Exploring the underground economy

An analysis of cash withdrawal policy

Authors: LUCÍA MONTEJANO and XÈNIA ALEMANY

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ABSTRACT

In recent years, the debate on the limitation and abolition of cash has ained considerable attention and has become increasingly urgent in light of the growing prevalence of electronic payments. This article seeks to explore the potential benefits of a cash withdrawal policy from a critical perspective. It will first discuss the dynamics of the underground economy and present an overview of the literature written on the subject. Subsequently, the effects of the cash withdrawal policy, which is currently under discussion, will be examined to determine if it has a positive impact on the economy. Finally, conclusions and recommendations will be drawn.

INTRODUCTION

When estimating the size of the world economy, official statistics related to production, trade and investment are often taken as a reference. Nevertheless, there are activities with a significant economic
impact that are not recorded in these statistics as they are carried out outside the scope of the overnment. The set of these activities is mainly known as the underground or shadow economy.

Unfortunately, it is very challenging to obtain precise information about its components since these are
characterised by significant efforts to attempt to avoid detection. They cover a wide range of activities, from drug trafficking or prostitution*, to “black payments” or domestic work. Precisely, this heterogeneity makes it difficult to establish a definition and consensus on the term.

DEFINITION

It is undeniable that the shadow economy represents a form of the informal economy. The underground
economy is a significant component of the global economy, production of goods, services and income that are not registered or taxed. However, there is a disagreement on its definition, and consequently on the activities that comprise it and the procedures for estimating it.

Some positions define it as: “those economic activities that are not counted in the official economic
statistics of the government, regardless of whether they are legal or illegal.“¹ This perspective suggests the following subdivision:

• Criminal. The criminal sector involves illegally produced goods and services, such as the production and trade of illicit narcotics.
• Irregular. It refers to legally produced goods and services that evade legal reporting requirements,
  such as tax evasion.
• Household. The household sector is composed of household production.
• Informal. The informal sector consists of economic activities that are not subject to laws and
  regulations, such as unregulated microenterprises.

However, other organisations such as the UN or the OECD qualify it as: “The underground economy consists of all unrecorded activities that contribute to the officially calculated (or observed) gross national
product“². Therefore, this definition excludes the criminal sector by not contributing by its legal nature to the national economy.

Having no definition consensus implies troublesome when governments and institutions must record of
that non-documented practice. Even a more serious issue with the disagreement is when fighting that
practice with some policy application since if due to the disagreement institutions can adopt different
measures which can act oppositely and minimize their potential effect.

MEASUREMENT

As previously stated, the shadow economy is not recorded, so in the national accounts, it does not reflect the true state of the economy. This implies that both the policies of central banks and nations are not
entirely efficient; to make it feasible, a high level of precision is required in statistics such as output or
unemployment.

For this reason, the importance of its measurement relies on the fact that it allows obtaining a closer idea of the magnitude of the unrecorded economy, which would help to determine the real structure of the
economy and the relative sizes of the formal and informal sectors. It is useful for governments that can use this data to design policies that encourage the formalisation of sectors and improve tax collection. In
addition, its measurement would help us to better understand the behaviour of prices and economic
growth.

Measurement Methods

There are three distinct methods for estimating the size of the underground economy: the direct method, the indirect method, and the Multiple Indicators and Multiple Causes (MIMIC) method.

The direct method involves gathering information directly from individuals and economic agents through surveys, interviews, and focus groups. However, this method is often criticised as those engaging in tax
evasion due to undeclared income have little incentive to share honest information.

The indirect method attempts to measure the size of the shadow economy by evaluating the relationship between the underground economy and various macroeconomic variables, such as disposable income,
gross domestic product, electric consumption, spending, employment, and money in circulation.
Nevertheless, this method is not entirely reliable as the economic data used may not accurately reflect the size of the shadow economy.

Lastly, the MIMIC method, also known as the ‘structural equation’, requires the collection of data from
various sources, similar to the direct method, and the application of statistical models to analyse the data.
The advantage of this method is that it can provide a more comprehensive picture of the shadow economy than either direct or indirect measurement, still it is not perfectly accurate and has to be interpreted taking into account its margin of error.

The limitations discussed suggest that current measurement methods used to estimate the size of the
shadow or underground economy are imperfect. Furthermore, the methods used to measure this sector
can be impacted by several factors, such as the difficulty of obtaining reliable data, the difficulty of defining what constitutes an underground economy, and the difficulty of distinguishing between legitimate and illicit activities. As such, it is important to recognize that the estimates given are likely to be inaccurate and further research should be done to better understand and accurately measure the size of the underground economy.

IMPLICATION

The Shadow Economy has been identified as a major threat to the economic and social well-being of a
nation, with its negative implications ranging from the government’s inability to accurately measure the
size of the economy to an increase in inequality, crime, and financial instability. Despite the numerous
concerns, the topic remains highly controversial and open to debate as to the potential positive effects it
may have on an economy.

On the one hand, the activities of the shadow economy are not reported to the government, meaning that the government is unable to accurately gauge the size of the economy, plan for economic growth, or assess the effectiveness of its economic policies, resulting in a decrease in economic growth. Furthermore, it reduces the amount of tax revenues generated by the government, as well as its ability to provide financial support to businesses, leading to a decrease in investment and job creation. Additionally, it results in a greater concentration of wealth in the hands of the wealthy and a decrease in the quality of public services due to a lack of government funding, thus increasing poverty and social unrest, and decreasing social mobility. Moreover, due to the lack of government monitoring, it can create an environment of corruption and crime, resulting in an increase in bribery, money laundering, and other forms of financial crime.

On the other hand, many developing countries are dependent on the shadow economy for their economic structure and growth, and it is argued that it is more competitive and efficient than the formal sector. Additionally, the contrary view argues that numerous studies have shown that two thirds of the valueadded produced in the shadow economy would not be produced at all if it did not exist, and that earnings from the hidden economy significantly raise consumer spending, resulting in a positive effect on economic growth³. Taking these factors into consideration, the debate over the positive or negative effects of the shadow economy is ongoing.

Determining whether the underground economy brings more positive or negative effects is of utmost
relevance, particularly in shaping public policies. Intuitively, if the underground economy proves to have a net positive impact, the government should consider promoting its practice and vice versa. Although the
dilemma has been exposed in absolute terms, starting from a global situation, perhaps the most
appropriate approach would be to explore its effects in different countries and regions to get a closer
understanding of the exposed purpose.

To delve into the discourse surrounding electronic payments, the article draws its basis in the context of
the most developed countries. These nations not only serve as the epicenter of the ongoing debate but
also present a higher prevalence of electronic payments. Therefore, the article will start from the
assumption that the underground economy exerts a net negative effect, aligning more closely with the
outcomes outlined in the first arguments.

CASH WITHDRAWAL POLICY

Cash is the most common form of payment used in the underground economy, since it is difficult to trace it can be used to hide illegal activities. Nevertheless, in recent years, the advent of digital revolution has
brought forth a variety of new payment instruments, such as debit and credit cards, mobile payments, and most recently bizum payments. This has led to a debate concerning whether cash should be phased out of circulation. In particular, cash withdrawal policies, which limit the amount of cash payments that can be made, have been proposed as a means to regulate underground economic activities and tax evasion.

The discussion over the efficacy of cash withdrawal policies to combat underground economies is an Open one, with both sides presenting compelling arguments. Recently, the issue has been brought to the forefront as some governments around the world have proposed cash withdrawal limits, citing a need to
tackle corruption and money laundering. This has sparked debate about whether such restrictions can be effective in reducing the size of underground economies. In this section, a closer look at the arguments for and against cash withdrawal policies, and how governments around the world are currently approaching the issue will be considered.

Evidence and studies show that physical money is still broadly used nowadays. The primary application of this policy is aimed at reducing the prevalence of the underground economy through the assessment of the transaction costs incurred due to the introduction of cash withdrawal limits, and the subsequent impact on activities conducted within the underground economy. However, the ability to substitute the payment to other payment methods, whether in another currency or even in kind, implies that transaction costs may not have a significant impact.

Furthermore, cash has numerous advantages, particularly for those who are marginalized due to their
socio-economic circumstances and lack access to a bank account, such as the homeless, elderly,
impoverished, indigenous, and low-income individuals. Moreover, cash is tangible, providing greater
security to those who have a lack of trust in financial institutions. Additionally, cash affords greater
autonomy to consumers, as it is not subject to the regulations and limitations of banks and other financial institutions, thereby offering a sense of security and privacy that is unavailable in other payment methods.

EVALUATION OF INDICATORS

In this section, an attempt will be made to answer the debate that arises around the question: “Is the cash withdrawal policy an adequate one to be implemented?” The hypothesis that was stated, after analysing the severe impact that the withdrawal of physical money could have, was that governments should be
careful when implementing the policy since they had to know the characteristics and needs of the population. Multiple characteristics should be evaluated to shed some light on the debate. Among them
are the population access to bank accounts, credit or debit cards, and the internet, and the proportion of the disadvantaged groups within the population.

To prove the importance of the characteristics mentioned, an analysis of the correlation between the
underground economy percentages and the data found on credit and debit cards and the population that had a bank account was computed.

Drawing on data from the International Monetary Fund (IMF) and World Economics, this article presents an analysis of the underground economy as a percentage of GDP. The IMF data, collected in 2015, was
estimated using the MIMIC method, resulting in approximate mean, median, standard deviation, minimum and maximum values. While the mean is not always an accurate indicator, both the mean and median were used when correlating data. The IMF data is referred to as ‘Average’, while the median variables are referred to as ‘Median’. Furthermore, to ensure more recent and accurate data, the article also considers data from World Economics regarding the underground economy as a percentage of GDP. This data was then correlated with debit, credit card and bank account access.

There is a correlation between the percentage of the population with a bank account and the percentage
of the underground economy that can be observed in most of the countries computed. The negative
correlation between these variables suggests that greater access to bank goods and services leads to less underground economic activities. This negative correlation is quite reliable, as it is shown by the -0.6
coefficient. However, we must be mindful that this correlation is not absolute. The degree of development of the country must also be taken into account, as this affects not only the accessibility to banking services but also the size of the underground economy.

To sum up, the data from the World Economics survey shows a negative correlation between the variables ‘bank account access‘ and ‘underground economy’ across most countries studied. This trend is further
validated by the fact that more recent data demonstrate a better correlation, suggesting that many
countries are making progress in terms of improving their systems and creating a more efficient approach to goods and services. This is especially true in developing countries, which are continuing to advance their technologies and infrastructure, consequently limiting the scope of the underground economy.

The data from the percentage of credit card users compared to the underground economy as a percentage of GDP from different countries provides evidence that no-credit card populations are associated with significant levels of shadow economic activities. Notably, the levels of credit card usage across the countries in our sample range from 0-20%, while many societies show up to 50% of GDP as unofficial transactions. Despite this correlation, it is difficult to draw a generalized assumption as many other factors are not taken into account. Furthermore, when considering more recent data, the correlation is further strengthened.

Finally, the reduction of the shadow economy may be indirectly impacted by the increased use of debit
cards. It is evident that in countries with a low prevalence of unofficial transactions, widespread usage of
debit cards is a commonality. Upon comparison between the two, it is evident that debit cards are more
extended than credit cards.

In this regard, access to bank accounts as well as credit and debit cards offer various alternatives to cash as a means of payment. Thus, if the use of credit and debit cards is popularized and more people have access to bank accounts, fewer transactions are likely to be conducted through cash, consequently reducing the scope of the underground economy. This is the basis of our analysis.

CONCLUSION

The completion of this article has shown the authors how hard it is to get measurements of the
underground economy in each country, the difficulties of comparison of data available online among other limits the paper has found.

Regardless of the hard knocks, these pages summarise what is the underground economy, the disagreements found in its definition, its types and measurement methods as well as a basic but clear
statistical comparison between influential variables to form an opinion on whether the cash withdrawal
policy recently proposed by some institutions would be proper to implement or not.

After all the information collected, the article concludes with the perception that the implementation of a cash withdrawal policy is not a viable solution to reduce the underground economy, given the significant
disadvantages it would bring to the entire population. Moreover, this student-made article has not found
clear evidence that some factors like bank account access or the use of debit and credit cards are strictly
related to the size of the shadow economy of a country. While these variables may be present in societies with low levels of the shadow economy, further research should be conducted to determine the real impact of the elimination of physical money from circulation.

SPECIFICS

1. Matthew H. Fleming, John Roman, and Graham Farrell. Shadow economy ↩︎
2. “The shadow economy consists of all currently unregistered economic activities that contribute to the officially calculated (or observed) gross national product (GNP)” F. Schneider. Illegal activities and the generation of value added: size, causes and measurement of shadow economies. ↩︎
3. F. Schneider; D. Enste Hiding in the Shadows. The Growth of the Underground Economy. Economic Issues n.30. ↩︎

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