The Underground Economy in the United States: Reply to Acharya
Author: Mr. Vito Tanzi

In his comment1 on my 1983 paper,2 Acharya lists five problems relating to the use of what he calls the “Tanzi method” in estimating the size of the underground economy, problems that he considers “quite significant.” I fully agree that there are limitations to my approach, and I clearly indicated them in my concluding remarks to the paper:

Abstract

In his comment1 on my 1983 paper,2 Acharya lists five problems relating to the use of what he calls the “Tanzi method” in estimating the size of the underground economy, problems that he considers “quite significant.” I fully agree that there are limitations to my approach, and I clearly indicated them in my concluding remarks to the paper:

In his comment1 on my 1983 paper,2 Acharya lists five problems relating to the use of what he calls the “Tanzi method” in estimating the size of the underground economy, problems that he considers “quite significant.” I fully agree that there are limitations to my approach, and I clearly indicated them in my concluding remarks to the paper:

The results obtained in this paper should not be taken as precise measures of the underground economy; they are, at best, broad indications of trends and of orders of magnitude because they are sensitive to the assumptions made as well as to data revisions.3

In my several other works on the subject, I have also discussed at length factors—such as regulation of some economic activities and prohibition of others, and various forms of corruption and criminal action—that, in addition to taxes, may bring into existence underground or parallel economic activities.4 Moreover, I have clearly recognized that “obviously, many forms of tax evasion (claiming nonexistent exemptions, exaggerating deductions, non-reporting of interest income received, etc.) have nothing to do with currency usage…,”5 so that they are not assessed by my method.

Again, the so-called Tanzi method has had one and only one objective: to estimate or, better, to give indicators of the trend in and the magnitude of those underground economic activities that in the United States have been generated by income taxes. The method has provided estimates that are relatively close to those obtained by the U.S. Internal Revenue Service and others,6 and, at least for that reason, it takes its place among the credible approaches reviewed in my paper. As Acharya says, the method “has gained wide currency among scholars”7 and has by now been applied to a large number of countries. Some of these applications clearly have been justified, but others have ignored the caveats I made. For these uses of the “Tanzi method” I accept neither credit nor blame.

Let me consider the five questions or difficulties Acharya has raised. I shall take them up in the reverse order in which he has presented them.

His last comment is that “Tanzi’s approach is ill-suited to assessing the significance of nontax causes that might lead to the underreporting of incomes and transactions….8 I certainly agree, and for this reason I would not apply it without substantial modifications to, say, India, where such nontax causes are likely to be important. The fact is that much of the discussion of the underground economy in the United States has emphasized the importance of income taxes in addition to that of criminal activities. Criminal activities were explicitly excluded from my estimates. In countries such as the United States, Sweden, Canada, and in other industrial countries where a large share of underground economic activities is caused by high income tax rates, the method is likely to give realistic estimates. The more important are nontax causes, the less useful my method becomes.

Acharya’s fourth point is that many “underground” transactions are not undertaken solely with cash. For those countries where there is banking secrecy, I certainly agree. But in the United States, where the Internal Revenue Service can at any time get a statement of all checks written and cashed by any individual, I have difficulty in believing “that many of these transactions occur through the banking system.”9

His third comment is, again, somewhat irrelevant, at least in the example given, if the method is applied to the United States. In the United States indirect taxes have hardly changed enough to make “the relation between tax-evaded income and illegal currency” an unstable one.10 The point that the income velocity of illegal currency can change is indeed valid—but then so can the velocity of legal currency. Because my method assumes that the two velocities are the same, an assumption that Acharya criticizes in his second point, his third comment can be dealt with jointly with the second.

Acharya in his second comment objects to my agnostic position on whether the velocity of money in the underground economy is greater or smaller than in the legal economy. I could, of course, have presented arguments supporting different assumptions. However, in my work I have always been mindful of a statement attributed to Keynes, that it is better to be approximately right than precisely wrong. I thus have never believed in the usefulness of theoretical arguments intended mainly to give a pseudoscientific quality of precision to particular positions. Rather, I prefer results that are broad indications of trends or magnitude, a preference I indicated in my concluding remarks to the paper.

The first comment by Acharya is perhaps the most perceptive. Yet, although logically right, his point is not empirically important. As he says, one can assume that the underground economy is totally additive to the legal economy. This was the assumption that I made in the calculations for my paper, even though I discussed reasons for the likely invalidity of the assumption.11 Or, one can assume that the official (that is, the measured) gross national product totally includes the underground economy. This alternative assumption implies that the underground economy is strictly a problem for the tax authorities but not for the national accounts agencies. This assumption would be equally unrealistic, as many articles have argued.12 Whatever the assumption made, and I do not know which would be closer to the truth, it would not have significantly changed the estimates of the size of the underground economy that I derived. Certainly, the margin of error in these estimates is greater than this difference.

Let me sum up. Acharya has made some interesting points in his comment. Some of those points are, as he says, logically correct. My considered judgment is that they are also largely irrelevant. The “Tanzi method” was applied to the U.S. case—where income taxes have been universally blamed for sending some activities underground; where other taxes have not played much of a role; and where, because of the absence of banking secrecy, it seems reasonable to assume that most underground transactions are made in cash. It was explicitly stated in my work that non-tax-related causes (such as criminal activities) that may generate underground incomes are not captured by my method. I would certainly not apply, without major modifications, the “Tanzi method” to situations quite different from the case I examined. The study of underground economic activities is in its infancy. Our methods must be refined, and the quality of the estimates improved. But let us not fall into the trap of believing that, at this juncture, we can generate estimates that indicate more than orders of magnitude.

SUMMARIES

Domestic Credit and Exchange Rates in Developing Countries: Some Policy Experiments with Korean DataLeslie lipschitz (pages 595–635)

This paper analyzes the efficacy of alternative financial stabilization policies in response to disturbances from various sources. A model, appropriate to the institutional structure of a developing country, is estimated. The model is subjected to shocks from the domestic real economy, domestic financial circumstances, and the external terms of trade. Alternative policy reactions are evaluated with respect to each of these shocks.

A few generalizations may be drawn from the results. First, exchange rate changes are a powerful instrument of adjustment, even when the estimated price elasticities of trade are small. Second, even in a country that does not have an open financial system that is integrated with the rest of the world, monetary conditions have a large and rapid effect on the balance of payments. Third, in many cases the most effective policies for stabilizing the external balance entail large fluctuations in exchange rates and prices. To the extent that these fluctuations are themselves regarded as unacceptably costly, less dramatic measures may be preferred. Fourth, the source of a disturbance to the economy is often more important to determining the best policy response than the manifestation of the disturbance. For example, inflation that is the result of unwarranted monetary expansion might require a different policy reaction from that required by the same rate of inflation caused by a rise in import prices. Fifth, policy adjustment lags—that is, lags between environmental disturbances and policy reactions—are very important. The length of these lags may significantly affect the path of the economy, especially when the disturbance to the economy is of short duration. Finally, the appropriate policy response to any disturbance depends on the expected duration of the disturbance. The benefits of avoiding excessive early adjustment have to be weighed against the costs of a probable greater, and more painful, adjustment at a later stage.

On Growth and Inflation in Developing Countries—omotunde e.g. Johnson (pages 636–60)

The hypothesis that inflation, up to a point, can be beneficial to growth in developing countries is traditionally discussed in the context of structuralism and inflationary financing of government investment (inflation tax) and of private investment. In structuralism, the argument is that increases in growth engender increases in the relative price of the agricultural good and that, because of price rigidity in the industrial sector, such relative price increases are accompanied by increases in the rate of inflation.

Both the inflation tax and inflationary financing of business investment can be effective only if the ratio of investment to gross domestic product (GDP) increases with inflation and if growth increases with the ratio of investment to GDP. It is important for the inflation tax that government expenditure relative to GDP increases with inflation, that a rising fraction of such expenditure is invested, and that government investment does not seriously crowd out private investment. The inflation tax must also not induce appreciation of the currency.

The inflationary financing of business investment will tend to be effective and to have a positive growth effect if it leads to a transfer of income from wage earners to profit earners, on the assumption that the marginal propensity to save of profit earners is greater than that of wage earners.

The existing empirical evidence for developing countries seems to support the view that, up to a relatively low level of inflation, changes in growth may be positively correlated with changes in inflation. But more complete empirical analysis than has thus far been undertaken is clearly needed: not only to investigate the overall relation between inflation and growth, but also to uncover the conditions for positive correlation between changes in growth and changes in inflation that, for the period studied, were and were not satisfied.

Effects of Increased Market Access on Exports of Developing Countriesnaheed kirmani, pierluigi molajoni, and thomas mayer (pages 661–84)

The rising trend toward protectionism in industrial countries, if unchecked, could critically constrain the growth and development prospects of developing countries. Many developing countries are undertaking difficult adjustment efforts to overcome their balance of payments and external debt problems and to establish sustainable growth in the medium term. Trade restrictions in foreign markets may limit the volume of developing countries’ exports and, hence, may adversely affect their capacities to adjust. Against this backdrop, the present paper analyzes the consequences for the exports of selected developing countries if market access for a number of their products were to be enlarged in industrial countries. The exercise is based on partial analysis with certain simplifying assumptions, and its results must therefore be qualified accordingly.

The authors have compiled evidence on the height of tariff and nontariff trade barriers in four Organization for Economic Cooperation and Development markets (the United States, the European Community, Japan, and Canada) for seven selected sectors (meat, cereals, sugar, textiles, clothing, steel, and footwear) during 1979–81. From these data they estimate the impact of lowering such barriers on the exports of a geographically distributed sample of ten developing countries that currently are undertaking adjustment programs with Fund financial assistance, or that have done so in the recent past. The results of the analysis indicate that the trade liberalization assumed could lead to a real increase of 5 to 10 percent in the combined exports of the sample countries, depending on the strength of supply response. The authors thus conclude that improved market access could contribute significantly to the export performances, and hence to the adjustment efforts, of developing countries.

Credit and Fiscal Policies in a “Global Monetarist” Model of the Balance of Paymentspeter montiel (pages 685–708)

The fundamental equation of the monetary approach to the balance of payments expresses the flow of foreign exchange reserves as the difference between the flow demand for money and the flow supply of domestic credit. Because this relation is a balance-sheet identity, it should be satisfied by any properly specified macroeconomic model. Nonetheless, this fundamental equation has sometimes been interpreted to justify the conclusions that changes in the flow of domestic credit give rise to equal but opposite changes in the balance of payments and that fiscal policy affects the balance of payments only through its implications for domestic credit expansion. Because these conclusions are statements about the reduced-form coefficients of certain policy variables, however, they cannot be established solely by reference to a balance-sheet identity. Instead, their justification has to rely on the specification of an underlying structural model. These hypotheses are frequently associated with a class of models known in the literature as “global monetarist.” Such models are characterized by their assumptions of continuous purchasing-power and interest parity and of flexible nominal wages.

It is argued in this paper, however, that even these restrictive assumptions are not sufficient to generate the conclusions that the balance of payments is determined solely by the overall flow of domestic credit and that fiscal policy has no independent influence on the payments balance. If asset demands depend on wealth and if conventional saving behavior is assumed, fiscal policy can have a direct, independent effect on the balance of payments in both the short run and the long run through its influence on the flow demand for money, even if “global monetarist” assumptions are imposed. Therefore, the class of models for which the roles of fiscal and credit policies are as described above seems to be rather narrow.

The Fund Agreement in the Courts—XXjoseph gold (pages 709–41)

This installment in the series of articles on litigation involving the Fund’s Articles of Agreement discusses two main topics. The first is the application of units of account defined in relation to gold by treaties not yet amended, replaced, or supplemented nationally by official decrees. The problem arises because the official price of gold has been abrogated.

The cases have been decided by courts in the United States, France, Italy, the Netherlands, and Austria. The treaties involve the Warsaw Convention and other international agreements. The tendency to reject the market price of gold as the solution is widespread. In all but the French case, the SDR has been considered and sometimes adopted. The U.S. Supreme Court has not adopted the SDR but has left the way open to it by executive action. The decision endorses the last par value of the dollar, but on the basis of dubious reasoning. The Supreme Court rejected the decision of the lower court that the Warsaw Convention is unenforceable because there is no official price for gold. Decisions on gold units are important because, for various reasons, the Montreal Protocols and other proposed amendments of treaties have not come into force.

The other topic is international law on movements of capital as prescribed by the Fund’s Articles, the Treaty of Rome, and the Code of the Organization for Economic Cooperation and Development. The relationships among these treaties are explored. The discussion is based principally on a decision of the Court of Justice of the European Communities, which interprets what is meant by a movement of capital.

RESUMES

RESUMENES

In statistical matter (except in the résumés and resumenes) throughout this issue,

Dots (…) indicate that data are not available;

A dash (—) indicates that the figure is zero or less than half the final digit shown, or that the item does not exist;

A single dot (.) indicates decimals;

A comma (,) separates thousands and millions;

“Billion” means a thousand million, and “trillion” means a thousand billion;

A short dash (-) is used between years or months (for example, 1981–83 or January-October) to indicate a total of the years or months inclusive of the beginning and ending years or months;

A stroke (/) is used between years (for example, 1981/82) to indicate a fiscal year or a crop year;

Components of tables may not add to totals shown because of rounding.

*

Director of the Fiscal Affairs Department.

1

Shankar Acharya, ‘The Underground Economy in the United States: Comment on Tanzi,” Staff Papers, International Monetary Fund (Washington), Vol. 31 (December 1984), pp. 742–46.

2

Vito Tanzi, “The Underground Economy in the United States: Annual Estimates, 1930–80,” Staff Papers, International Monetary Fund (Washington), Vol. 30 (June 1983), pp. 283–305.

3

Ibid., p. 302.

4

See Vito Tanzi, “The Underground Economy in the United States: Estimates and Implications,” Quarterly Review, Banca Nazionale del Lavoro (Rome), No. 135 (December 1980), pp. 427–53 (reprinted in The Underground Economy in the United States and Abroad (Lexington, Massachusetts: Lexington Books, 1982), pp. 69–92), especially pp. 427–30; Vito Tanzi, “A Second (and More Skeptical) Look at the Underground Economy in the United States,” in Tanzi, ed., The Underground Economy, pp. 103–18, especially pp. 104–14; and Vito Tanzi, “The Underground Economy: The Causes and Consequences of This Worldwide Phenomenon,” Finance & Development, Vol. 20 (December 1983), pp. 10–13.

5

Tanzi, “The Underground Economy: Annual Estimates,” p. 302 n. 10.

6

Ibid., p.302 and references cited therein.

7

Acharya, “The Underground Economy: Comment,” p. 742.

8

Ibid., p.745.

9

Ibid.

10

Ibid.

11

Tanzi, “The Underground Economy: Annual Estimates,” p. 303.

12

See the papers collected in Tanzi, ed., The Underground Economy, especially those by Peter Reuter, “The Irregular Economy and the Quality of Macroeconomic Statistics,” pp. 125–43, and by Daniela Del Boca and Francesco Forte, “Recent Empirical Surveys and Theoretical Interpretations of the Parallel Economy in Italy,” pp. 181–97.