The Underground Recovery
by P.J. DiNuzzo June 4, 2013
The Underground Recovery
A few weeks ago, the New Yorker magazine reported on a study by an obscure but astute University of Wisconsin economist named Edgar Feige, who has been poking around in the economic activity that takes place "underground," out of sight of traditional statistics. Chances are, you participate in this obscure corner of the economy; if you stuff money into the bartender's tip jar, give a few dollars to the skycap at the airport when you hand over your bags, or pay a nanny in cash--or, on a larger scale, if you happen to hire migrant workers off the books to put a roof on the house you're building, or to pick the fruit off your orchard of avocado trees.
Beyond that, few people buy their marihuana or cocaine using a credit card--and this trade activity is not insignificant. It has been estimated that fully half of the Mexican economy is underground and related to the drug trade.
How much economic activity are we talking about in America's subterranean world of cash transactions? An estimated $2 trillion. If taxes were paid on this unreported income, the government's annual budget deficit would go away.
Most of this hidden economy runs on cash, and by tracing the off-the-books movement of some seven hundred and fifty billion dollars in actual bills, Feige was able to solve a problem that has mystified less perceptive economists. Even though household income is still well below what it was in 2007, personal consumption has risen higher than it was before the recession, and retail sales have been climbing briskly. The consumption figures would be appropriate if the unemployment rate were below 6%, compared with the official 7.6% figure that the government reports.
There is evidence that the recession was a growth driver of the underground recovery, since people have a motivation to work on the side while collecting unemployment benefits. But Feige's figures suggest that the underground sector has been growing steadily over the years. IRS estimates suggest that lost tax revenue has increased fivefold since 1992, and Feige believes this is an underestimate.
As the nature of work changes, as more companies are exchanging long-term employment opportunities for temporary contract labor to save on benefits and payroll taxes, more people are viewing themselves as independent contractors. Casual employment morphs into under-the-table work, neither side pays taxes on the exchange of value, and everybody wins except the tax collector. Indeed, a survey of 300,000 general contractors in the construction industry recently found that two-thirds had no direct employees and, therefore, no payroll taxes.
And, of course, the recent increase in tax rates for many Americans will do little to hinder this trend.
There are several things to learn from Feige's analysis. First, unemployment may not be as disastrously high as the government reports would indicate, and the economy may not be as weak as the above-ground numbers suggest.
More worrisome is the idea that the U.S. is moving in the direction of Greece and Italy, where earnings are actively hidden from the government and taxes have to be negotiated in the absence of clear information. We're far from there yet, and as some states legalize (and tax) marihuana sales, as immigration reform brings migrant workers above-ground, we will see large parts of the underground economy rise back into visibility even as the economy as a whole seems to be slowly sneaking into the shadows.
P.J. DiNuzzo, CPA, PFS®, MSTx, MBA
President, Founder, and Chief Investment Officer