Politicians must bite the bullet to shrink our shadow economy

Context: Shadow economy is that part of economic activity which is not captured in the gross national product (GNP). According to an estimate, 22% of India’s economy came from the shadow economy in 2007.

Shadow economy: An analysis

• Factors leading to shadow economy: High tax and regulatory discretion, a weak rule of law, high incidence of bribery, and a high share of shadow-economy activity. E.g. India.
  • A study of 76 countries showed that with every 1% increase in the index of regulatory intensity, the shadow economy grows by 10%.
• Exemption of informal economy: Informal economy may not come under direct taxes, as income here may mostly be under the taxation threshold.
• Advantages:
  • Underground economy responds to the economic environment and market demand for small-scale manufactures and urban services.
  • It increases competition and efficiency—E.g. Latin American countries.
• Concerns:
  • Failure to understand black money: as a combination of black wealth, black income and black transactions. (Black wealth>black income>black transactions)
    • The focus of tax authorities on catching black transactions rather than black wealth generated.
  • Political cronyism: Electoral bonds with no trails are effectively an invitation to a government-crony nexus and a recipe for further generation of black money.
  • Erosion of tax base: This may lead to higher tax rates, which in turn could further expand the shadow economy while gradually weakening of the collective economic and social basis.
  • Corruption: Entrepreneurs go underground to reduce the burden of politics, bureaucracy and corruption. If corruption goes down by 1%, there is an 8-11% decline in the shadow economy.

Conclusion: A relatively low tax rate and regulatory burden, sizeable resource mobilization, the reliable rule of law and corruption-control can result in reducing the scope of the shadow economy.