Which of the following best describes what is meant by the term underground economy?

2.2 Indirect or Discrepancy Approaches

The underground economy is reflected in discrepancies showing up in various markets. Persons working in the unofficial sector are able to spend more than their officially recorded income. The discrepancy between the two may be observed at the level of individual households, as well as in the aggregate national accounts. This approach is questionable, as this expenditure–income discrepancy may either be due to measurement errors (which is indeed often the case) or to reasons unrelated to the underground economy (e.g., the use of credits, or reductions in wealth).

Another discrepancy may be observable in the labor market. A decline in official participation rates, or a low participation rate compared to other countries, may be an indication of unofficial work. But again, the discrepancy may be related to other factors. Moreover, this approach is unable to isolate those persons who are at the same time active in the official and the unofficial economy (which seems often to be the case, according to other approaches).

A third discrepancy may be visible in the monetary market. The dominant approach starts with the assumption that underground transactions are paid in cash in order to make detection more unlikely. The size of the underground economy is reflected in the amount of cash used in a country beyond that used for official transactions. This approach is elegant and easily applicable because the amount of currency is well documented. The assumption that unofficial activities are transacted in cash is, however, questionable. Empirical research suggests that between 20 percent and 30 percent of the unofficial activities are not paid in cash, i.e., either by payment in kind or via a bank. This fact is especially bothersome for the currency demand approach when the share of cash payments changes over time and differs between countries. A significant portion of some currencies is held outside the country issuing it; thus the US dollar is widely used in South America and Asia. Again, the discrepancy is influenced by many factors unrelated to the underground economy, such as the use of credit cards. Finally, it is problematic to infer the size of the unofficial sector from currency transactions, because the velocity of cash circulation may differ between the official and the unofficial sector. Some of the difficulties just mentioned have been successfully addressed by more recent research. Thus, the use of credit cards and the amount of currencies outside a country have been taken into account. Most importantly, instead of comparing the actual use of cash to the one deemed necessary for the official economy, a cash demand function is empirically measured, i.e., econometrically estimated. This allows us to check for influences (such as changes in the interest rate or the increasing use of cash substitutes) unrelated to the underground economy. Moreover, the extra use of cash has been directly attributed to causal factors, in particular to an increase in the tax and social security burden. Figures for the size and development of the shadow economy can be calculated by comparing the difference between the development of currency when the direct and indirect tax burden and government regulations are held at their lowest value, and the development of currency with the current (higher) burden of taxation and government regulations. The currency demand approach is one of the most commonly used approaches.

The most recent discrepancy approach looks at physical inputs, in particular the use of electricity. How much electricity would normally be used to produce the official national income is calculated. The excess use can be attributed to the underground economy. This approach again has the great advantage of relying on easily available data, which is a distinct advantage for developing and transition economies. However, not all underground activities use much, if any, electricity, and the relationship between production and electricity used may change over time, or differ between countries, due to substitution and technical progress.

A general problem of all discrepancy approaches is that one has to assume a base year without underground economy. Only then is it possible to attribute the existence and rise of a discrepancy to the underground economy.

4.3 Tax evasion

Our third example of how the Friedman rule breaks in the presence of an incomplete tax system is perhaps the most direct illustration of this principle. In this example, there is an underground economy in which firms evade income taxes. The failure of the Friedman rule due to tax evasion is studied in Nicolini (1998) in the context of a cash-in-advance model with consumption taxes. To maintain continuity with our previous analysis, here we embed an underground sector in our transaction cost model with income taxation. Specifically, we modify the model of Section 3 by assuming that firms can hide an amount ut of output from the tax authority, which implies that the income tax rate applies only to the amount F(ht) − ut. Thus, the variable ut is a measure of the size of the underground economy. The maximization problem of the firm is then given by

F(ht)−wtht−τt[F(ht)−ut].

We allow the size of the underground economy to vary with the level of aggregate activity by assuming that ut is the following function of ht

ut=u(ht).

The first-order condition associated with the firm's profit maximization problem is

F′(ht)=wt+τt[F′(ht)−u′(ht)]

This expression shows that the presence of the underground economy makes the labor input marginally cheaper in the amount τtu′(ht).

All other aspects of the economy are assumed to be identical to those of the economy of Section 3 without income taxation at the level of the household. We restrict attention to the case of a linearly homogeneous production technology of the form F(h) = h. It follows that when the size of the underground economy is zero (ut = 0 for all t), the economy collapses to that of Section 3 and the optimal inflation rate is the one associated with the Friedman rule.

When the size of the underground economy is not zero, one can show that the Ramsey problem consists in maximizing the lifetime utility function (1) subject to the feasibility constraint

[1+s(vt)]ct+gt=ht,

the implementability constraint

∑t=0∞βt{Uc (ct,ht)ct+Uh(ct,ht)ht−u(ht)−u′(h t)ht1−v′(ht)[ Uc(ct,ht)1+s(vt)+vts′(vt)+Uh(ct,ht)]}=Uc(c0, h0)1+s(v0)+v0s′(v0)R−1B−1+M−1P0

and the following familiar restrictions on money velocity

vt≥v_andv t2s′(vt)<1,

given (R−1B−1 + M−1) and P0.

Letting ψt > 0 denote the Lagrange multiplier on the feasibility constraint, λ > 0 the Lagrange multiplier on the implementability constraint, and μt the Lagrange multiplier on the constraint vt > v, the first-order condition of the Ramsey problem with respect to vt is given by

(23)μt=ψts′(vt)ct−λu(ht)−u′(ht)ht1−u′(ht)Uc(ct,ht)[1+s (vt)+vts′(vt)]2[2s′(vt)+vts″(vt)],

where μt satisfies

(24)μt≥0,andμt(vt−v_)=0.

In deriving these conditions, we do not include in the Lagrangean the constraint vts′(vt) < 1, so one must verify its satisfaction separately.

Consider two polar cases regarding the form of the function u, linking the level of aggregate activity and the size of the underground economy. One case assumes that u is homogeneous of degree one. In this case, we have that u(h) − u′(h)h = 0 and the above optimality conditions collapse to

ψts′(vt)ct(vt−v_)=0,vt≥v_,ψtcts′(vt)≥0.

This expression is identical to (17). We have established that, given our assumption regarding the form of the transaction cost technology s, optimality condition (17) can only be satisfied if vt = v. That is, the only solution to the Ramsey problem is the Friedman rule. The intuition for this result is that when the underground economy is proportional to the above-ground economy, a proportional tax on the above-ground output is also a proportional tax on total output. Thus, from a fiscal point of view, it is as if there was no untaxed income.

The second polar case assumes that the size of the underground economy is independent of the level of aggregate activity; that is, u(ht) = ū, where ū > 0 is a parameter. In this case, when vt equals v, optimality condition (23) implies that μt = −λ ūUc(ct, ht)vs″(v) < 0, violating optimality condition (24). It follows that the Friedman rule ceases to be Ramsey optimal. The intuition behind this result is that in this case firms operating in the underground economy enjoy a pure rent given by the amount of taxes that they manage to evade. The base of the evaded taxes is perfectly inelastic with respect to both the tax rate and inflation, and given by ū. The government attempts to indirectly tax these pure rents by imposing an inflation tax on consumption.

The failure of the Friedman rule in the presence of an underground sector holds more generally. For instance, the result obtains when the function u is homogeneous of any degree ϕ less than unity. To see this, note that in this case when vt = v, Eq. (23) becomes μt=−λu(ht)(1−ϕ)1−ϕu( ht)/htUc(ct,ht) v_s″(v_)<0. In turn, the negativity of μt contradicts optimality condition (24). Consequently, vt must be larger than v and the Friedman rule fails to hold.

The right panel of Table 2 presents the Ramsey optimal inflation rate and labor income tax rate as a function of share of the underground sector in total output. In these calculations we assume that the size of the underground economy is insensitive to changes in output (u′(h) = 0). All other functional forms and parameter values are as assumed in Section 4.1. Nicolini (1998) reported estimates for the size of the underground economy in the U.S. of at most 10%. Table 2 shows that for a share of underground economy of this magnitude the optimal rate of inflation is only 50 basis points above the one associated with the Friedman rule. This implies that in the context of this model tax evasion provides little incentive for the monetary authority to inflate.

From the analysis of these three examples we conclude that it is difficult, if not impossible, to explain observed inflation targets as the outcome of an optimal monetary and fiscal policy problem through the lens of a model in which the incentives to inflate stem from the desire to mend an ill-conceived tax system.

In the next section we present an example in which the Ramsey planner has an incentive to inflate that is purely monetary in nature and unrelated to fiscal policy considerations.

Measuring Tax Evasion

Tax evasion represents a potentially serious loss of revenue to governments, resulting in the possible underfunding of public service and an “unfair” burden falling on honest taxpayers. In the United States, it has been estimated that over 25% of all taxpayers underpaid their taxes by $1500 or more in 1988. In developed countries, tax evasion is frequently estimated to be at about the 20% level of tax revenue. The estimated loss in revenue in the United States in 1992 through underpaid federal income taxes was $95.3 billion. In developing countries, the problem may be worse; the loss in the Philippines, for example, has been estimated to be as much as 50% of income tax revenues.

Empirical work has also focused on the link between tax evasion and socioeconomic characteristics. There would appear to be considerable evidence that evasion declines with taxpayer age, and is more common among men and in households in which the head of the household is married. Measurement of the size of socioeconomic effects and the deterrent effects of audit probability, fines, or penalties necessitates the use of multiple regression analysis. The evidence that is available suggests that both penalties and audit probabilities have significant deterrent impacts on evasion, although the extent of the impact is not clear. In addition, it seems possible that the probability of detection is more important than the fine in deterrence.

Much of the empirical work on tax evasion is centered on the United States and is based on audit data or tax amnesty data. Both types of data suffer from an element of bias, the former because auditors are generally unable to detect all evasion, the latter because only those evaders who respond to the amnesty will be included in the data set. Survey data can be used to circumvent this problem, although self-reporting of actual evasion imports bias, even with confidential surveys. An alternative approach is to use survey responses to hypothetical questions. One group of researchers looked at a question related to hypothetical situations involving collusion with a builder; the builder would offer the individual a lower price to do a job if the individual would pay in cash, hence obviating the need for the builder to declare the income to the tax authorities. A further question relating to the evasion of income tax was also asked. In both cases, in excess of 50% of the population indicated that they would indeed engage in such behavior, a tendency that was greater for the young than for the old. This use of hypothetical questions to analyze real-world problems may have potential value in other areas.

1.3 Bitcoin and Market Efficiency

A deposit holder in a specific currency has to keep in mind many of the aspects related to this very basic investment. First, the perspective of the currency and of the underlying economy, second the interest rate, and last but not least the creditworthiness of the bank taking the deposit if the bank is located in currency’s domestic country. The strengthening of the American dollar during 2014 compared to the European currency is a good example of the first point. Since the Eurozone crisis the American economy has observed a faster and stronger recovery similar to the European Union and many analysts expect the U.S. dollar to be as strong as the euro. Thus, based on this appreciation we can see deposit flight toward the U.S. currency.

In the case of a cryptocurrency it would be very difficult or almost impossible to make any judgment about the economy backing the currency. In fact, the only reasoning would be linked to the degree of confidence merchants have toward that particular currency. Interest rates are another argument for holding deposits in a classic currency, but in the case of cryptocurrencies, interest rates are a complex topic. Even though some economists argue about the existence of an implied interest rate, a Bitcoin account holder does not receive interest in the same way a Yen deposit holder does.

The deposit guarantee scheme, which is proposed for almost all developed countries for deposits lower than 100 thousand dollars (euros) does not apply to cryptocurrencies, at least until banks adopt one of them.

Therefore, underlying the true nature of Bitcoin (or other virtual/cryptocurrencies) is crucial before beginning a risk assessment. Looking at its pure econometric feature it can be observed that Bitcoin is as far away from the features of a classic currency as it can be. The persistence in returns, clustering in volatility, and fat tails in Bitcoin/USD exchange rates emphasize the fact that Bitcoin should be regarded differently than other currency. Bitcoin has a lot in common with commodities, with sudden changes in the supply demand equilibrium. One of the similarities relates to energy (e.g., electricity, gas, emissions). Jumps and spikes in energy (electricity) prices are explained by the fact that small increases in demand can inflate prices rapidly, and vice-versa oversupply can push prices very low if there is no need for that commodity. As shown in Figure 5 the Bitcoin/USD rate exploded in 2013, which is very uncommon for a real currency even in a growing, emerging economy. The shock observed in 2014 when Bitcoin lost almost 50% of its value to the dollar would have catastrophic consequences if this happened to a real currency. However, commodities on the energy markets this kind of variation happens frequently as regime changes in price equilibrium occur often.

As the Bitcoin becomes more popular and its flows grow in volume and frequency, the question of market efficiency is naturally raised. EUR/USD exchange is one of the most liquid markets across the globe and given its features could be a good candidate for market efficiency. In the case of Bitcoin, the language is different than that used in classic markets. A Bitcoin deposit owner is generally a Bitcoin generator if he is also involved in the mining process. The mining process adds a lot of particularities that impact market efficiency. In a classic and efficient market, all investors have homogeneous access to information and the ability to buy and sell a fraction of the available currency or stock. If a classic currency faces high and sudden depreciation the central bank can try to address the issue by buying back currency or altering interest rates. Obviously, in the case of the cryptocurrency this does not apply. The mining of currency creates an asymmetry among “investors” due to the fact that not all miners have access to the same mining tools, in terms of computation speed and so on. Thus, some have more advantages than others due to the features of their gear. Obviously, those with stronger mining tools have an advantage in price discovery. Each technological jump also creates new sources of asymmetry among miners. In theory, this heterogeneity will need to be addressed when the total Bitcoin monetary mass becomes stable, due to the fact that the mining will became more and more cost intense. If technology represents a first source of behavioral asymmetry, another source of inefficiency is the breakdown of memory and computational capacity among miners. From this point of view miner profiles vary strongly between solo miners, pool miners and farms. A solo miner might use classic technology like a central processing unit, a graphical unit, or application specific integrated circuit (ASIC) for generating Bitcoins on a standalone basis. For a solo miner the time for processing a block is given by the following equation:

(1) Time=Difficulty⋅232Hashrate

where the hashrate depends on technology.

In theory, the average time for a solo miner using a standalone computer to solve a block is around 2000 years. Thus, the only economically feasible solutions are either a massive inflation of the mining capacity or joining mining pools. Mining farms have started to become a trend in countries where the cost of electricity and rent are cheap, since energy consumption is the main variable cost in the mining process. Table 3 shows the cost of the kWh in several countries, emphasizing the fact that Asian countries and ex-USSR republics have a net advantage in terms of electricity cost compared to developed countries.

Table 3. Electricity Price by Country (USD/kWh)

Notes: Countries from Southeast Asia and ex-USSR block have low prices. The only developed countries with similar levels are Canada and the United States. The European Union generally has high prices.

Of course, mining farms or pools would have a net informational advantage over solo miners or smaller pools. A higher capacity for solving the cryptographic game the higher rate of block solving, thereby giving a better view of the Bitcoin inflows. If a Bitcoin pool trades Forex against a real currency, they will have more information about the volume of Bitcoins to come on the market, i.e., the impact of technology. Structurally, they are better and more informed than a solo miner. This is a crucial source of market inefficiency as a pool can generate bearish or bullish momentum on the market depending on the circumstances. The power market has similar issues in countries where there are big producers or quasi-monopolies. For example, in Germany the main power producer RWE obviously has more information about the market than a small hydro-power producer, due to its position as main supplier and trader.

Table 4 shows a series of tests for market efficiency (weak form) that discussed in detail in a separate chapter. All test statistics computed for a holding period of 10 trading days are higher than the 95% confidence level value, thereby rejecting the weak form efficiency of the Bitcoin/USD rate.

Table 4. Tests for Assessing the Efficient Market Hypothesis (Weak Form)

Notes: The tests are performed on the time series of daily returns of Bitcoin/USD exchange rate from July 22, 2010 to December 31, 2014 assuming a holding period of 10 trading days.

We recall that Lo and MacKinlay [24] tested the random walk process and used stock-market returns, which involves the use of specification tests based on variance estimates. In particular, this method exploits the fact that the variance of the increments in a random walk is linear in the sampling interval. This hypothesis is rejected for the timeseries of Bitcoin/USD exchange rate. Chow and Denning [25] test, a generalization of the Lo and MacKinlay test obtained from the maximum absolute value of the individual statistics confirms the results. Wright’s [26] alternative non-parametric test using signs and ranks is complementary to Lo’s test. Both sign (R1 and R2) and rank (S1) statistics reject the hypothesis of random walk. The Richardson and Smith [27] version of the Wald test and the Portmanteau test of Escanciano and Lobato [28] for autocorrelation also confirm these findings. Markets do not become efficient automatically from their inception. It is the actions of investors and various traders, arbitrage opportunities and putting into effect schemes to take profit from the market, which make markets efficient.

In the Bitcoin system, bringing efficiency to the market is related to mining capacity. Not all miners have the same mining capacity and the mining capacity needs to increase much faster than the Bitcoin transactions, which means a double-edge effect can occur. On the one hand, there could be a massive increase in the number of new investors that purchase and trade Bitcoin, without mining. On the other hand, the mining capacity may remain constant or progress at a much lower level. This could be the reason Bitcoin/USD became massively inefficient during 2013, when a massive inflow of demand was followed in an asymmetric manner in terms of mining ability. Figure 9 shows the random walk test applied over of a rolling window of 200 days for a holding period of 10 trading days. The non-parametric Wright test shows the non-random walk effect that occurred in 2013.

Private Information

The constraint that people possess private information about themselves that other people and/or the government do not know deserves separate mention in this brief history of second-best theory. Private information is also commonly referred to as asymmetric information. It has been one of the more important focal points of public sector analysis over the past 25 years, if not the most important. The intense interest in the implications of private or asymmetric information is understandable. It opens up a whole new range of possibilities for public sector economists to consider, possibilities that challenge much of the received doctrine in public sector theory.

Private information is different from the other second-best constraints because it is not simply a technological or practical assumption tacked on to an otherwise first-best model. It is in part an assumption about how people behave, that they are willing to use their private information for their own personal gain and to deceive if need be. As such, it leads normative public sector theory down a very slippery slope.

On the one hand, the idea that people are willing to deceive the government for their own ends tears at the very fabric of society. It belies the expectation of good citizenship and makes a mockery of the traditional notion that the government's proper economic function is as an agent of the people acting to correct market failures by pursuing the public interest in efficiency and equity. What is the normative appeal of maximizing an individualistic social welfare function when some people are willing to deceive and others are honest? Should the deceivers receive zero marginal social welfare weights? How much deception does it take before the society collapses? The objective function of public policy is not at all obvious when people are prone to act selfishly to exploit their private information.

On the other hand, some people certainly do use private information to their own advantage, and such behavior is entirely consistent with the economic view of individuals as self-interested utility maximizers. The willingness to exploit private information is not just a matter for positive economic analysis, however. It matters for normative analysis as well. All normative policy prescriptions must make assumptions about people's behavior and about how they will respond to the policies, and the prescriptions are only useful if the behavioral assumptions are reasonably accurate. Normative theory cannot simply ignore the issue of private information. The problem, though, is that the existence of private information can be extremely constraining for a government dedicated to the public interest in efficiency and equity, to social welfare maximization.2

The force of the private information constraint turns on the very meaning of an equilibrium in the social sciences, as a situation in which no one has any incentive to change his or her behavior. The particular requirement of an equilibrium in the presence of private information is that no one has any incentive to deceive or to represent one's private information as other than what it really is. The only feasible public policies are those that are consistent with this notion of equilibrium. To be feasible, therefore, a public policy must be such that everyone's best strategy is to tell the truth about themselves given the policy; deception cannot lead to personal gain. For example, high-income people cannot pretend to have low income in order to reduce their taxes.

In the parlance of game theory, public policies must honor the revelation principle or, equivalently, be incentive compatible. In terms of formal modeling, private information necessitates adding one or more incentive compatibility constraints to a social welfare maximization problem to assure that the resulting policy prescription is feasible.

Incentive-compatibility constraints can indeed place severe restrictions on the set of feasible policies. To begin with, they rule out almost all lump-sum redistributions unless they can be targeted to readily observable characteristics that an individual cannot hide or change, such as age. The feasible redistributions are unlikely to have much distributional bite, however. In truth, the government really has no chance of satisfying the first-best interpersonal equity conditions in a world of private information. And, as we have seen, the entire body of first-best theory rests on shaky foundations when the scope of lump-sum redistributions is limited.

It turns out that economists have been unable to find very many public sector policies that are both efficient and equitable for which truth telling is the dominant strategy. The most obvious inventive-compatible distributional policy in the face of private information is to do nothing; simply accept the initial distribution of resources. This policy may be consistent with efficiency but it is likely to be seen as unjust.

Another variation of private information is the ability to engage in market exchanges in the underground, informal sector of the economy, out of sight of the government. The possibility of underground exchanges can severely limit the government's ability to do much of anything if escape to the informal sector is relatively easy. For example, the government may not be able to collect taxes or enforce sanctions against illegal activities.

Notice, too, how the presence of an underground economy changes the perception of markets. The traditional view of markets is that they are the best mechanisms yet devised for promoting efficient exchanges. The relatively few exceptions are the instances of market failure that require government intervention, such as nonexclusive goods or decreasing-cost services. Markets in the underground economy, even highly competitive markets there, are destructive to efficiency, however. They sharply constrain the feasible set of government policies that can be used to promote efficiency (and equity).

The existence of underground economies is hardly a trivial problem, even in the industrialized market economies. Friedrich Schneider, Andreas Buehn, and Claudio Montenegro attempted to measure the size of the underground economy in 162 countries from 1999 to 2007. They chose a narrow definition of an underground economy, one consisting of market transactions that would be legal if undertaken in the regular economy and included in national income and product but that go underground either to avoid paying taxes or to escape certain regulations such as minimum wage laws, safety standards, and various administrative procedures. They ignored other illegal activity and all barter activity. They estimated that the underground economy averaged 17.1% of the total economy over 8 years for the 25 Organisation for Economic Co-operation and Development (OECD) countries, with a maximum of 28.0% (Cyprus) and a minimum of 8.5% (Switzerland, with the United States next lowest at 8.6%). The ratios were generally much higher in the non-OECD countries.3

Still another variation of private information that causes problems for normative public sector theory is the limited information that consumers and the government have about their relevant opportunity sets. Regarding the consumers, traditional microeconomic analysis assumes that consumers maximize their utilities with full information about their opportunity sets, including perfect foresight about future events. In fact, consumers often have very limited information about their opportunity sets and little economic incentive to obtain much more information. Instead, they engage in some form of bounded rationality, often basing their decisions on simple rules of thumb consistent with the limited information available to them. Normative policy analysis typically assumes that consumers maximize under full information because it is the convenient assumption to make. If consumers instead use simple rules of thumb, questions arise as to what rules they follow, and how they change their behavior as their information sets change. There are no obvious answers to these questions, yet a normative theory has to know how consumers will respond to public policies. Regarding the government, public policies often result in large changes in the economy that affect many people and many prices. Policy makers are hard pressed to keep track of all the general equilibrium changes in the economy, to say the least. They, too, have only limited information, not enough to know for sure whether any given policy increases or decreases social welfare.4

In summary, the presence of private or asymmetric information offers any number of challenges to traditional normative public sector theory. The challenges are especially strong if private information takes a form that utility-maximizing individuals can use for their personal gain. For then the government has to be concerned with designing incentive-compatible policies that may severely limit its ability to pursue the public interest in efficiency and equity, which mainstream economists view as its primary function. At some point the willingness to deceive may so restrict the government's options that economic policy is hardly worth doing. The social contract is broken and the goal of developing a normative public sector theory is no longer compelling.

We will demonstrate the implications of private information at various points in this part of the text. The underlying assumption throughout is that the government's pursuit of efficiency and equity remains a worthwhile endeavor.

5 Tax Evasion

Tax evasion is an illegal activity which aims to hide taxable income from the view of the tax authorities. It should be distinguished from tax avoidance, which consists in trying to reduce one's taxable income by exploiting the tax law while staying inside its boundaries. While the distinction between the two may sometimes be unclear, there are at least a large number of cases that definitely belong in the evasion category; these are sometimes referred to as the hidden or black economy.

Tax evasion is a risky activity. By holding back information from the tax authorities, there is always a risk of being discovered, in which case one typically faces a penalty rate on the unreported income. The gain on a dollar of unreported income, i.e., the regular rate of income tax, must be balanced against the probable loss, which is the probability of detection times the penalty rate of tax. When the regular income tax rate goes up, the gain increases, and it thus tends to encourage evasion, e.g., in the form of working in the hidden economy. Theory seems to support the common concern that a high tax level encourages cheating and dishonesty. However, this should not lead us to expect that high-tax countries necessarily have more tax evasion than countries with lower tax levels. The extent of evasion depends not only on the level of income taxation, but also on a number of other social and economic factors, and these are likely to vary considerably among countries.

Theoretical hypotheses in this area are particularly hard to confront with empirical data; in the nature of things, there are no official statistics for the hidden economy, and survey research faces some special difficulties in making individuals answer questions truthfully. A number of the empirical studies that have been made use very indirect methods, such as deducing the size of the hidden economy from the public's holding of cash, and the reliability of this kind of approach is highly disputed (Cowell 1990). More standard approaches tend to yield estimates which indicate that the hidden economy has a volume of 2–10 percent of the GNP of the official economy. Many studies also indicate that evasion is higher for self-employed than for salaried employees. This is in good accordance with the theory, for wages and salaries are usually reported directly by employers, so the probability of evasion being detected is much higher for employees than for the self-employed, implying that evasion is a less risky gamble for the latter.

It should be added that the emphasis on rational risk-taking behavior as an explanation of tax evasion does not imply that in the economist's view of the world all taxpayers are completely amoral, reporting their income only when a cost–benefit calculation has shown them that evasion does not pay. There are strong indications that many taxpayers report their true income even when under-reporting could easily go undetected. The chief aim of the theory is to explain the behavior of those who do evade taxes, and although they too may take moral considerations into account, they are also likely to consider the risk-taking aspects of their activities in a rational manner.

2.4 Second Economies and Socialist Reform

Believing they alone could best determine how social wealth should be redistributed, Party leaders initially opposed economic activity not encompassed within plans. The inability of planning to cover social needs at the given level of technological endowment, however, compelled officials to permit and even legalize some small-scale private effort, known as the ‘second’ (or informal, unofficial, or shadow) economy. Among its forms were food production on small plots, after-hours repair work or construction, typing, tutoring, unofficial taxi services, etc. Because these activities overlapped with semilegal and illegal ones, their situation was everywhere precarious, with authorities persecuting them more in some times and places than in others. The second economy was largest in Hungary after 1968, for example, small in Cuba until Castro's ‘Rectification’ of 1986, harassed in Romania throughout the 1980s; it burgeoned in post-1978 China; extreme forms are reported for the Soviet Union, where entire factories ran illegal production after hours. Crucial to understanding the second economy is that it nearly always utilized materials from the first (or formal, official) economy; its much-noted high rates of productivity were subsidized, then, by state firms. The prevalence of second-economic activity both indicated popular resistance to the Party's definition of needs and helped to fill those needs by voluntarily lengthening the working day.

Pressure from the second economy was but one of many signs of difficulty in socialist planning that led to repeated efforts at reform, initiated from both within and outside the Party. Beginning with Lenin's New Economic Policy, every socialist society experienced cycles of reform and retrenchment, devolution and recentralization (cf. Skinner and Winckler 1969, Nee and Stark 1989). Most exhibited a trend toward less stringent planning and the introduction of market mechanisms, heightened material incentives, and mixed property forms. System-wide experimentation began with Khrushchev's 1956 ‘Secret Speech’ criticizing Stalin and increased as each society moved from ‘extensive’ development (mobilizing resources) to the ‘intensive’ phase (attention to productivity). Hungary and Yugoslavia introduced the most durable early reforms; those in the Soviet Union ended in the collapse of the Soviet bloc, while comparable reforms continued in China, North Vietnam, and Cuba. As they reformed, socialist societies increasingly diverged not only from the Stalinist model but from one another, introducing path-dependent differences that became ever more marked.

Despite these differences, the reforms everywhere redefined basic units of activity (e.g., revitalizing villages or households at the expense of collective farms, teams, or brigades); altered gender relations (usually in favor of men and patriarchal authority) and increased other inequalities; affected networks of reciprocity (expanding horizontal over vertical connections); dismantled at least some socialist property (as with China's decollectivization, begun in 1978); shifted the locus of authority (usually downward, provoking reactions from higher-level bureaucrats); and entailed new, more intimate forms of state penetration (implied, e.g., in Chinese rituals that no longer imagined gods or ancestors as inhabiting a nether world but found them immediately present).

4.1.1 Data problems

Ascertaining the extent and characteristics of evasion immediately runs into two problems – one conceptual and one empirical. The conceptual problem is that, although one can assert that legality is the dividing line between evasion and avoidance, in practice the line is often blurry. Sometimes the law itself is unclear, sometimes it is clear but not known to the taxpayer, sometimes the law is clear but the administration effectively ignores a particular transaction or activity. The importance of these factors certainly differs across situations.

The other difficulty is that, by its nature, tax evasion is not easy to measure – merely asking just won’t do. Several different approaches have been attempted. One approach relies on inferring the level or trends in noncompliance from data on measurable quantities, such as currency demand or national income and product accounts. The monetary indirect estimates are based on the presumption that most unreported economic activity takes place in cash, and that some time in the past the underground economy was small. In Gutmann (1977), increases in the ratio of currency to demand deposits since 1937–41 measure the underground economy; in Feige (1979), changes since 1939 in the ratio of total dollar transactions to official GNP since 1939 measure it. Tanzi (1980) estimates regressions explaining the ratio of currency to money defined as M2, and interprets the portion explained by changes in the tax level as an indication of changes in the size of the underground economy. None of these approaches is likely to be reliable, however, as their accuracy depends either on unverifiable assumptions or on how well the demand for currency is estimated. The indirect noncompliance estimates based on discrepancies between national accounts measures of income and income reported to the tax authority are also problematic. For one thing, national income estimates of several key forms of income are based on tax return data. Second, there are many inconsistencies between how income is defined for tax purposes and for national accounts. However, Engel and Hines (1999), in a study of tax evasion dynamics which focuses on the possibility of retrospective examination of previous-years’ returns, study this measure of evasion in the U.S. for the years 1947 to 1993 and find that it responds as their model predicts. For example, annual fines and penalties imposed by the IRS subsequent to audits are correlated with contemporaneous and several lags of tax evasion as calculated from national income statistics.

The most reliable source of information about tax compliance concerns the U.S. federal income tax, and exists because of the IRS’s Taxpayer Compliance Measurement Program, or TCMP. Under this program, approximately every three years from 1965 until 1988 the IRS conducted a program of intensive audits on a large stratified random sample of tax returns, using the results to develop a formula used to inform the selection of returns for regular audits. The TCMP data consist of line-by-line information about what the taxpayer reported, and what the examiner concluded was correct. This data formed the basis for the IRS estimates of the aggregate “tax gap”, and provides much useful information about the patterns of noncompliance with respect to such variables as income, occupation, line item, region of the country, age, and marital status. While informative, it is widely recognized that even the intensive TCMP audits imperfectly reveal particular kinds of noncompliance, such as income from the underground economy.

3.6 Popular and Consumer Culture

During the Soviet years, the ‘shortage economy’ placed a premium on the hoarding, rather than consumption, of goods by individuals. Yet consumer goods were vitally important to socialist ideology. Images of communist abundance were crucial in securing the regime's legitimacy—especially in the context of the current sacrifices. In reality, the shortage of goods resulted in their informal distribution through a ‘second economy.’ Access to goods was a coveted and largely political privilege: those who possessed it were in some respects analogous to the Western moneyed and propertied class (Osokina 1998).

As new goods flow into the post-Soviet space and as the new consumer culture develops, new questions arise. Do the new relations of capitalism dissolve the fabric of pre-existing, socialist-era social relations? Does the international flow of goods homogenize cultures? How are we to understand the capitalist ‘break’: is there a link between the Soviet and post-Soviet consumer cultures (Humphrey 1995)?

Russian scholars and Western scholars of Russia alike have shown tremendous interest in the recent flowering of popular culture—a new feature of post-communism. Youth culture, night life, and new media are just a few areas of recent scholarly interest. As more cultural artifacts are imported to Russia from the West, the post-Soviet cultural landscape changes further. The study of popular culture's contemporary forms, however, requires careful consideration of the peculiar trajectory of the concept in the Soviet and Russian contexts (Barker 1999).