THE VALUE OF ESTIMATING THE HIDDEN ECONOMY
Estimating the size and distribution of the hidden economy is a vitally important role for researchers and statisticians, according to Dilip Bhattacharyya of the University of Leicester, writing in the latest issue of the Economic Journal. In particular, the existence of unrecorded economic activities raises doubts about the accuracy of national income estimates, which has potentially serious implications for policy:

A true measure of national income is essential for proper planning. In the context of the European Union budget, for example, the correct GDP measure is necessary for calculating individual country's contributions.
The correct estimation of tax losses is important for fiscal management. It might even be argued that tax collection on currently untaxed income would reduce the tax burden of existing taxpayers.
The existence of the hidden economy distorts the relations between different economic variables. Since it is distributed across different sectors and different regions of the economy, it should have an important impact on policy formulations.
Bhattacharyya notes that the hidden economy is often interpreted as tax-evaded income. But although tax-evaded income may be the major component of the estimated hidden economy, it cannot be the total. For example, people who provide domestic help may earn a small amount of money that is not taxable, but this would be included in hidden economy estimates. At the other extreme, a self-employed person might collect VAT from the customer but not pay it to the VAT authority. This amount of money would also be missing from the national income estimates, and the tax rate on this amount would be 100%.

Bhattacharyya proposes a method to estimate the sectoral hidden economy and uses it to estimate the unrecorded economy of the service sector and the industrial sector in India. His estimates suggest that the growth of the unrecorded economy is much faster in India’s industrial sector than in its service sector. This result has many economic implications, in particular that the growth of corruption is directly related to the growth of the unrecorded economy in the industrial sector. This has been substantiated by the corruption cases detected by the Indian police in recent years.

Bhattacharyya’s research also indicates that expenditure on consumer durables depends on the hidden economy, potentially reducing the propensity to spend. The work also suggests that the hidden economy distorts the results of a large number of studies that use published data to show economic convergence of rich and poor countries. The results are misleading, he argues, and the conclusions arrived at in these studies are likely to be incorrect.

Note for Editors: ‘On the Economic Rationale of Estimating the Hidden Economy' by Dilip Bhattacharyya is published in the June 1999 issue of the Economic Journal. The author is at the University of Leicester.

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