Shadow Economy How Far Will It Stretch

Economies worldwide are experiencing unprecedented financial crises. What is the role governments play in creating this disaster as they scramble to keep revenues flowing in? The following article discusses the concept of ‘shadow economies’, their causes and the negative impact on the very survival of individuals and nations.

Shadowing the Shadow Economy – By Steven Pomeranz

I recently read an article on shadow economies and wanted to share its key points with you. The article was written by J.D. Tuccille for, a website on finance, economics, politics and more.

I found it interesting that highly-developed countries like the US, UK and Japan, even today, have sizable shadow economies – parallel economies that focus on the trading of legitimate goods but in the shadows. The obvious question is why??

While we all know that illegal activities – like prostitution and drug trafficking – are done away from the eyes of the law, it’s interesting that 100% legitimate business activities are also conducted away from the law, and more importantly, away from the eyes of the taxman. It’s these latter activities… legitimate business activities… that form the shadow economy the author speaks of.

I’ll get into the details in a bit but the reason this shadow economy is in the news is because states and governments are having a hard time balancing their budgets – due to high unemployment, especially in Europe and some parts of the US—-governments have been collecting less and less in taxes and have done little to rein in their own expenses – although we are starting to see some movement in this regard.

So now, when government coffers are severely strained, governments are scrambling to track these shadow economies so they can rake in billions in fines and back-dated taxes to keep the machinery of the state running just a little bit longer. California for example, stands to collect $7 billion in revenue. The European Commission, on the other hand, estimates its shadow economy is worth 2 trillion Euros!

The bottom line is: The government surely is going to tighten up on these activities and the penalties on defaulters will be stiff. So in case any of my listeners have assets, bank accounts or investments that are undeclared, you may want to consider taking advantage of voluntary disclosure programs to come clean rather than risk heavy fines and possible jail time.

What may seem harmless is actually a white collar crime, a criminal offence punishable with jail time. So, just please be aware, perhaps consult a tax attorney confidentially and know your options, including the worst that can happen to you.

Now coming back to the article, Friedrich Schneider at the Johannes Kepler University in Austria, wrote that business go into the shadows to avoid income taxes, social security contributions, and to skirt labor laws such as minimum wages, safety standards or working hour limits that make them less competitive in today’s global markets. Mr. Schneider also thinks the shift to a shadow economy is directly related to the extent of government regulation and interference with business operations. The more onerous or burdensome government oversight gets, the more people will seek to operate in the shadows.

Another set of economic researchers, writing in the Journal of Public Economics posited that businesses flee to the shadows more when an onerous bureaucracy is accompanied by high levels of corruption and a weak legal system. These researchers believe that bureaucracy in a corruption-free and transparent system does not cause companies to flee as much – and that it’s really the corruption, lack of clear processes and procedures and the lack of satisfactory judicial redress that foster shadow economies.

And turns out, data supports their view.

A 2007 survey showed that corruption free and transparent economies with strong and efficient judicial systems had a smaller percentage of their GDP engaged in shadow businesses. In this ranking, Australia, New Zealand and Switzerland were rated the highest in terms of freedom to conduct business with minimal oversight.

The shadow economy as a % of GDP was 10.7% in Australia, 9.8% in New Zealand and 8.2% in Switzerland.

The next group, where businesses were mostly free of government interference included, in order, countries like Canada, Ireland, USA, Denmark and the United Kingdom.

The US was ranked #6 in terms of private sector freedom from excessive government oversight and had 7.2% of its GDP tied up in a shadow economy – which, by the way, is the lowest (lower, even, than Switzerland) shadow economy as a % of GDP. Canada had 12.6% of its GDP, Ireland had 12.7% in the shadows, despite being ranked higher on the freedom from government oversight scale.

On the low end of this list, among highly developed nations, Italy and Greece have almost a fourth of their GDP tied up in the shadows because of heavy government interference, heavy regulations and permits, thriving corruption within government, and a weak courts system that is tainted, ineffective, corrupted and lengthy in resolving cases.

So, the conclusion for governments is that if you want to minimize your shadow economy, leave private businesses alone – minimize government regulation, heavily penalize corruption and increase judicial effectiveness.

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About the Author: So why should we care, as investors? The list is a great way to steer your foreign investments into countries with smaller shadow economies. Which may mean higher returns for you because it’s just better for businesses; it’s better for dividends and long-term stock performance. Steve Pomeranz is a Managing Director for United Capital Financial Advisers, LLC, “United Capital”, and owner of On The Money. On The Money is not affiliated with United Capital.nArticle Source: