The Underground Economy
Illegal Immigrants and Others Working Off the Books Cost the U.S. Hundreds of Billions of Dollars in Unpaid Taxes

By Jim McTague
Barron's

America has two economies: First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the fast-growing underground economy, where millions of nannies, construction workers, landscapers and others are paid off the books, their incomes largely untaxed. The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It could soon pass $1 trillion.

What is largely fueling the underground economy, experts say, is the nation's growing ranks of low-wage, illegal immigrants. The government puts this population at 8.5 million, but that may represent a serious undercount. Robert Justich, a senior managing director at Bear Stearns Asset Management, makes a persuasive case in a recent research report that illegal immigrants actually number 18 million to 20 million. If that's true, the economic implications are profound and could help shape this year's debates over both immigration policies and tax reform.

Measuring the size of the underground economy is tough, since most of its denizens seek to remain anonymous. But convincing anecdotal evidence and a number of academic studies suggest that it is expanding briskly-probably by an average of 5.6% a year since the early 1990s, edging out the real economy.

In the process, the underground economy is undermining the effectiveness of the IRS. If the IRS could collect all the taxes it says that it is owed from the underground economy in a given year, then the current budget deficit would disappear overnight. And if the IRS could collect these taxes every year, then the nation would have surpluses far into the future. The IRS has estimated that its tax gap-the amount of taxes owed minus the amount collected-is around $311 billion in any given year. A new estimate due out this year could be as high as $400 billion, says former IRS Commissioner Donald Alexander.

It's not just illegal immigrants fueling the growth of the underground economy. It's also corporate downsizing, which has forced many workers to go out on their own. "We have had an 85% taxpayer compliance rate," says Nina Olson, the IRS's taxpayer advocate. "I expect the number to decline," because the portion of employees who have taxes withheld from regular paychecks is falling. Such employees are 99% compliant with tax laws, she says, but in today's economy, "more people are being treated as independent contractors. We are losing people from the withholding environment."

Result: The underground economy has kept growing nearly unchecked. Academics accept the work of Austrian Friedrich Schneider as the best estimate of the underground economy's size. Using data on currency flows and the consumption of electricity, he guessed that in 1996 it was about 8.8% of the nation's gross domestic product. This estimate was made before the flood of immigration from South America, so it might be conservative if used today, when GDP stands at $11 trillion.

Huge Disconnect

To be sure, the U.S. underground economy, as a percentage of GDP, is smaller than those of some other countries. But the rate of growth is cause for concern. If Mr. Justich's estimate of illegal immigrant workers is correct, the underground economy may now be growing at a markedly faster rate than the legitimate economy. Mr. Justich, working with Bear Stearns colleague Betty Ng, an emerging-markets economist, says he's found evidence of a larger illegal immigrant population by analyzing data on construction and on remittances sent from the U.S. to Mexico and other countries. He also had conversations with more than 100 immigrants from Mexico, Brazil, the Dominican Republic, Guinea, China and Tibet. And he interviewed local business owners, real-estate salespeople and police.

Mr. Justich, a veteran Wall Street analyst, began digging into the underground economy because of its broad ramifications for the real economy. In his spare time, he has been exploring the immigrant communities of northern New Jersey for his work as executive producer of a documentary film about immigrants. Mr. Justich was struck by the economic impact of Brazilian immigrants on a neighborhood of Newark near the city's train station. (Related article: Homelands Prosper, but Immigrants Keep Coming.) Sidewalks and stores are packed with shoppers. Restaurants are filled with diners. New three-family housing units are popping up.

He and Ms. Ng started to do some detective work. They compared housing permits in the gateway communities with census data and were shocked at the results. The census data indicate that the populations of Newark, New Brunswick and Elizabeth grew by 5.6% between 1990 and 2003, and less than the 9% growth in their three corresponding counties. Yet housing permits in the three cities were up sixfold versus a threefold increase for the counties; and 80% of the permits in the cities were for multifamily dwellings. That struck him as a huge disconnect, suggesting the immigrant populations are larger than shown by the census.

Mr. Justich's analysis of remittances from the U.S. to Mexico also indicates a larger population of immigrants than the official numbers show. According to a study done for the Pew Hispanic Center, remittances to Mexico tripled to $13.2 billion between 1995 and 2000. Yet the official tally of Mexicans in the U.S. rose 56% and the estimate of their weekly wages rose 10%.

From all this, Mr. Justich concludes that Fed Chairman Alan Greenspan's estimates of productivity gains in the U.S. economy are overly rosy. "The productivity miracle may be slightly overstated because they are counting the output of millions of illegal immigrants but not counting the input," he says. Likewise, long-term budget projections could be overstating the potential growth of the legitimate U.S. economy or underestimating the need for high illegal-immigrant flows to hit the forecast growth targets.

Ideas like that could become food for thought for Rep. Bill Thomas of California, chairman of the House's tax-writing committee. He wants to push ahead with tax reform this year, including the creation of a national sales tax. In theory, a sales tax would capture the underground economy, since all wage earners have to spend money to live.

A larger number of illegal immigrants also would have a profound impact on coming discussions on immigration reform. President Bush proposes a form of temporary amnesty for illegal aliens already in the country, allowing them to obtain permits to work legally for three years and stay longer if their jobs otherwise can't be filled by native-born workers. But if there are, in fact, 20 million illegal aliens, the Bush proposal could trigger enormous unanticipated costs. (Related article: Bush Struggles With Immigration Policy.)

Tide May Be Turning

The IRS's Ms. Olson says that tax collectors and cops enthusiastically pursue two groups of tax evaders-the underpayers and the crooks. But she says there's little effort at the federal level to capture the sidewalk vendor who's hiding most of his income or to ferret out which lawn-care service is skipping taxes. Authorities just don't think it's worth the enforcement costs.

The truth is, employers hiring illegal workers have little to fear from the government right now. Data from the U.S. Citizenship and Immigration Services show that enforcement actions against employers and illegal workers have dropped sharply since 1997. Instead, agents are trying to catch workers at border-crossing points. Opponents argue that cracking down on employers would be more effective. If immigrants couldn't get work, the argument goes, they wouldn't bother to come.

There are signs that tide may be turning. The IRS last year added 2,200 enforcement employees. Ms. Olson, for her part, favors more spot audits of even the smallest small businesses because, she says, word of enforcement actions spreads like wildfire and makes others think twice about cheating.

And Ms. Olson notes, it's hard work for someone to stay hidden in the underground economy. At some point, perhaps when the tax evader wants to buy, say, a house and encounters lenders who demand tax returns, the incentive to turn legal can become great.

In the meantime, however, employment of illegal immigrants is flourishing. Mr. Justich believes that undocumented workers now hold 12 million to 15 million jobs in the U.S. If those showed up in official data, the Bush administration's job-creation record would look significantly better. In fact, four million to six million of these positions have moved from the legitimate economy into the underground economy in recent years, he says.