Underground Economy

Underground Economy: Definition, Size, Examples, and Effects

The underground economy (also called the shadow economy, black market, or informal economy) consists of economic transactions that evade legal oversight. This includes activities that are illegal by nature (e.g., illicit drugs, human trafficking) and otherwise legal activities that go unreported to avoid taxes, regulation, or paperwork (e.g., under‑the‑table wages, untaxed sales).

Key points

• Estimates of size vary by method and jurisdiction. Some studies place the U.S. underground economy between 11–12% of GDP (roughly $2–2.5 trillion in recent years), while other measures show lower or higher shares depending on methodology and time frame.
• Globally, the shadow economy differs widely: a cross‑country study found a mean size near one‑third of formal GDP, with some countries exceeding 60% and others below 10%.
• The underground economy can include both illicit markets (drugs, weapons, trafficked goods) and informal, untaxed legal work (cash labor, barter not reported to tax authorities).
• Participation is driven by factors such as avoiding taxes and regulation, lack of legal alternatives, poverty and unemployment, and in some cases corrupt governance.

Why measurement is difficult

By definition, underground activity avoids official records and tax returns, so direct measurement is not possible. Analysts instead use indirect indicators (discrepancies in national accounts, surveys, cash and currency demand, or tracking expenditures that are not reflected in reported transactions) to estimate its scope. Different methods and time periods explain why estimates vary.

Size and trends

• U.S. estimates have fluctuated over time. For example, some estimates placed the U.S. underground economy near $1 trillion (~8% of GDP) in 2009 and higher in subsequent years, with some analyses estimating around $2–2.5 trillion more recently.
• An international study of many countries over several decades found an average shadow‑economy share of roughly 32% of GDP. Country examples from that analysis included very large shares in some developing countries and much smaller shares in certain advanced economies.

Examples of underground activity

• Illegal goods and services: narcotics, weapons, endangered species, stolen art and antiquities, illegal organ trade.
• Human trafficking and forced labor.
• Smuggling and untaxed imports to avoid duties.
• Unreported legal income: cash wages paid “under the table” (restaurant tips or wages, babysitting income when not reported), informal barter, or sales of goods that are not declared for tax purposes.
• Tax‑sensitive items and evasion: high‑tax products (e.g., cigarettes) are often subject to large informal markets; some local studies have shown large shares of cigarette sales bypassing official channels.

Legal boundaries and changing rules

What counts as underground varies by jurisdiction and over time. A product or service may be illegal in one place and regulated or legal in another. For example, attitudes and laws around cannabis have changed significantly: many U.S. states now allow medical cannabis and a growing number permit recreational sales under regulation, removing some activity from the underground market but leaving other cannabis trade still informal or illicit in some places.

Characteristics and motives

Characteristics:
* Often cash‑based or otherwise hard to trace.
* Mixes purely illegal markets with unreported portions of legal markets.
* Can include barter and nonmonetary exchanges not captured in official statistics.

Motives:
* Avoiding taxes, duties, and compliance costs.
* Accessing goods or services that are illegal or unavailable through formal channels.
* Reducing labor‑law or regulatory burdens.
* Responding to weak enforcement, corruption, or lack of formal employment opportunities.

Economic and social impacts

• Negative effects: lost tax revenue, reduced capacity to fund public services, distortion of competition, exposure of workers to unsafe or exploitative conditions.
• Contextual effects: in some settings, informal activity can provide livelihoods and sustain domestic demand when formal opportunities are limited; in severely corrupt systems, some underground activity may circulate funds that would otherwise be captured by corrupt officials rather than used for public benefit.

Practical note on reporting

Income that is not illegal per se can still be taxable. For example, income from babysitting or other informal self‑employment is generally considered taxable and must be reported when it exceeds the applicable filing threshold.

Takeaways

The underground economy is a complex mix of illicit markets and informal, untaxed legal activity. Its size and effects vary widely across countries and over time. Understanding the underground economy requires careful, methodical estimation and recognition of how law, enforcement, taxation, and economic opportunity shape incentives to operate outside the formal economy.