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Europe: Hidden economy
By Victor Mallet and Guy Dinmore
Shi Songbin’s existence in Italy came to light one morning in the Via Barsanti in the town of Prato only when stunned residents found his body outside an underground car park surrounded by drab apartment blocks.
Investigators suspect Shi, a 29-year-old Chinese illegal immigrant, died from an overdose of the drugs he took to keep him working on a gruelling day-long shift. His shadowy employers disposed of him in the street to avoid calling the attention of the authorities to their anonymous sweatshop.
Prato – a medieval jewel of a town once renowned for its textile industry – has been transformed into an example of how economic globalisation and weak government have combined to fuel the development of black economies on the southern and eastern fringes of Europe. Illegal sweatshops and their toll of death and misery are, however, only the most gruesome aspect of a multi-faceted, Europe-wide unofficial economy that embraces millions of ordinary citizens – from Bulgarians to Belgians – as well as illegal immigrants from Asia and Africa.
The western world’s economic and financial crisis of the past three years – and particularly the more recent upheaval in the eurozone sovereign debt markets – has aroused new concerns about underground economic activity. “Black” workers pay no taxes, reducing government income and increasing budget deficits, which can prompt higher taxes to make up for lost revenue, which in turn tempts more people into the black economy – a vicious circle of rising crime and decreasing government legitimacy.
For Italy, 1987 was the year of il sorpasso, when revisions to the estimated size of that country’s black economy helped it surpass the UK to become, briefly, the world’s fourth-largest economy.
Contrary to words such as clandestine, black, shadow or underground, a hidden economy is clearly not all bad. Welcome activities – reciprocal favours for neighbours, say – might be hidden from statisticians and also perfectly legal. The hidden economy also enables valuable activity to circumvent stifling bureaucracy, such as unnecessary licences. Without such activities, many societies would be poorer and fail to benefit from the money earned, which is usually spent in the formal part of the economy.
Of course, large parts of the hidden economy are also corrupt, dangerous, illegal and have no social value. So with both good and bad elements to a hidden economy, politicians and economists need to know its size and composition. By definition, however, the hidden economy seeks to avoid detection and measurement. This has created a niche industry in guessing its size but there is little agreement either on the best measurement techniques or the results.
Some things are known. Poor countries have larger hidden economies than rich ones. Southern Europe has a bigger black market than the north. It is also bigger in countries that have numerous restrictions than in more deregulated economies. But going much further is fraught with difficulties. Most techniques use a measurable proxy to estimate “real” activity, then subtract what is measured to leave the residual as the hidden economy. Proxies include electricity consumption, cash in circulation and the volume of transactions.
But to work effectively, these estimates rely on a stable relationship between the proxy and “real” activity. If an economy becomes more electricity-intensive – for example through a switch to electric transport – an electricity-based measure would erroneously show an increase in the size of the hidden economy.
Other methods examine differences in measures of expenditure and income, reasoning that most spending takes place in the regular economy. More complex techniques attempt to relate causes, such as the burden of regulation and attitudes to tax, to indicators of the consequences in measured hours worked and labour force participation rates.
The most compelling reason to treat any specific measure with scepticism, however, is the huge variation in results generated by different researchers. In 1976, two estimates of Canada’s hidden economy by the same authors using the same method but slightly varying techniques yielded estimates that ranged from 4.9 per cent to 27.5 per cent. Chris Giles
Spain – where police have sometimes raided illegal Chinese clothing workshops but where much of the black economy takes the form of humdrum tax evasion by its own citizens – illustrates the complexity of a phenomenon that has spawned its own branch of economic research.
According to Friedrich Schneider, economics professor at Johannes Kepler University in Linz, Austria, the size of the Spanish black economy is equivalent to 19.2 per cent of official gross domestic product. That happens to be the same proportion as the average he calculates for 31 European countries, with Bulgaria the highest at 32.6 per cent and Switzerland the lowest at 8.1 per cent.
It is this clandestine activity that helps to explain one of the more embarrassing economic mysteries of modern Spanish society: an extraordinarily high rate of official unemployment without much of the civil unrest and popular anger that such a problem would normally generate. If it were true that 4.9m people, or more than 21 per cent of the workforce, were jobless, Spain would not be as peaceful as, barring a few demonstrations, it has so far been, say economists and business leaders.
It is an open secret that the Spanish jobless rate – double the European average – is a fiction. Hundreds of thousands of people claim unemployment benefit when they actually have some kind of work; millions are not registered as working, which means that neither they nor their employers are paying social security contributions. One proof, say employers, is that when unemployment fell to 8.5 per cent at the height of the boom in 2006-07, they could find no workers to hire. Yet that figure, the recent Spanish minimum, is high enough that it would be associated with a deep economic recession in almost any other industrialised country.
Madrid would like to cut the jobless rate dramatically. But ministers are reluctant to do so by openly condemning Spaniards as cheats or dismissing their own statistics as unreliable, since that would undermine the country’s reputation further in the midst of an already damaging sovereign bond crisis.
Instead, the government has launched a campaign against the black economy. In April, it approved a law that will sharply increase fines for social security transgressions in order to “combat in an extraordinary and urgent manner the phenomenon of irregular employment”, in the words of the labour ministry. Mari Luz Rodríguez, secretary of state for employment, says the government has provided a total of more than €113bn ($165bn) in aid to the unemployed since 2007.
Ignacio Mauleón, economics professor at Madrid’s King Juan Carlos University, says it is the economic crisis and the need to reduce public spending that has made the previously tolerated black economy such a hot topic. “When there’s no crisis, no one worries about it,” says Prof Mauleón, who co-authored a study this year showing that the number of jobs in Spain’s underground economy had risen from about 1.5m in the early 1980s to more than 4m in the three years to 2008. “But now it’s an issue that everyone thinks about, because of the country’s budget deficit.”
Unregistered employment in construction, farming and other sectors, though, is only one side of a black economy that includes tax evasion by professionals and indeed by almost every Spanish homeowner. In many transactions, including house purchases, part of the payment is official and taxable, and the rest is paid in cash, known as “black money” or “payment B”. That sort of activity helps shed light on why Spain is often said to be the European Union country with the most €500 notes – the largest denomination – in circulation.
But Spain is not unique. Governments in several countries have long tolerated such practices and it is often hard to say where the official economy ends and the “black” one begins, since cash usually flows back into the recorded economy to be taxed.
Nor is it always obvious that the black economy is as detrimental to a nation’s welfare as its label suggests. The shadow economy can be counter-cyclical, softening the negative impact on the formal economy in times of recession. “When wages go down, there is more incentive to move towards the black economy. It is almost a form of insurance, a way out,” says Pietro Reichlin, economics professor at Rome’s Luiss university.
Prof Schneider agrees that underground economies can be useful. “It’s welfare-enhancing,” he says. “Without the shadow economy, Spain would collapse. It’s the only part of the economy that keeps the economy alive You immediately get cash, you immediately earn something to feed your family.” But he notes that in Spain even the shadow economy has shrunk recently, so severe has the crisis been.
That does not mean the black economy is about to disappear as a contributor to the broader eurozone economy. Clandestine employment, after all, has been nourished both by globalisation and by increasingly burdensome regulations imposed on employers by European governments. Take the Chinese in Italy: a decade ago, an illegal immigrant such as Shi would have embarked on a dangerous journey hidden on a ship, possibly crossing from the Balkans on foot. Now tens of thousands simply fly into Europe on three-month tourist visas but then stay for years.
A town of some 180,000 people, Prato is now home to an estimated 35,000 Chinese, about half of them illegal. Just outside the city walls, a Chinatown provides all their needs – Chinese supermarkets, restaurants, travel and marriage agencies, massage parlours and driving schools. The pronto moda – “instant fashion” – garment business they have created, from dyeing imported materials to producing finished goods, can generate hundreds of thousands of items a day, probably the largest concentration of Chinese-run industry in Europe.
By being based in western Europe, the Chinese in Prato can respond to the latest hot market trend within days, rather than weeks if they were delivering from China. The garments can also carry the desirable “made in Italy” label. City law enforcement agencies last year raided 320 businesses, seizing 144 properties and 6,250 sewing machines. But the illegal immigrants they arrest and serve with a deportation order are soon at work again. China refuses to take back its undocumented citizens, while Brussels recently overturned an Italian law making illegal immigration a crime. Piero Grasso, head of the national anti-mafia directorate, estimates that up to €5bn was transferred to China over the past five years through Prato’s money transfer agencies using a branch of Bank of China in Milan. The law allows an individual to transfer €1,999 in cash with no questions asked, so large quantities are broken down.
“The Bank of Italy is sleeping on this issue,” says Silvia Pieraccini, a local journalist and author.
In Italy, as in Spain, the complex phenomenon of the black economy is not just sweatshops and illegal immigrants. It ranges from simple tax evasion by doctors and accountants, paid in cash with no receipts issued, to increasingly sophisticated operations run by organised crime. The Bank of Italy estimates that the amount of money laundered each year, mostly by “criminal multinationals”, is worth 10 per cent of GDP. In 2010 the central bank identified 37,000 suspect transfers.
Prof Reichlin says most studies give Italy’s black economy an overall value equal to some 25 per cent of GDP (Prof Schneider’s latest calculations say 21.8 per cent), compared with an average among industrialised countries of some 15 per cent. Germany is just above the average for the 34 members of the Organisation for Economic Co-operation and Development, while the UK and US are below.
“Among the main causes of the black economy is the level of taxation. The higher the tax and the regulatory burden the bigger the shadow economy of the country,” Prof Reichlin says. “There are also historical reasons shared by countries like Italy, Spain and Greece – a weaker rule of law, lower confidence in the state and a lower social capital.” He sees the solution in reforms to simplify and reduce taxes, lighten the regulatory burden, decrease barriers to labour and improve the judicial system.
A weak state may also help to explain why linguistically divided Belgium shows up in the Schneider figures with a black economy representing 17.4 per cent of GDP, compared with just 10 per cent for the more centralised Netherlands to the north.
All this raises the question as to whether governments will succeed when they try to crack down. In May, the Spanish government publicised a €127,000 fine imposed on Talleres Macor, a car repair and servicing company in southern Spain, for failing to make social security payments for employees. The idea is to deter others from hiring illegal workers. Nevertheless, Spanish employers and economists say a better way to tackle the black economy would be to liberalise the inflexible local labour market.
“There’s an underlying issue here, which is that it’s expensive to hire workers,” says Gayle Allard, professor of economic environment and country analysis at IE business school in Madrid. “You are going to have to do something to make it easier for companies to hire.”
That will not bring Shi back to life. It may not even do much to dent illegal immigration to Europe. But it could help to reduce the substantial share of the continent’s economy accounted for by illicit activities.
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