Estimates of the Black Economy Based on Consumer Demand Approaches

We propose a consumer demand system approach to estimating the size of the black economy where alternative hypotheses affecting the empirical results can be tested in a nested framework. This approach allows for the estimation of the under-reporting of household income from various sources, dispensing with the need to use arbitrary criteria to classify households by their main source of income. It also avoids potential bias in black economy estimates arising from mistaking preference heterogeneity (substitution) as income effects. We illustrate these arguments by estimating the extent to which self-employment income in the UK is underreported using parametric and nonparametric techniques. The black economy, broadly defined as the economic activities that are hidden from public authorities to avoid taxation, has recently received increased attention in the literature due to arguments that the rising tax burden and state regulation is driving economic activity underground (Tanzi and Schuknecht, 1997; Enste and Schneider, 1998). The usefulness of attempts to estimate the size of the black economy, however, is a controversial issue. The sceptics emphasise the difficulties associated with the precise definition of black economy activities and point to the widely different estimates of the size of these activities resulting from alternative methods (Dixon, 1999; Tanzi, 1999; Thomas, 1999). Authors approaching the subject in an optimistic frame of mind emphasise positive aspects of estimating the size of the black economy such as the correct measurement of GDP and other macroeconomic variables (e.g. employment) and the design of policy and econometric models (Bhattacharyya, 1999; Giles, 1999). The controversy on estimation issues, however, does not subtract from the widespread concern about the undesired consequences of the black economy. Undeclared economic activities reduce the tax base, thereby undermining the financing of public goods and social protection. A country trying to curtail the loss of tax revenue by raising tax rates can create a vicious cycle, as this reinforces the incentive not to declare economic activities to the public authorities. High tax rates have a distorting effect resulting in inefficient allocation of resources due to unequal opportunities and willingness to evade in different sectors of the economy and can undermine the ability of the country to compete internationally. Distortions in the labour market can also arise because individuals working in the black economy may have difficulty in moving from one job to another. Furthermore, in countries where health, pension and other social security payments are not universal, individuals working in the black economy and their families are outside the