Numerous empirical studies indicate that higher marginal income tax rates stimulate the supply of
goods and services in the underground economy. But very few studies have analysed the demand
for these underground commodities. In new research published in the latest Economic Journal,
Bernard Fortin, Guy Lacroix and Claude Montmarquette investigate the impact of working in
the underground sector on the demand for underground commodities.
Using a survey on the underground activities of over 5,000 individuals, they highlight a network
effect, whereby individuals who sell goods and services in the underground sector are also far
more likely to buy goods and services in the underground sector. The data show that underground
workers spend six times as much on underground commodities compared with others. The
implication of this result is that policies to reduce the size of this hidden economy may have
greater effects than is currently thought since they not only reduce supply to the sector but also
demand from it.
The network effect the researchers detect stems from the fact that workers in the underground
economy have access to better and more timely information on the availability of underground
commodities. This reduces their search costs and may therefore induce them to spend more on
underground goods and services.
The results are based on a unique randomised survey conducted in Canada in 1994. The term
'underground' refers to activities that generate income that is not reported to the tax authorities.
Using a statistical methodology that highlights the effects of specific factors, the results indicate
that:
l Workers in the underground economy are far more likely to be consumers in the
underground economy.
l The more educated have a higher propensity to purchase underground commodities.
l Men are more likely to purchase underground commodities than women.
The study also highlights the policy implications of these results. In particular, the network effect
significantly increases the impact of changes in enforcement (e.g. penalties on tax evasion,
expenditures to detect irregular activities, etc.) on the size of the underground economy. In the
presence of this effect, the demand and the supply for underground commodities are
simultaneously affected by changes in enforcement.
Hence, more stringent enforcement policies may lead workers to reduce their hours in the
underground sector as well as their expenditure on underground commodities.
And although, according to the survey results, underground workers only represent 4% of the
population aged 18 and above, their total expenditure is sufficiently large that any reduction will
translate into a significant reduction of the underground economy. Naturally, the converse also
holds: an increase in income tax rates will have a larger (positive) impact on the size of the
underground economy because of the network effect. Omission of this demand effect thus results
in significant underestimation when assessing the impact of tax and enforcement policies on the
size of the sector.
Note for Editors: 'Are Underground Workers More Likely to be Underground Consumers?' by
Bernard Fortin, Guy Lacroix and Claude Montmarquette is published in the October 2000 issue of
the Economic Journal. Fortin and Lacroix are at the Université of Laval, Quebec; Montmarquette
is at the Université de Montréal. They are all members of CIRANO, an inter-university Canadian
centre of research in economics.
For Further Information: contact Bernard Fortin on 001-418-656-5678 (email:
bernard.fortin@ecn.ulaval.ca); RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or
07768-661095 (email: romesh@compuserve.com); or RES Media Assistant Niall Flynn on 020-
7878-2919 (email: nflynn@cepr.org).