While in Italy recently, we got a taste of the grey economy in this so-called developed country. Checking in at our hotel in Venice, we were informed that the room we had booked was in fact not with a canal view, contrary to what was previously indicated. But not all was lost, an over-obliging Mr Giovanni was happy to accommodate us for a few extra euros—in cash, of course.

Ironical as it may seem, two Indians who have grown up in India were reminded of the grey economy while in Italy.

As in most things economic, does a simple risk to return profile explain the existence of a grey economy? If you think about it, it does. Grey economies seem to coexist with overly regulated white economies, where the return is not great in all parts of the legitimate economy, a situation which wouldn’t exist in the context of a free market.

Grey economies also flourish with rampant corruption and weak law enforcement, so the risk of engaging in such activities is low. So a lack of economic freedom likely creates shadow markets, or perhaps the state believes that the shadow markets make it a necessity to be hard-handed on economic freedom—a classic chicken and egg issue.

The existence of an overly regulated economy, which does not reward its entrepreneurs to stay within the letter of the law, alone cannot explain the existence of a grey economy. Most societies with significant grey economies also exhibit a deep distrust of the state to put one’s taxes to good use.

Also Read Rajeshree Varangaonkar and Bharat Indurkar’s earlier columns

In the former Soviet countries, stealing from the state was almost a virtue. China, too, is supposed to have a large grey economy. But what unifies these countries is a totalitarian and communist government.

The question then arises, why does a democratic country like India have such a large grey economy. Perhaps we don’t trust the government’s capital allocating skills, given its past track record, or perhaps we choose our own good over the society’s.

Is this a classic developing country phenomenon where opportunities aren’t plentiful, or is this more of a cultural issue with us Indians?

Is it even worthwhile differentiating between grey economy activities and an outright black market? We think not. After all, besides crisis situation like war, both are generally outcomes of the same stifling over regulation that creates endless shortages.

How often do we see that when a good or service is debilitatingly taxed or outright banned, the demand for that doesn’t necessarily fall, but just moves to the black market. Fortunately for the improved convertibility of the Indian rupee, we would imagine the black market for foreign currency must have reduced since the 1980s.

Prohibition is a classic example of a market pushed into the grey under moralist guise. The US had its attempts at prohibition in the 1920s and never again went back to it. Doesn’t it make sense to have such substances under the state’s regulatory purvey rather than deals being cut in shadowy by-lanes, not to mention the lost revenue stream for the government. Meanwhile, arguments about legalizing marijuana are reaching a fever pitch in the US. While this might ruffle conservatives, the discussion does seem pragmatic.

A recent study in China found that the urban rich were more involved in their informal economy than the poor—now that sounds close to home. This strikes a chord with the cultural tax evasion issue in India. A seemingly unrelated issue is the wealthy in India not being remotely as interested in philanthropic causes as say, in the US.

Are the two really unrelated? This interest in only self-betterment with an apparent apathy towards the broader society seems somehow inexplicable in a fairly market-driven economy such as India’s.

Most developing countries have flourishing grey economies, but tend to overcome these if development progresses along the right path. The fiscal deficit, sometimes pro-cyclical and sometimes acyclical, but always omnipresent, is perhaps the worst example of the systemic parallel economy problem in India.

Doing away with the shadow economy in India is as much a challenge for regulation as it is for the Indian mindset.

Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to globalbeat@livemint.com