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Vol 2, No 40
20 November 2000
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Sam VakninThe Blessings of the Informal Economy
Sam Vaknin

Some call it the "unofficial" or "informal" economy, others call it the "grey economy" but the old name fits it best: the "black economy." In the USA "black" means "profitable, healthy" and this is what the black economy is. The countries in transition—from Hungary and Poland to Moldova and Macedonia—should count their blessings for having had a black economy so strong and thriving to see them through. If they had to rely only on their official economies, they would have gone bankrupt long ago.

A hefty income

The black economy is made up of two constituent activities:

  • Legal activities that are not reported to the tax authorities and the income from which goes untaxed and unreported. For instance: it is not illegal to clean someone's house, to feed people or to drive them. It is, however, illegal to hide the income generated by these activities and not to pay tax on it. In most countries of the world, this is a criminal offence, punishable by years in prison.
  • Illegal activities which, needless to say, are also not reported to the state (and, therefore, not taxed).

These two types of activities together are thought to comprise between 15 percent (USA, Germany) and 60 percent (Russia) of the economic activity of a country (as measured by its GDP). It would probably be an underestimate to say that in countries like the republics of former Yugoslavia, Albania, Russia and Ukraine and other Newly Independent States (NIS) 40 percent of the GDP is "black." This equals USD 1.2 billion per annum in tiny Macedonia alone.

It all comes flooding back

The money generated by these activities is largely held in foreign exchange outside the banking system or smuggled abroad (even through the local banking system). Experience in other countries shows that around 15 percent of the money "floats" in the recipient country and is used to finance consumption. To return to Macedonia as a benchmark, this should translate to one billion free-floating dollars in the hands of its two million citizens. Billions are transferred to the outside world (mostly to finance additional transactions, some of it to be saved in foreign banks away from the long arm of the state). Estimates are that USD 30-60 billion leave Russia this way—annually. This is more than its total gross international borrowing. A trickle of money comes back and is "laundered" through the opening of small legal businesses.

The latter are excellent news. They mean that when the macro-economic, geopolitical and (especially) the micro-economic climates all change, billions of dollars flow back. People bring their money back to open businesses, to support family members and just to consume it. It all depends on the mood and on the atmosphere and on how much these people feel that they can rely on political stability and rational management.

Such enormous flows of capital happened before: in Argentina after the Generals and their corrupt regime were ousted by civilians, in Israel when the peace process started and in Mexico following the signature of NAFTA, to mention but three cases. These reserves can be lured back and can transform the economy in countries in transition as well. Actually, it is their great white hope.

Catalyst of change

But the black economy in these countries has many more important functions.

The black economy is a cash economy. It is liquid and fast. It increases the velocity of money. It injects much-needed foreign exchange into the economy and inadvertently increases the effective money supply and the resulting money aggregates. In this sense, it defies the dictates of "we know better" institutions such as the IMF. It fosters economic activity and employs people. It encourages labour mobility and international trade. The informal economy, in short, is very positive. With the exception of illegal activities, it does everything that the official economy does—and, usually, more efficiently. Unfortunately, in the countries in transition, the proceeds of crime and laundered money far outweigh the turnover of tax evasion.

So, what is morally wrong with the black economy? The answer, in brief: it is exploitative. Other parts of the economy which are not hidden (though they would have liked to be) are penalized for their visibility. They pay taxes. Workers in a factory owned by the state or in the government service cannot avoid paying taxes. The money that the state collects from them is invested, for instance, in infrastructure (roads, phones, electricity) or used to pay for public services (education, defence, policing). The operators of the black economy enjoy these services without paying for them, without bearing the costs and worse: while others bear the costs. This encourages them, in theory, to use these resources less efficiently.

These considerations perhaps hold true in a highly efficient, almost ideal market economy. The emphasis is on the word "market." Unfortunately, the denizens of the former Soviet space, all live in societies which are regulated by bureaucracies which are controlled (in theory, rarely in practice) by politicians. These elites have a tendency to misuse and to abuse resources and to allocate them in an inefficient manner.

Even economic theory admits that any dollar left in the hands of the private sector is much more efficiently deployed than the same dollar in the hands of the most honest and well-meaning and well planning civil servant.
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Well-meaning (let alone honest) bureaucrats are the stuff of science fiction in the countries in transition. Governments all over the world distort economic decisions and misallocate scarce economic resources. This is infinitely more true in the rumps of the collapsing empires of the East.

Thus, if the goals are to encourage employment and economic growth, the black economy should be welcomed. This is precisely what it does and, by definition, it does so more efficiently than the government. The less tax dollars a government has, the less damage it does. This is an opinion shares by most economists in the world today. Lower tax rates are an admission of this fact and a legalization of parts of the black economy.

Sam Vaknin, 20 November 2000

The author is General Manager of Capital Markets Institute Ltd, a consultancy firm with operations in Macedonia and Russia. He is an Economic Advisor to the Government of Macedonia.

DISCLAIMER: The views presented in this article represent only the personal opinions and judgements of the author.

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