliance, the more incentive there is to evade it.


Q: Does the current tax system encourage otherwise law-abiding citizens to hide income?

A: To the extent that people perceive the code as unfair and inequitable, yes it does. And as I mentioned, higher tax rates, the increasing complexity of the code, lower audit rates, all these things contribute to increasing evasion.


Q: Why the sudden increase?

A: Some of this may be due to revised estimates of how much of our currency is held overseas. If you look at the Fed’s own flow of funds data, its official number ranges from 37 percent to 40 percent of U.S. currency that is overseas.  But confidential information from the New York Fed suggests an even smaller amount is there. That coupled with my own data, which trace funds flowing overseas and coming back, more directly suggest that number is actually closer to 25 percent, which means a larger amount is un-reported in the U.S.


Q: What are the social and political implications of this large scale unreported income and tax evasion?

A: The bad news is that, to the extent there is this evasion, it redistributes income away from honest taxpayers to those that are dishonest, and that clearly has a demoralizing effect.

One of the major problems not addressed about underground economies is that they tend to break down the social fabric. People begin to increasingly see government as ineffective and inequitable and civic institutions as unworthy of their participation. Young people are particularly disillusioned with politics now. They see no hope that Social Security or the government or the economy will be there for them. They are convinced the future is not going to be as bright as the present, and that can be very, very dangerous.


Q: Does the underground economy at least partly explain why consumer spending is rising while unemployment remains high and wages remain low?

A: As unemployment in the economy increases, people have a greater incentive to try to supplement their income and manage their income by trying to earn funds off the books. So the good news is that our unemployment rates may be overstating the degree of unemployment because it does not measure those working off the books.

This does imply that the economy is stronger than the common estimates, stronger than we think it is. When you look at measures of consumption and retail sales, they have been stronger than we would have predicted based on standard employment and income figure. And one obvious explanation is the off-the-books income not reported.


Q: Your paper seems to indicate that tax avoidance declined after the Tax Reform Act of 1986. Was that the case?

A: Our estimates do suggest that the 1986 Tax Reform act had a short-run effect of increased compliance. But the effect was short lived and, needless to say, it is difficult to attribute the decrease to any one cause.


Q: Would tax reform solve the problem?

A: Tax reform would have a major impact on the perception of the code but that, of course, depends on the nature of reform. The kind I would like to see is a substantial reduction in income tax rates and the establishment of a transaction tax, similar to a financial transaction tax like 13 European countries are about to adopt. This is a variant of a tax I proposed back in 1989 to the President’s tax reform commission. I proposed the replacement of our current system of individual and corporate income, sales, excise, capital gains, import and export duties, gift and estate taxes with a single comprehensive “revenue neutral” Automated Payment Transaction (APT) tax. It would be a flat-rate tax levied on all voluntary transactions, hitting the broadest conceivable tax base and therefore requiring the lowest conceivable marginal tax rate.

I would now prefer to see the APT as a revenue-neutral added tax used to significantly lower corporate and individual income tax rates by using the revenues obtained from taxing financial transactions to both reduce the deficit and reduce the income tax rates on corporations and individuals.