Copyright (c) 1997 by The Fraser Institute. All rights reserved.

No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. The authors of this book have worked independently and opinions expressed by them, therefore, are their own, and do not necessarily reflect the opinions of the members or the trustees of The Fraser Institute.

Printed and bound in Canada.

Preface

As a natural extension of its interest in the ways in which the private sector reacts to the activities of government, The Fraser Institute has long studied the underground economy. In pursuing this research, the Institute assembled a roster of experts in Vancouver in April 1994. They included government officials, accountants, economists, lawyers, federal police, politicians, and public policy analysts from Canada, the United States, Britain, Mexico, Chile, Peru, Russia, and Hong Kong.

The papers prepared for this meeting, as subsequently revised by the authors, constitute a unique collection of information about the underground economy and how it is manifested in a variety of countries. The purpose of this book is to collect these research findings to make them available to those who are interested in how this fascinating and increasingly prevalent segment of economic activity operates.

Section One collects papers that deal particularly with the underground economy in Canada. Rolf Mirus and Roger Smith were the first economists to measure the underground economy in Canada and their paper provides an up-to-date assessment of the size of this sector. While their calculation that the underground economy could be as much as 20 percent of the measured economy has received considerable attention, the estimates made by Mirus' and Smith's methods attract controversy and criticism by statisticians working for Statistics Canada and other statistical agencies. In his paper, Philip Smith provides Statistics Canada's views about the size of the underground economy. It is fair to say that these two papers represent the extremes of the measured range of the size of the underground economy. Philip Smith also provides the acronym UGE to describe the underground economy and henceforth in this preface we will use his abbreviation.

While Mirus and Smith estimate the UGE to be as large as 20 percent of the measured Gross Domestic Product, Statistics Canada offers an estimate in the range of 2.7 to 5 percent of the measured GDP.

In Section One's third paper, Peter Spiro provides a specific estimate of the impact that tax changes have on the size of the UGE. In particular, he analyzes the relatively significant impact of the Goods and Services Tax. According to Spiro, the introduction of the GST was the single most important factor contributing to a spurt in the growth of the UGE in 1991.

Bruce Flexman adopts a different approach to the UGE in his paper. He relies on surveys of opinion to infer how much people may be avoiding and evading taxation by reorganizing their activities. The survey also sought to determine people's attitudes towards the purchasing of smuggled goods and black market liquor and cigarettes. While the majority of citizens surveyed indicated that they would not engage in these kinds of underground activities, a very significant minority said that indeed they would. When asked whether they thought others would engage in such activities, the respondents were even more strongly of the view that other people participated in tax evasion. Perhaps the responses to these questions reflected in part the very strongly held view, revealed in the survey, that Canadians do not get value for the taxes they pay to governments.

The remaining two papers in Section One provide the views of Revenue Canada's Tim Gahagan, and British Columbia's Lois McNabb, who attempts to measure that provincial government's revenues in the face of changing behaviour by taxpayers. These two papers provide an interesting practical insight into the problems of tax evasion and tax avoidance.

Section Two of The Underground Economy: Global Evidence of its Size and Impact outlines a perspective of the UGE which is not often encountered, specifically, the view of law enforcement officials. The three papers in this section deal respectively with the size of the underground substance economy, the legal aspects of the UGE in the United States and an assessment of the economic activities of the Mafia.

In his paper, inspector Tim Killam of the RCMP points out that while the Statistics Canada estimate of the size of the entire underground economy is about $19 billion, police estimates suggest that trafficking in illegal drugs amounts to at least half of that figure. (Statistics Canada, like other agencies, does not include illicit activities in its UGE measurements, but includes only activities which, other than being clandestine, are legal.) Moreover, Killam is of the view that this is a very conservative, minimum estimate of the size of the illicit drug trade. One of the issues that Killam addresses in his paper is the very active smuggling which results from high excise taxation. This smuggling activity, Bruce Zagaris points out in his paper, has been facilitated by the increasing amount of international trade involving all of the major industrialized nations. The apparatus which has been established for legitimate trading activity also facilitates illicit trade.

Zagaris draws our attention to the fact that illegal trade in human beings in the form of illegal immigration is rapidly growing and may be the most profitable of the underground activities. Another outcropping of the UGE is more money laundering, which is, as Zagaris notes, an important component of the UGE. The increasing ability to communicate and the electronic transfer of funds makes money laundering an increasingly easy service for participants in the underground economy. Finally, Zagaris notes, there is an emerging problem called the "grey area phenomenon" or GAP. Essentially the GAP emerges when non-state actors and non-governmental organizations become the de facto "government" in a particular area. The activities of narcotics traffickers in Andean countries and the activities of private groups in U.S. innercities are examples of this sort of development.

John Burton, in his paper, points out that the Mafia is a natural private outgrowth of underground economic activity as well as an adjunct to ordinary economic activity. In effect, Burton maintains, the Mafia should be seen as a private protection industry. His analysis of the involvement of this industry is intriguing.

Section Three contains seven papers that analyze the underground economy in different countries and from different perspectives. Those who have an interest in the underground economy will be impressed by the diversity of experience in the countries discussed-from the United States and Britain to Mexico, Peru, and Chile, through to Russia and China. The findings of these papers are too numerous to summarize in this preface, but it is worth noting one of the conclusions in the paper by Edgar Feige, the father of UGE analysis.

Feige's paper is based on a study of the amount of U.S. currency held abroad. In the most careful analysis ever conducted of this issue, Feige concludes that the amount of U.S. currency held abroad indicates that there is an underground economy equal to the size of the U.S. economy hidden amongst the reported economic activities in the world's countries. Of course, much of that hidden economic activity is the subject of the country studies contained later in Section Three.

The fourth and final section of the book consists of two papers by two eminent Canadian economists-Jonathan R. Kesselman and Francois Vaillancourt. The papers have as their focus, once again, the Canadian economy and some policy implications of the UGE.

As was noted in the earlier discussion of the paper by Bruce Flexman, a majority of Canadians believe that they do not receive enough benefits for the taxation they are required to pay. In his paper, Francois Vaillancourt suggests that an obvious solution to the problem of tax evasion and the underground activity which accompanies it might be the adoption of user fees and user taxes. His analysis is that the wider use of these kinds of levies would open the way for reducing general tax rates that would in turn diminish incentives for tax evasion and therefore the size of the underground economy.

Jonathan Kesselman's paper poses some challenging questions for the avenues open to governments to reduce the size of the UGE. He provides an interesting analysis of the distribution of the costs and benefits of both tax evasion and the enforcement efforts which are pursued to stop it. Kesselman's analysis leads him to remind policy makers that, "even a relatively small underground sector could generate serious inefficiency and inequities." However, the effort to eliminate the UGE can also engender problems. One of the main public policy recommendations for tax authorities is that many of the problems of compliance with tax policy can be anticipated and to a large extent avoided in the design of the tax policies themselves.

Conclusions

The extensive discussions engendered by the papers in this book produced some interesting insights. For example, while the range of estimates of the underground economy was large, a more precise understanding of the definitional differences used to calculate the different estimates revealed that the range was much narrower than had first appeared. It was also pointed out by the Associate Deputy Minister of Finance for Canada, Don Drummond, that even if the smaller estimates-those in the five percent range-were more accurate, the implications are still important. In particular they are significant for the ability of governments to forecast current revenues and to accurately assess the possibilities for future revenue development.

The discussions also revealed that there are important implications for understanding the mechanisms of economic activity. Does the unemployment rate really mean what we think it means? In the Atlantic provinces, for example, where there has been evidence of considerably more underground economic activity than in the rest of the country, how do we account for the employment in the UGE? When we have a black economy, should we use the unemployment rate as an indication of economic cyclicality at all?

The search for the solution to the "problem" of the UGE led to two different lines of thinking. First, is this economic sector a problem or a solution? Some experts suggested that the tax wedge in the economy is killing economic activity which simply redevelops in the underground. In that sense, the underground is not a bad thing but a good one. Regulation often stifles business activity which then escapes partially or completely into the UGE. In other words, the UGE is, in fact, a measure of economic activity that is in some way a victim of tax and regulation policy and should not be regarded as a problem, but rather as a solution. Is society better or worse off as a consequence of a robustly growing underground economy?

The second line of thinking emerged from Canada's revenue Minister David Anderson, who pointed out that unsupported economic activity leads to unfairness in the distribution of the tax burden, a point which was further explored in the paper by John Kesselman written after the conference to reflect his reactions to the discussions. The fact is that the UGE represents a kind of uneven playing field when different taxpayers and different businesses comply with the tax system in different and unequal ways. This is certainly a problem.

But the attempt to deal with it, by making enforcement stricter or making the effective tax rate bite more decisively, may in fact produce further problems in the way of more evasion activity because, of course, the enforcement activity itself makes the effective tax rate higher. The studies of the underground economy in the various countries represented at this conference have led to an understanding of the enormous flexibility of the market economy to respond to unreasonable regulation or unsustainable tax rates.

We would be well advised to look more closely at the evidence from Peru and Chile. We now find that informality is as much as 50 percent of the economy in some developing countries. I think we have often tended, in North America at least, in looking at Latin America, to think that informality is a sign of some sort of cultural ineptitude. In fact, it is probably just the result of excessive regulation. The underground or informal economy, as they call it, is a natural consequence or expression of market adjustment rather than anything specifically cultural. And that is very important to understand as we begin to regulate the curvature of cucumbers and other things-that we can also produce a culture of evasion and a culture of avoidance and a culture of resort to the less efficient underground economy.

We also saw from the experience of Mexico that dramatic revenue increases can be a result of large tax rate reductions-that is, if those tax reductions are correlated with an appropriate public information program and an effective program of compliance or a change in effective compliance, so that, at the same time, you reduce the rewards of evasion and make a more effective effort to collect taxes. I suppose that the reverse situation is also true.

Finally, of course, and most importantly for researchers, there have been many suggestions for further research. There have been examples and there have been challenges thrown out by the people in government to get a better understanding of the ways in which the underground economy works. There has been a challenge to come to a more general agreement of how the UGE should be measured, and a plea for economists to collaborate to reach a consensus about the size and operation of the underground economy.

Among the most compelling pieces of evidence about the size of the UGE are the anecdotes that one encounters in everyday life. There has been a certain tendency for analysts to downplay this evidence. It is fair to say that the conclusion suggested by the evidence surveyed in this volume is that the everydayexperience evidence is fairly close to the mark. The UGE is a large and growing aspect of economic life in the world. The Fraser Institute has been pleased to support the research in this volume which has sought greater clarity about the issues of detection and measurement. However, the researchers have worked independently and the views they express may not reflect those of the members or trustees of The Fraser Institute.

-Michael A. Walker

Executive Director, The Fraser Institute

About the Authors

Michael Alexeev

Michael Alexeev is an Associate Professor at the Department of Economics of Indiana University. He received the M.A. equivalent in Economics and Mathematics from Moscow University in 1975 and the Ph.D. in Economics from Duke University in 1984. His current research interests lie mostly in the fields of comparative economics and economics of transition from socialism to a market economy with a particular focus on informal aspects of economic behavior. Since early 1992 Dr. Alexeev, who is a native of Russia, has been actively participating in the technical assistance programs to the former Soviet Union.

John Burton

John Burton is Professor of Business Administration and General Coordinator of the Strategic Management Research Group in the Department of Commerce, Birmingham Business School, University of Birmingham, UK.

He has previously held professorial posts at the Leeds Business School and the European Business School, and lecturing appointments with the Universities of Southampton and Birmingham, Kingston Polytechnic, and Boston University. From 1984-1987 he was a Research Director at the Institute of Economic Affairs, London; and in 1987 also a Special Adviser to the House of Commons Treasury and Civil Service Select Committee. He is a co-founder of the magazine Business Studies (launched in 1988), and has contributed numerous articles in refereed journals. His books and monographs include: Whither Sunday Trading? (1994); Retail Rents: Fair and Free Market? (1992); (with D. Parker, Joint eds.) Studies in Business and Management (1991); Would Workfare Work? (1987); (ed.) Keynes's General Theory: Fifty Years On (1986); Why No Cuts? (1985); (ed.) Hayek's `Serfdom' Revisited (1984); (With J.T. Addison) Trade Unions and Society (1984); Picking Losers...? (1983); The Job-Supports Machine (1979); (with J.M. Buchanan and R.E. Wagner) The Consequences of Mr. Keynes (1978); Wage Inflation (1972).

Edgar L. Feige

Edgar L. Feige is Professor of Economics at the University of Wisconsin-Madison. He has taught at Yale University, The University of Essex, Erasmus University and the University of Leyden where he held the Cleveringa Chair. He was appointed Fellow at the Netherlands Institute for advanced Study and Fulbright Scholar in Spain. He is the author of more than sixty publications in monetary and macroeconomics and is best known for his work on Underground Economies. He has served as a consultant to the United States Treasury Department, The Agency for International Development, the Supreme Soviet of the Russian Federation, the Board of Governors of the Federal Reserve System and on the Task Force on Economies in Transition of the National Research Council. He received his B.A. at Columbia University and his Ph.D at the University of Chicago.

Bruce P. Flexman

Bruce P. Flexman received a B. Sc. in Engineering and Mathematics from Queen's University and an M.B.A. with distinction from Cornell University. He is a chartered accountant specializing in GST and income taxes. Mr. Flexman is currently responsible for the Vancouver tax practice at KPMG and provides national technical leadership on GST matters. From 1991 to 193 he was on executive exchange with Revenue Canada acting as Deputy Director General for GST Policy and Legislation. He has also acted as technical advisor to the Senate Committee on Banking, Trade and Commerce in their deliberation concerning the introduction of the GST and was consulted by the Finance Committee on their review of alternatives to the GST.

Tim Gahagan

Mr. Gahagan is presently the manager, Underground Economy and Compliance Initiatives Section, Revenue Canada, in Ottawa. He holds a Bachelor of Mathematics degree from the University of Waterloo. Mr. Gahagan is also a Certified Management Accountant (CMA). In his 20 years with Revenue Canada, Mr. Gahagan has held various positions in Hamilton, Edmonton, and Ottawa before assuming his present responsibilities in January 1994.

Enrique Ghersi

Enrique Ghersi was born in Lima, Peru, in 1961. He is a lawyer, journalist, and Professor at the University of Lima's Law School. Mr. Ghersi has been a member of Parliament since 1990, representing Lima. He is co-author of the bestseller The Other Path with Hernando de Soto. His weekly articles appear in over 40 newspapers from 20 countries.

Jonathan R. Kesselman

Jonathan R. Kesselman is Professor of Economics, University of British Columbia; Director, Centre for Research on Economic and Social Policy, UBC; Ph.D. in economics, MIT, 1972. Consultant to governments in Canada, Australia, India, New Zealand, and the United States; member, B.C. Premier's Forum on New Opportunities for Working and Living, 1994-95; member, Musqueam Indian Band Taxation Advisory Council (chair, 1992-96). He holds visiting appointments at the Institute for the Research on Poverty, University of Wisconsin-Madison; Delhi School of Economics, India; and the Australian National University as Professorial Fellow in Economic Policy of the Reserve Bank of Australia. Dr. Kesselman's areas of specialization include theoretical and policy assessment of taxation, income security, employment programs, and social insurance finance.

Timothy George Killam

Inspector Killam joined the Royal Canadian Mounted Police (RCMP) in 1976 and has since enjoyed a variety of policing and administrative experiences. He has five years experience in drug enforcement as an investigator and undercover operative. Inspector Killam spent nine years in a commercial crime unit investigating white-collar crime, including tax evasion and major frauds. In 1990, he was transferred to the RCMP Professional Standards Directorate, where he acted, on separate occasions, as advocate and solicitor in the roles of prosecution and defence. In 1993, he was appointed the Officer-in-Charge of the Anti-Drug Profiteering Program and a year later was transferred to his present position as the officer responsible for the RCMP Proceeds of Crime Program. He received an LL.B. (1990) and a Bachelor of Commerce (1985) from the University of Windsor and a Bachelor of Arts from St. Thomas University in 1976.

Owen Lippert

Owen Lippert worked as a policy and communications advisor in Ottawa for Kim Campbell when she was Justice Minister, and for Rob Nicholson when he was Science Minister. Prior to 1991, Dr. Lippert worked for the B.C. Premier's Office in Victoria. Owen Lippert earned a Ph.D. in History and Government from the University of Notre Dame, Indiana. He has taught at universities in the United States, Canada, Taiwan, and has independently advised the federal departments of Justice and Industry Canada as well as several private companies.

Lois McNabb

Lois McNabb is the director of the Economics and Trade Branch of the B.C. Ministry of Forests. From 1989 to 1996 she was director of the Fiscal and Economic Analysis Branch of the B.C. Ministry of Finance and Corporate Relations. From 1982 to 1989, she held various manager and director positions in the ministry. Prior to joining the B.C. government, Ms. McNabb was an economist in the revenue forecasting section of the federal Department of Finance. She graduated with a B.A. in Economics and Mathematics from McMaster University in 1974 and obtained an M.A. in Economics from the University of Western Ontario in 1977.

Rolf Mirus

Rolf Mirus is a Professor in the Faculty of Business and the Department of Economics at the University of Alberta. He served from 1984 to 1996 as Director of the Canada China Management Education Program link-ing the University of Alberta to Xi'an Jiaotong University. From 1989 to 1992 he was the Founding Director of the faculty's Centre for International Business Studies. Dr. Mirus obtained his Ph.D. in Economics from the University of Minnesota in 1973. He researches and teaches in macroeconomics, international finance, and international business; he has held visiting appointments at universities in Germany, Austria, China, Kenya, Pakistan, and the U.S.

Roger S. Smith

Roger S. Smith is a Professor in the Faculty of Business and the Department of Economics at the University of Alberta. He served as Dean of the Faculty of Business (1976-88) and as Acting Vice President (Academic) (1994-95). The years 1977-78 and 1995-96 were spent as a Visiting Scholar with Harvard's International Tax Program. He is currently Chair of the Board of Directors of the Banff School of Advanced Management. Dr. Smith received his Ph.D. in Economics from the University of California (Berkeley) in 1969. He worked for the IMF (1972-74), and has been a consultant to the IMF, World Bank, OECD, the Auditor General of Canada and other private and public organizations. His research and teaching is in the area of tax policy and macroeconomics.

Philip Smith

Philip Smith is an economist with a B.A. from McGill University and M.A. and Ph.D. degrees from Queen's University. He worked for several years at the federal Department of Finance as Director of Fiscal Policy and later, of International Finance and Development. For the past nine years he has worked at Statistics Canada, first as Director of National Accounts and Environment and currently as Director of Industrial Organization and Finance.

Peter S. Spiro

Peter S. Spiro is a Toronto-based economist specializing in macroeconomic policy issues, with wide experience working in both the public and private sectors. He has graduate degrees in economics from the University of Toronto and the University of Chicago, where he studied under Nobel laureates Milton Friedman and Gary Becker. He has published many research studies in professional journals, and is the author of a critically praised book, Real Interest Rates and Investment and Borrowing Strategy. The opinions expressed in his contribution to this volume are personal and do not represent any organization with which he may be affiliated.

François Vaillancourt

François Vaillancourt holds a Ph.D. from Queen's University and is Professor, Department of Economics and Research Fellow, Centre de recherche et développement en économique (C.R.D.E.) at the Université de Montréal and Fellow, I.R.P.P. He teaches, conducts, research and has published extensively in the area of public finance and the economics of language. He has conducted research and acted as a consultant for organizations such as the Canadian Tax Foundation, the Conseil de la language française, the Department of Finance, the Economic Council of Canada, Statistics Canada and the World Bank.

Michael A. Walker

Michael Walker, Ph.D., is Executive Director of The Fraser Institute. Since 1974, he has directed the research activities of The Fraser Institute. He has written or edited 40 books on economic topics. His articles on technical economic subjects have appeared in professional journals in Canada, the United States, and Europe. He has been a regular columnist in the Vancouver Province, the Toronto Sun, the Ottawa Citizen, and the Financial Post. He taught at the University of Western Ontario and Carleton University, and was employed at the Bank of Canada and the Federal Department of Finance. He received his B.A. at St. Francis Xavier University and his Ph.D at the University of Western Ontario. He is a director of a number of firms and other enterprises.

Raymundo Winkler

Raymundo Winkler is the Director-General of the Center for Economic Studies of the Private Sector (CEESP), Mexico's leading private-sector economic think tank. He has a B.A. in Economics and post-graduate studies in Economic Development from the Instituto Politecnico Nacional in Mexico. Mr. Winkler has served in both the public sector, where he was in charge of the Department of International Economic Studies at the Ministry of Mines, Energy and State-owned Enterprises, and in the private sector, where he has been in charge of economic studies for several firms, including a mining company and DESC, one of the largest industrial conglomerates in Mexico. When Mr. Winkler joined CEESP, he was placed in charge of its research program, and while in this role published two books. He continues to write about short-term developments in the Mexican economy on a regular basis.

Yue-Chim Richard Wong

Yue Chim Richard Wong is Professor of Economics at the University of Hong Kong. He studied economics at the University of Chicago (A.B. 1974, A.M. 1974, and Ph.D. 1981), and was Visiting Scholar at the National Opinion Research Centre at the University of Chicago in 1985 and at the Hoover Institution of War, Revolution and Peace at Stanford University in 1989. His current research interest is in the economics of transition in China and the political economy of Hong Kong. He has authored numerous books and articles. In addition to his scientific work, Dr. Wong is founding Director of the Hong Kong Centre for Economic Research; a free market policy research institution. The Centre is currently leading a 36-volume study entitled Economic Policies for Hong Kong: Beyond the Transition. He is a member of the Economic Advisory Committee, HK, Hong Kong Committee for Pacific Economic Co-operation Council, Industry and Technology Development Council, HK , University Grants Committee, HK, and Finance Committee of the Hong Kong Housing Authority. Contact: School of Economics and Finance, The University of Hong Kong, Pokfulam Road, Hong Kong. Tel: +852-2547-8313, Facsimile: +852-2548-6319, Email: rycwong@econ.hku.hk.

Bruce Zagaris

Bruce Zagaris received his B.A., J.D., and LL.M. (tax) from George Washington University, his LL.M. (comparative) from Stockholm University, Sweden, and his LL.M. (international) from the Free University, Brussels. He did legal work in Europe and Africa for two years, including as a U.N. consultant in West Africa. He practiced customs law in San Francisco, and taught at the Law Faculty of the University of the West Indies before practicing law in Washington which he has done since 1978, currently as a partner with the law firm of Cameron & Hornbostel. His practice includes counseling and defending white collar criminal cases with significant international elements. His work has a large focus on international tax law, including advising and negotiating agreements and serving as counsel in criminal tax litigation. He has also done a lot of work in the money laundering area. He is an Adjunct Professor of International Criminal Business Law at Fordham Law School, New York City. He has written four books (three as editor) on international law and many articles. Bruce Zagaris is founder and editor-in-chief of the International Enforcement Law Reporter. He is chair, Committee on International Criminal Law, Criminal Justice Section, American Bar Association and chair, Committee on International Tax, Section of International Law & Practice, American Bar Association.