The Underground Economy

The Internal Revenue Service (IRS) estimated that during tax year 1976 as much as $135 billion in income went unreported and, as a result, as much as $26 billion in potential tax revenues to the Government went uncollected. These estimates are probably understated because IRS did not include estimates of unreported illegal-source income for many type activities such as arson for profit; smuggling goods other than drugs; bootlegging of cigarettes, films, tapes, and records; or pornography, protection rackets, embezzlements, or theft. The results of the IRS study indicate that some of our economic indicators and unemployment rate statistics may be overstated. Some people involved in the household survey from which unemployment rates are calculated may have income that they are not reporting. If sales, output, and income statistics are understating the true magnitude of economic activity, then our economic policymakers need to know the magnitude of the problem and adjust their decisionmaking accordingly. If the existence of a large underground economy means that our economy is more healthy than we realize, it is possible that the inflationary consequences of a given macro-economic policy will be more severe than we planned. In order for the Government to improve its tax administration activities, the IRS must determine the extent to which it is presently detecting unreported income from the various pockets of noncompliance. It then needs to consider reallocating its resources based on that determination and assess the need for additional resources to close the tax gap for each source of unreported income.