A Re-examination of the U.S. Underground Economy: Size, Estimation, and Policy Implications

We re-examine the size of the underground economy in the U.S. between 1972 and 2006, after properly adjusting for several statistical issues relating to its estimation. The dynamic error-correction-based currency demand approach confirms that income tax rates have no contemporaneous effect on currency demand, but they have positive and significant effects with a one-period lag. In addition, we observe that the size of the underground economy in the U.S. has grown considerably during the post-1990 period from $148.7 billion (3.4% of official GDP) in 1973 to $691.2 billion (6.0% of official GDP) in 2006. We also find that misspecified models have a propensity for overstating the size of the underground economy. During recessionary periods, the underground and official economies move in a same direction, although the growth rates of the underground economy are more unpredictable than those of the official economy.