Unmeasured GDP

GDP doesn’t measure what people don’t want measured: typically illegal, or at least underground, activity. We used to call this the black market, but that’s not politically correct. Now we call it the shadow economy.

In the U.S. it can be hard to visualize how big the shadow economy is in other countries; relatively speaking, we’re girl scouts when it comes to hiding our affairs from the tax man.

The Wall Street Journal piece entitled “Tax Evasion Dogs Greece” has a table showing the size of the shadow economy in various developed countries.

Not surprisingly, it’s large in the PIGS or the PIIGS, and much smaller in G-7 countries (for example, it’s 22.3% of GDP in Italy, but only 10.6% in the U.K.). Part of this is certainly cultural in these countries, and part of it has to do with institutions that are not as well developed.

One important consideration for these countries currently, is how they are going to service their national debts. Tax revenues are the main source, but how do you tax the shadow economy.

There is way … but it’s a politically uncomfortable way: inflation.

Since shadow economies run largely on cash, and since inflation reduces the value of cash, it is in some sense a tax on the use of cash, and therefore an effective tax on the shadow economy.

The intellectual hurdle you have to leap to understand this is figuring out where the money goes. Inflation takes value away from people’s wealth held in cash. But, it can’t change the overall wealth of the economy (at least if people don’t flee the country with their stuff). So, what must be going on is that inflation is a tax/transfer scheme (like social security). But … inflation takes from those who hold their wealth in cash, and transfers it to those who hold their wealth in other assets.

Often, we assert that countries are mismanaged because they have both 1) a big shadow economy, and 2) a lot of inflation. But, really these are two faces of the same issue.