Financial Term of the Day: Underground Economy.

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DEFINITION of ‘Underground Economy’

The underground economy refers to illegal economic activity. Transactions in the underground economy are illegal either because the good or service being traded is itself illegal or because an otherwise licit transaction does not comply with government reporting requirements. The first category includes drugs and prostitution in most jurisdictions. The second includes untaxed labor and sales, as well as smuggling goods to avoid duties. The underground economy is also referred to as the shadow economy, black market (not gray market) and informal economy.

BREAKING DOWN ‘Underground Economy’

Measuring the Underground Economy

It is difficult to gauge the size of underground economies, because they are by nature not subject to government oversight and do not generate tax returns or show up in official statistics. Discrepancies in these statistics can indicate the approximate size of informal economies, however. For example, national income and national expenditure would in theory be identical, if every transaction were fully visible to the people compiling the data. In practice, though, expenditures exceed income, because income from an illegal transaction will not appear in the data, but that money will show up in expenditures when it is used in a legal transaction. Along the same lines, if electricity consumption grows faster than GDP, it might suggest that the underground economy is growing at the formal economy’s expense.

According to estimates by Friedrich Schneider, the American underground economy was about 8% of GDP, or $1 trillion, in 2009. By 2013, largely due to the financial crisis and resulting contraction of the formal economy, the amount had reached $2 trillion, according to Edgar Feige. The share of America’s underground economy is relatively small. The OECD average, according to Schneider, was around 20% from 1999 to 2010. France’s was closer to 15%, Mexico’s to 30%. On the other hand, as with formal economies, underground economies are not hermetically sealed. Demand for narcotics in the U.S., for example, fuels much of the underground economy in Mexico and elsewhere.


The underground economy can be benign or harmful, depending on the perspective and economic context. In developing countries, the share of the informal economy is relatively large, at around 36% in 2002-2003, according to Schneider, as opposed to around 13% for developed countries. On the one hand, this is bad for developing-country governments, which forgo tax revenue on a large share of transactions. That in turn is bad for citizens, including participants in the informal economy, which do not enjoy quality government services.

On the other hand, keeping income that might otherwise be taxed can benefit participants in the underground economy and boost economic activity overall through added demand. That is especially true if tax revenues would just be siphoned off by corrupt officials rather than funding the government – another aspect of the underground economy.

Activities and Participants

A huge array of activities falls under the label “underground economy,” and the list varies depending on the laws of a given jurisdiction. In some countries, alcohol is banned, while in others brewers, distillers and distributors operate openly. Drugs are illegal in most places, but some U.S. states and a few countries have made the selling cannabis legal. Tobacco is legal in New York City, but steep sin taxes mean that perhaps 60% of cigarettes in the city are sold illegally, as part of the underground economy. Forced labor, the sex trade (where illegal) and human trafficking are part of the underground economy. Black markets exist for copyrighted material, endangered animals, products subject to sanctions or tariffs, antiquities and organs. In addition, anyone who makes taxable income they do not then report to the tax authorities – even if it’s $50 for babysitting – is technically participating in the underground economy.

Participants in underground economies are a diverse bunch as well. They include unregistered, untaxed food vendors on street corners. If a police officer accepts bribes to allow those vendors to do business, the officer is then part of the underground economy. So are elephant poachers, meth dealers, undocumented workers, government ministers who hoard stolen cash in tax havens, entrepreneurs who sell subsidized fuel across borders, graphic designers or handymen who do side-gigs for cash, servers who underreport tips, and people-smugglers who ship refugees and migrants across borders.

Read more: Underground Economy Definition | Investopedia
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