Numerous empirical studies indicate that higher marginal income tax rates stimulate the supply of goods and services in the underground economy. But very few studies have analysed the demand for these underground commodities. In new research published in the latest Economic Journal, Bernard Fortin, Guy Lacroix and Claude Montmarquette investigate the impact of working in the underground sector on the demand for underground commodities.
Using a survey on the underground activities of over 5,000 individuals, they highlight a network effect, whereby individuals who sell goods and services in the underground sector are also far more likely to buy goods and services in the underground sector. The data show that underground workers spend six times as much on underground commodities compared with others. The implication of this result is that policies to reduce the size of this hidden economy may have greater effects than is currently thought since they not only reduce supply to the sector but also demand from it.
The network effect the researchers detect stems from the fact that workers in the underground economy have access to better and more timely information on the availability of underground commodities. This reduces their search costs and may therefore induce them to spend more on underground goods and services.
The results are based on a unique randomised survey conducted in Canada in 1994. The term ''underground'' refers to activities that generate income that is not reported to the tax authorities. Using a statistical methodology that highlights the effects of specific factors, the results indicate that:
- Workers in the underground economy are far more likely to be consumers in the underground economy.
- The more educated have a higher propensity to purchase underground commodities.
- Men are more likely to purchase underground commodities than women.
The study also highlights the policy implications of these results. In particular, the network effect significantly increases the impact of changes in enforcement (e.g. penalties on tax evasion, expenditures to detect irregular activities, etc.) on the size of the underground economy. In the presence of this effect, the demand and the supply for underground commodities are simultaneously affected by changes in enforcement. Hence, more stringent enforcement policies may lead workers to reduce their hours in the underground sector as well as their expenditure on underground commodities.
And although, according to the survey results, underground workers only represent 4% of the population aged 18 and above, their total expenditure is sufficiently large that any reduction will translate into a significant reduction of the underground economy. Naturally, the converse also holds: an increase in income tax rates will have a larger (positive) impact on the size of the underground economy because of the network effect. Omission of this demand effect thus results in significant underestimation when assessing the impact of tax and enforcement policies on the size of the sector.
''Are Underground Workers More Likely to be Underground Consumers?'' by Bernard Fortin, Guy Lacroix and Claude Montmarquette is published in the October 2000 issue of the Economic Journal. Fortin and Lacroix are at the Université of Laval, Quebec; Montmarquette is at the Université de Montréal. They are all members of CIRANO, an inter-university Canadian centre of research in economics.