Home / Opinion / Views /  Politicians must bite the bullet to shrink our shadow economy

The ‘shadow economy’ is understood differently by different people. For tax authorities, it is anything that has escaped the tax net, while for economists it is that part of economic activity which is not captured in the gross national product (GNP). While India’s informal sector has been estimated at 65% of GNP, its black economy was put at 22% by Schneider’s research in 2007. A substantial part of the informal economy is captured in the formal national accounts and by the tax net. It may not come under direct taxes, as income here may mostly be under the taxation threshold.

But the crunch lies in our failure to understand black money as a combination of black wealth, black income and black transactions. Black wealth is several times more than black income, and the latter is many times of black transactions. With precious little being done about black wealth in the absence of a wealth tax and property-tracking efforts, new income can easily be hidden. What gets caught represents only some black transactions. Tax authorities seem keen to catch these, and they seek powers to register first information reports, make arrests, carry out custodial interrogations, and treat those actions as cognizable offences. Until the entire chain is addressed, however, catching black transactions will do too little, and too invasively. That is also the reason demonetization did not help in the elimination of black money.

People who work in the informal sector often are below the tax exemption threshold, and thus cannot be considered part of the unaccounted-for or shadow economy. But what is of concern is the illegal money that governments should have the guts to take on. That seems unlikely so long as politics prospers with cronyism. Electoral bonds with no trails are effectively an invitation to a government-crony nexus and a recipe for further generation of black money.

The reason the shadow economy is a challenge to the welfare state is that it erodes the tax base and pushes the state into a vicious cycle of budget deficits and tax-base erosion. This may lead to higher tax rates eventually, which in turn could further expand the shadow economy while gradually weakening of the economic and social basis of our collective arrangement. With lower tax revenues, less public goods can be provided.

The shadow economy develops all the time and is highly adaptable. It adjusts to changes in taxes, sanctions, the probability of detection and general moral attitudes. It is a product of the equilibrium that the political economy reaches. A relatively low tax rate and regulatory burden, sizeable resource mobilization, reliable rule of law and corruption-control characterize a good equilibrium, like in the Organisation for Economic Co-operation and Development countries. India has high tax and regulatory discretion, weak rule of law, high incidence of bribery, and a high share of shadow-economy activity. This is the opposite of a good equilibrium, but a balance nonetheless. Unless the vicious cycle is broken, the country might stay at this bad equilibrium.

The underground economy grows when people and firms choose an exit rather than voting option. An ineffective and discretionary application of rules pushes the economy into this undesirable trajectory. Cross-country statistics shows that entrepreneurs go underground to reduce the burden of politics, bureaucracy and corruption. High marginal tax rates, an extremely complex tax system, intense regulations and high tax resistance all incentivise a flight to the shadow economy. A study of 76 countries showed that with every 1% increase in the index of regulatory intensity, the shadow economy grows by 10%. But the redeeming feature is that 66% of earnings from the unaccounted-for economy are used almost immediately in the official economy.

So, is the health of the underground economy inversely related to the formal economy? The evidence is ambiguous. The problem is more structural than cyclical. The neo-classical view is that an underground economy responds to the economic environment and market demand for small-scale manufactures and urban services. It increases competition and efficiency. Studies in Latin America show that a thriving underground economy could aid growth, though our one-size-fits-all understanding winces at such a conclusion.

But black wealth and corruption reduce competitiveness. If corruption goes down by 1%, there is an 8-11% decline in the shadow economy. Countries with more corruption and bribery have a larger shadow economy, as going underground can be a lifeline out of oppressive corruption.

Corruption per se is the big problem, and it is not limited to the public sector. Private-sector corruption comes down drastically when the government is not an ally. A clean-up of electoral corruption is a good starting point for other sectors to take the cue and for political leaders to earn the moral right to shrink the shadow economy. Reducing the complexity of the tax system rather than just rates, easing regulations, and encouraging tax morality can support such an exercise. But it will have to start first with political corruption, particularly electoral corruption. Will our political system bite the bullet?

These are the author’s personal views.

Satya Mohanty is former secretary to the Government of India

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.
Recommended For You
Edit Profile
Get alerts on WhatsApp
Set Preferences My ReadsFeedbackRedeem a Gift CardLogout