Author: FERNANDO DE HOLANDA BARBOSA FILHO *

Source: ETCO Magazine, no.10, August 2008

Daily, a significant part of the Brazilian economy operates outside the reach of the State. Activities not observed by the State can range from the sale of umbrellas on the streets during thunderstorms, to the homemade manufacture of cakes and breads, the employment of workers without a wallet and partial reporting of the sale of a certain commercial establishment. What do all these activities have in common? They are all part of what we call the underground economy. It is noted, therefore, that the definition of underground economy is quite broad, which makes its study quite complex.

For many years, the underground economy, whether or not measured by government agencies, was considered residual, and was not an object of concern for policy makers. However, from the 70s onwards, it was realized that the size of economic activities not measured by the State could represent an important share in the countries' GDP.

A definition usually accepted in the literature on the subject is that the underground economy is “all the production of goods and services not declared to the government deliberately in order to: a) evade taxes; b) evade contributions to social security; c) avoid compliance with labor laws and regulations and d) avoid costs resulting from compliance with applicable rules in a given activity ”. All of these activities reduce the collection of taxes, the credibility of official statistics, make it difficult to choose public policies, in addition to leading to uneven competition between firms in the official and underground economies. The reduction in the tax collection base implies higher rates on those who pay taxes and, with this, a greater tax distortion.

The development of the underground economy is a sign that there is something wrong with the country's institutional apparatus. In other words, the underground economy is expanding because the costs associated with the official economy are high enough to provide gains for those operating outside it. In addition to offering goods and services, not offered by the official economy, the underground economy generates jobs and income, and has its own dynamics resulting from market forces that seek greater flexibility in the operation of economic activities. As an unobservable object, therefore difficult to measure, the analysis of the underground economy is too difficult, since it can be composed of legal or illegal activities, involving currency or barter, for fiscal or administrative reasons.

In Brazil, an important part of the underground economy aggregates the informal economy, which, in general, is defined as workers who do not have a formal contract or workers who do not contribute to social security. The informal economy is easily observed. Official statistics on the informal economy indicate how regulated the Brazilian labor market is, which places around 30% of its employees in different conditions than legally determined 1. 
In order to study the recent behavior of the underground economy in Brazil, IBRE, together with the ETCO Institute, carried out a work in which the first step was to precisely identify the activities that make up the Brazilian underground economy. The second step was to choose the estimation method and analyze the variables that influence a given activity in the underground economy. The method used to estimate the underground economy was the Multiple Causes and Multiple Indicators (MIMIC), developed by Jöreskog and Goldberger (1975) 2. The MIMIC method has the advantage of ordering the factors that most affect the underground economy, which facilitates economic policy prescriptions for the problem. A disadvantage of MIMIC is that this method does not scale the underground economy, but only provides an index that allows the analysis of its development over time.

MIMIC starts from the idea that, although the underground economy is not observable, it leaves some “traces” in the economy (the indicators) and is encouraged by some factors (the causes) 3. The “traces” of the underground economy we used were: the fraction of workers without a license on the total of employees and the ratio between paper money held by the public (PMPP) and demand deposits (DEP). The choice of the first variable is obvious since the informal economy is part of the underground economy. The second variable is chosen because activities that are outside the control of the State seek to use more currency than the banking system. Therefore, a growth in the PMPP / DEP ratio would indicate a growth in the shadow economy. The factors selected for affecting the underground economy are: tax burden, labor market rigidity, corruption, exports of industrialized products as a percentage of GDP and the level of economic activity.

A high tax burden stimulates the growth of the underground economy, as it increases the earnings of those who manage to evade taxes. The rigidity of the labor market is another factor that positively affects the underground economy, since compliance with all labor legislation raises the cost of labor considerably. Therefore, a company that does not comply with all legal requirements reduces its cost. Corruption stimulates the underground economy because an agent, who does not respect current legislation, has a way out to avoid punishment (from fines to imprisonment or corrupting the law enforcement officer). Exports contribute negatively to the underground economy as the export activity is extremely bureaucratic around the world, making the task very difficult for a company that tries to operate in the underground economy. Finally, we have the level of economic activity that, theoretically, has an ambiguous effect on the underground economy. In other words, the underground economy can expand when unemployment increases, with an anti-cyclical relationship; or the shadow economy may decline when unemployment increases, with a pro-cyclical relationship.
The results of our work show that the underground economy has a pro-cyclical relationship with the formal economy, that is, when the formal economy grows, the underground economy also grows. One possible explanation is that the two economies are not watertight compartments where the worker in the shadow economy only consumes products from the shadow economy, while the worker in the official economy only consumes products from the shadow economy. On the contrary, the two sectors interact and, with this, the increase in income in one sector stimulates the purchase of goods and services in the other sector and vice versa.

The results also indicate that in the last year the underground economy (8,7%) grew at a faster pace than the official economy (5,4%). This higher growth is the result of several factors, among which we can mention: greater flexibility to hire and fire from the underground economy, drop in exports as a reason for GDP and the increase in the tax burden. All of these factors together contribute to this greater growth in the shadow economy.

As mentioned earlier, one of the virtues of the method used in the estimation (MIMIC) is the analysis of the relative impact of each of the factors mentioned in the underground economy. In this work, we found that the variables that most influence the underground economy are: the tax burden, corruption, the level of activity and exports. Therefore, the government could reduce the underground economy with policies that lead to a reduction in the tax burden, a fight against corruption, an increase in exports or a combination of all these policies.

It is important to note that just combating the reduction of the Brazilian underground economy would not be enough to expand the official economy, as it offers several activities that are not offered when all rules, laws and taxes are complied with. A fight against the shadow economy must focus on its causes. Otherwise, a more severe repression in relation to its economic activities, would cause an increase in unemployment, a drop in income and a reduction in the goods and services offered in the market, increasing Brazilian social problems.

* Professor at FGV and economist at IBRE-FGV. This article is the result of work carried out in partnership between IBRE and ETCO. I am grateful for the collaboration of members of the ETCO council, especially Minister Marcílio Marques Moreira and Professor André Montoro Filho.