University Of Toronto!

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What is the impact of underground activities on the
welfare of Canadians?

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Yash Agarwal!
Economics 208!
Assignment 1- Due 30/6/2015!
Student no- 1000133535!

Canada is regularly ranked as one of the most socialist countries in the world. Though it
has free market economy, Canada stands out because of its excellent and very
extensive welfare system that includes free health and medical care. These benefits
that a common citizen enjoys are majorly based on the taxes collected by the central
government. It is estimated that in 2012, Canada lost about $42.4 billion in the form of
undocumented income and services aka, the underground economy.

The underground economy is more that just an unlicensed guy who paves your
driveway or mows your lawn or fixes your roof for half of the price of a true professional,
so that you can save some money. And isn't saving money a really good thing in any
kind of economy? Not really!

The existence and increase of an underground economy gives rise to three major sets
of concerns.
1. The economic and social conditions of individuals, household and countries are
evaluated in a biased way if one relies on the official statistics. Thus, the official
number of unemployed per sons may hide that an (unknown) share of them
actually work and receive wage income. As a consequence, the macro economic
policies are likely to be too expansionary and social policy too excessive.
2. A second concern is the loss of tax revenue as underground activities escape
taxation.
3. A third concern interprets the underground economy as an indicator of an
unhealthy state between citizens and government.
I will address these concurs in this papers and try to evaluate the effect of the
underground economy on the welfare of canadian.

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1. Definitions

Statistics Canada defines UE as consisting of market-based economic activities,

whether legal or illegal, that escape measurement due to their hidden, illegal, or
informal nature.

This definition excludes three major points:

(a) Production that by convention is not part of GDP, in particular private household
activities.
(b) Tax evasion is not value adding but redistributional and is therefore not included as
such in the above definition (e.g. when taxes on interest payments are evaded).
However, in general, no taxes are paid in underground activities (such as
moonlighting for house building) which are valueadding. Thus, underground
activities and tax evasion are related but certainly not identical.
(c) the assumptions that only self-employment income can be under-reported and that

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all individuals truthfully report all their sources of income.

2. Measurement approaches
Assessing the underground economy and quantify it is a challenging task as there are a
lot of discrepancies based on which methodology one chooses. According to a recent
paper submitted by Geoffrey R. Dunbar and Chunling Fu Sheltered Income: Estimating
Income Under-Reporting in Canada, 1998 and 2004, The government of cananda uses
national account discrepancies to estimate the shadow economy which is based on
microeconomic consumption data. Based on this it was estimated that in 2012, total
underground activity was $42.4 billion in Canada or about 2.3% of gross domestic
product (GDP). However, In his 2013 report Friedrich Schneider estimated that the
shadow economy in Canada is about 10.8%, which is considerably higer that the
canadain government estimate.This is based on macroeconomic data which they

choose to analyze the model with. For this paper, i will use the estimates provided by
the Statics Canada website.

3. The Effects of the Shadow Economy on the Official Economy

Even though the statistics point to a decreasing trend in the underground economy rate,
I feel that might increase with near future with firms like Uber, Airbnb, Handy etc. who
don't have tax regulations on their employees and therefore, technically, constitute as a
part of the underground economy. It also has detrimental effects on labour, as in the
case of uber, which has lead to worldwide protests by taxi drivers.
The conclusions of effects of an underground economy, especially when dealing with
developed countries, could be used to infer its effect on an other one. Therefore, i use
results from different researches to present my argument for the Canadian economy.
Based on the paper, authors integrate underground economies into macro economic
models. According to the model that these researchers develop, a macro model of the
business cycle as well as tax and monetary policy links with the shadow economy. Two
common point in their investigation on the growth of the shadow economy is that on the
one side its effect should be taken into account in setting tax and regulatory policies and
on the other side the existence of an underground economy could lead to an
overstatement of the inflationary (unemployment) effects of fiscal or monetary stimulus.
An underground economy could be useful at times as well. Based on the study
conducted by Adam and Ginsburgh (1985) which looks at the significance of the
shadow economy on 'official' growth in their study for Belgium. They found a positive
correlation between the growth of the underground economy and the official one and
under the assumptions that their are very low entry costs into the shadow economy due
to a low probability of enforcement. Based on that, they concluded that an
expansionary fiscal policy has a positive stimulus for both the formal and informal
economies. The underground economy can be beneficial because it responds to the
economic demand for services and smallscale production. From this point of view the
informal sector provides the economy with dynamic and entrepreneurial spirit and can
lead to more competition, higher efficiency and strong boundaries and limits for
government activities.

The informal sector may offer contributions to the creation of markets, increase financial
resources, enhance entrepreneurship, and transform the legal, social, and economic
institutions necessary for accumulation. The voluntary selfselection between formal and
informal sector, as described above, may provide a higher potential for economic growth
and, hence, a positive correlation between an increase of the informal sector and
economic growth. As the underground economy could, to a considerable extent, affect
the economic status of a country, it should be included in the GDP calculations to give a
more realistic value when assessing the economic welfare which is basically, per capita
real GDP. This is based on the Jones-Klenow results which state that the correlation
between the welfare measure and Real GDP per capita across counties is 0.95, which
is the case when compering Canada and United States.

4. Policy Consequences
While the underground economy does have some plus point for its effect on the official
economy, it is found, in both general perception and scholarly research, that it has a
more negative development which should be counteracted. This is mainly because most
business dealings are done in cash and therefore are not reported. By not reporting the
transactions, a owner/employer doesnt have to pay tax on it and therefore can claim
100% of the HST/GST back. For example, an expense of $1,000 properly documented,
will save you about $240 on your tax return so your net disposable income is $760.
However, If you were to pay cash, youre not entitled to an income tax deduction and
reduction in income. Youre disposable income is whatever amount you paid. If that
cash price is not lower than 75% of the normal receipted price, theres literally nothing in
it for you.
There are other reasons for not indulging in cash deals. No receipt means no warranty,
support, or guarantee of workmanship and, most importantly, if a member of the
economy isnt paying income tax then somehow, some way, the others will have to bear
that burden and will have to pay more to make up for him.
It has been argued that many developing and transition economies would break down
or function at a much lower level of production and welfare if the underground economy
did not exist. As has just been argued in section 3, too, unofficial activities are seen as a

desirable addition to the official economy whose productivity is strongly reduced by

excessive taxation and/or bureaucratic restrictions. A less pronounced evaluation points
out that the rise of the underground economy indicates that the relationship between the
state and the citizens is fragile and needs improvement. The taxpayers are dissatisfied
with what public services they get for their contributions and seek to restress the
balance by evading to the underground economy. It is feared that such reaction makes
government unable to finance the public goods necessary for an economy and society.

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In conclusion, an underground economy can be a beneficial asset if a country is facing

problems with production as it give a kind of boost to the economy. However, in the
case for Canada, it seems to have a detrimental effect with direct impact on organized
labour. Though Canada has one of the lowest recored rates of shadow economy, it must
still remain vigilant of changing dynamic of the market, as new business such as
uber,airbnb and such could lead to an increase in upcoming years. If left unchallenged,
the underground economy could erode the integrity of Canada's tax system.

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Biblography:

"About the Underground Economy." Government of Canada, Canada Revenue

Agency, Public Affairs Branch, Communications Directorate, Issues

Management and Program Communications Division. N.p., n.d. Web. 28 Aug.
2015. <http://www.cra-arc.gc.ca/undergroundeconomy/>.

"Do Companies like Uber, Handy Fuel Underground Economy? | Toronto Star."
Thestar.com. N.p., n.d. Web. 28 July 2015. <http://www.thestar.com/business/
economy/2015/02/23/do-companies-like-uber-handy-fuel-undergroundeconomy.html>.

Frey, Bruno S., and Friedrich Schneider. Informal and Underground Economy.
N.p.: n.p., 2000. Web. 28 July 2015. <http://www.economics.jku.at/members/
Schneider/files/publications/informal.PDF>.

Geoffrey R. Dunbar And Chunling Fu. Sheltered Income: Estimating Income
Under-Reporting in Canada, 1998 and 2004 (n.d.): n. pag. Web. 28 July 2015.
<http://www.bankofcanada.ca/wp-content/uploads/2015/06/wp2015-22.pdf>.

"The Underground Economy and Why It Is Bad For All Of Us." The
Underground Economy and Why It Is Bad For All Of Us. N.p., n.d. Web. 28 July
2015. <http://www.articlesalley.com/article.detail.php/50450/224/Consumer/
Culture_and_Society/32/
The_Underground_Economy_and_Why_It_Is_Bad_For_All_Of_Us>.

"The Underground Economy in Canada, 2012." Government of Canada,
Statistics Canada. N.p., n.d. Web. 28 July 2015. <http://www.statcan.gc.ca/
daily-quotidien/150429/dq150429c-eng.htm>.