Life underground

What’s the size of the shadow economy? Nobody knows, and estimates vary widely. But what’s certain is that it is a form of tax evasion.

Like many well-off professionals, Roger, a Quebec notary, hired a woman who came in every week to perform housecleaning chores. He paid her cash, and one is tempted to say, “Of course.” Everything was dandy until the day she fell down the stairs and broke a leg. Kind-hearted Roger whisked her off to a hospital.

A few weeks later, a representative of Quebec’s Commission des normes, de l’équité, de la santé et de la sécurité au travail, which supervises health and security in companies, knocked on Roger’s door, claiming that he had not declared an employee. “But I don’t have any employees!” Roger objected. Oh yes, you do, replied the official. At the hospital, the housecleaner had mentioned that the accident had happened while she was working at Roger’s residence.

This turned into an ordeal that cost Roger $10,000 in penalties and in compensation for the housecleaner’s forced inactivity. “And the insurance company refused to cover those costs,” says Gaétan Mignault, president of Groupe Adèle, who reports the anecdote. This happened in 1994 when Mignault was starting his company, the first legally incorporated housecleaning company in Quebec. “At that time, all my competition worked underground,” notes Mignault.

In Canada, housecleaning, an industry estimated at $3.6 billion annually, is still mostly an underground activity: 79% of it happens there, according to a 2009 Environics Research Group study, says Aaron Abrams, president of Molly Maid, another legally incorporated Canadian housecleaning company that now operates internationally. “The government has done nothing to change that,” he says. “It is socially acceptable to pay cash for a lady who comes regularly to your house.

Since she usually makes under $30,000 a year, she benefits from the small trader exemption and doesn’t have to collect tax or report it. She also doesn’t pay source deductions. All dollars go into her purse. That’s a huge price advantage.”

BIG CHUNKS

Housecleaning, though deeply embedded in the underground economy (UE), is but a small fraction of the UE whole. The major sectors are residential construction (28% of the total UE in 2012, according to Statistics Canada), finance, insurance, real estate, rental, leasing and holding companies (or FIRE, 13%), retail trade (13%) and accommodation and food services (12%).

“Four sectors accounted for 66% of the total estimated underground economy in 2012,” reports StatsCan. Adds another StatsCan report: “In 2013, household final consumption expenditure accounted for 65.2% of underground economic activity. Business gross fixed capital formation accounted for 27.9% and net exports represented the remaining 6.9%.”

These major UE sectors constitute significant chunks of the Canadian economy. For example, in the 2009 StatsCan evaluation, FIRE was the second most important industry in Canada, with a total gross domestic product (GDP) of $172.9 billion, while construction occupied the fifth place ($103 billion) and retail, the eighth spot ($79.3 billion).

Why do people opt for the underground life? When it comes to criminal activity, the reasons are obvious: the lure of illegal profit and the need to hide it from the law. But for the regular citizen who would normally work above ground, why go under?

The UE involves a few basic manoeuvres that all have to do with avoiding official government requirements. It is propelled by cash and the goal is to hide or underreport revenue and to skirt income and consumption taxes. Simply, it aims at tax evasion and tax avoidance. It also seeks to work around permits, accreditations, social charges and other regulatory requirements.

Behaviours range from the restaurant owner who neglects to register meal transactions to the restaurant server who doesn’t declare his or her tips, to the self-employed worker who doesn’t report parts of his or her revenue and to the construction manager who lowers his or her hourly rate for a residential renovation job and does not charge taxes to the client. There are also all the drug transactions that happen on street corners and in bar washrooms. The Internet is also adding new dimensions to the UE, with barter sites and commercial sites such as eBay and Kijiji operating under the radar of the taxman.

Josh (not his real name), a building contractor who operates in the Gatineau region, has a straightforward answer for his UE activity: market dynamics. “If it’s good for the client, it’s good for me too,” he says. Operating underground is a necessity for a large segment of the population, he says. “A guy who punches in every day at a job, he can’t make ends meet if he doesn’t have a second job, underground, especially if he has a wife and kids.”

Taxes are not the only thing the UE strives to cut out. It also seeks to avoid payment of social security contributions and certain legal labour market standards (minimum wage, maximum working hours). Another important part of the UE ignores permits and accreditations. Consumers don’t request building permits from their municipalities, builders pretend to be accredited and they pay cash to workers who don’t have adequate credentials or who are illegal immigrants.

UE activity sprouts up everywhere around the residential garden of life and some of its participants are rather colourful — and sometimes quite wealthy. “I know of an 11-year-old baby-sitter who also walks dogs for $30 an hour, and she has subcontractors,” says John-Kurt Pliniussen, associate professor of sales, e-marketing and innovation at Smith School of Business at Queen’s University in Kingston, Ont. “Another fellow, who has an Ivy League education, is also a dog walker. He walks five or six at a time, at $20 a dog. Do the math. At a wedding where I was a guest, the DJ was hired for $2,400 cash, and he does three weddings a week.”

MEASURING STICKS

How big is the UE? No one seems to agree on a number, and evaluations vary widely — if not wildly. The basic evaluation is from StatsCan, which places it at $45.6 billion in 2013, or about 2.4% of GDP (approximately $1.8 trillion). That proportion has remained fairly stable since 2002 and seems to be declining slightly. In 1994, the UE chunk of GDP stood at 2.7%, says Joëlle Noreau, senior economist, economic studies, at Mouvement Desjardins in Quebec.

Other studies throw in higher numbers. Analyzing retrospectively the years 1998 and 2004, a 2010 Bank of Canada study rates the amount of underreported income at between 14% and 19% of GDP. Another one, by Friedrich Schneider of the Johannes Kepler University of Linz in Austria, evaluates it as roughly 10%. A few older studies bring a magnifying glass to those numbers. One 1990 study arrived at a total of 21.6%, a 1976 study cranked it up to 27.5%, and one “subjective assessment” in 1989 put it at between 33% and 100%. (This article will refer only to the estimates made by Schneider, who has studied the area extensively and whose evaluations are frequently quoted.)

Those large spreads are not the result of disagreements about what constitutes the UE. StatsCan takes the narrowest view, including only the portion of market-based production of legal goods and services that escapes detection in the official estimates of GDP. Other analysts take a larger perspective that includes all illegal production, notably criminal activities.

According to Criminal Intelligence Service Canada, total value of the black market in Canada amounts to $77.8 billion, nearly double the “basic” total at which StatsCan arrives. In this total, drug trafficking takes the lion’s share with $44.5 billion, with financial crime running away with $5 billion and cyber-crime with $1.4 billion to $3 billion. Just taking into account drug trafficking doubles the StatsCan basic estimate of 2.4% of GDP. If StatsCan took into consideration all criminal activities, its estimated UE would be much higher at $123.4 billion, approximately 6.9% of GDP.

This percentage still falls short of most other estimates. The real size of the UE remains largely unknown — exactly what its participants aim for.

CONSOLATIONS

A 2015 Schneider paper compares the size and growth of the UE in 36 advanced economies from 2003 to 2015. Across the board, the size of the UE has been declining. He says the decline hinges on the economic recovery that followed the 2008 financial crisis, but that only partially explains a decline that was unfolding before the crisis.

The US, Australia, New Zealand, Japan and Canada constitute a privileged group where the UE stands at the lowest level of developed economies. In the period from 2003 to 2015, average UE activity in these five countries went from 12.2% to 8.6%. Canada is the worst performer of this group, its UE share dropping from 15.3% to 10.3%. The best performer is the US, where the UE slid from 8.5% to 5.9%.

That US score is the lowest of all the 31 advanced economies in Schneider’s paper. The best performing country after the US is Switzerland, where the UE in 2015 stood at 6.5% of GDP. The UK came in at 9.4%, France at 12.3% and Germany at 12.2%. Italy made the best show, at 20.6%, among the worst performers such as Greece (22.4%), Romania (28%) and Bulgaria (30.6%).

The advanced economies exhibit an exceptional feature: their workforce is formal and the UE represents the informal part. In some countries, according to an OECD report cited by Schneider in 2014, it is the reverse: informal is the norm. “In many middle-income countries incentives drive individuals and businesses out of the formal sector. ... 1.8 billion people work in informal jobs, compared to 1.2 billion who benefit from formal contracts and social security protection.”

INTERNET UE BOOM

While the UE seems to be shrinking in advanced economies, the Internet may be changing that. “More and more people equipped with computers,” says Pliniussen, “are incented to create more ‘solutions’” under the official economy. With Kijiji, barter sites globally and crypto-currencies, “it’s never been easier to go underground. All those combine like the perfect storm.”

Bunz, a phenomenon born in Toronto, is an eloquent example of what Pliniussen points to. Having started as a simple Facebook page, this barter platform for the masses was officially launched in January. Eight months later it had 74,000 members, who carry out 500 to 600 trades daily, says David Morton, marketing director of Bunz.

“This is the true sharing economy, not Airbnb or Uber,” says Richard Lachman, associate professor at Ryerson University and director of the Experiential Media Institute. With all the bicycles, couches and refrigerators being bartered “the value is still there, but no longer taxable,” adds Lachman. The virtual UE “is growing, but I couldn’t say how fast. Is it exponential growth? I don’t know.”

COSTS AND ADVANTAGES

There are significant costs to the UE. Minister of National Revenue Diane Lebouthillier, who once co-owned a B&B, identifies what is probably the single most important one: “More than 95% of people asked to pay for their accommodation in cash, without any invoice. It’s really part of the culture. People who operate underground hurt companies that obey norms and requirements and pay insurance. It discourages me from investing in my company to develop it.”

There are many disadvantages, says Pierre Lemieux, associate professor at the Université du Québec en Outaouais, in a 2007 paper published by the Montreal Economic Institute. For example, the UE involves losses of productivity because its enterprises remain small and less productive than the official ones. It also lowers quality standards. It encourages what Lemieux calls “rent seeking,” individuals and companies that seek to create monopolies and privileges, especially in the criminal part of the UE where it leads to violence. One major loss is in social capital, the stock of honesty that underlies social intercourse.

But some believe the UE provides some benefit. Lemieux says it partly neutralizes bad public policies, and helps compensate for the uncontrolled growth of the state. Thus individuals who feel crushed by the state prefer to disappear rather than protest.

Another purported advantage of the UE is that it supplies work and creates economic activity where little official opportunity exists. “After the Fort McMurray disaster,” says Pliniussen, “with the town devastated and thousands without work, if one could make oneself invisible, I think we would see thousands of innovative and undeclared ways of earning a living.”

WRONG TARGET?

But Pliniussen believes, despite these supposed advantages, that the UE should be suppressed by authorities. “Governments are increasingly in debt, with which you can deal in three ways: spend less or raise more money, or both. How can we get more taxes when we know that billions are circulating in this sector that are not taxed?”

However, Robin Thomas Naylor, professor of economics at McGill University, thinks the UE is something of a bugaboo. The UE is the wrong target to aim at to prop up government revenue, he says. Underground entrepreneurs are blamed for undermining the public trust and breaking the capacity of government to ensure the welfare security net. But blaming a shadow economy ultimately discredits the welfare state. It is a ploy to take attention away from the real culprits: very high-net-worth individuals, but mostly corporations that engage in massive international fiscal evasion and astronomical financial ploys that, in the last financial crisis, brought the world economy to its knees. “It would take a regiment, perhaps a full division, of waiters working under the table or plumbers working under the sink for their fiscal defalcations to come anywhere near to the amount that can be diverted by a single rich individual or a reasonably large corporation.” The UE is a tool in a long-term strategy “to shift the fiscal burden from upper- to lower-income groups.”

True or not, Naylor’s perception is shared by large portions of the millennial generation. “A secretary may be proportionally taxed three or four times more than an executive,” says Morton. “If Google or Microsoft paid full taxes, we could all get free schools. Our generation is pissed off at this. There’s bigger fish to fry than barter items at $150 apiece.”

Morton thinks that millennials are getting off the consumer train and moving toward a barter model because the official economy is moving out of their reach. “City houses are $800,000 and $1 million, with $6,000 monthly mortgages. This is why these ideas [like Bunz] have arisen.”

GOVERNMENT IN THE DRIVER’S SEAT

According to a prevailing view, taxes would seem to be the main driver of the UE. “In the official labour market,” writes Schneider, “the costs firms [and individuals] have to pay when ‘officially’ hiring someone are tremendously increased by the burden of tax and social contributions on wages, as well as by the legal administrative regulation to control economic activity. In various OECD countries, these costs are greater than the wage effectively earned by the worker — providing a strong incentive to work in the shadow economy.”

One occasion where higher taxes clearly led to an increase of the UE is when the GST was introduced in 1991. Peter S. Spiro, a Toronto-based economist, suggested in a 1997 article that it prompted a “growth in the underground economy of perhaps 2 percent of GDP from early 1991 to the end of 1993.”

But taxes and regulation would seem not to be the only drivers. Culture is a significant variable, say Pliniussen and Schneider — though we don’t really know which components of culture.

“Scandinavia has some of the highest tax rates in the world,” says Pliniussen. “The marginal tax rate is in the 45% to 50% range. Yet it stands at the lower end of the underground economy. That is a case that would merit study.”

To a large extent, the relationship between citizens and government plays an important role. For example, the GST “became the most unpopular tax imposed by a Canadian government in peacetime,” writes Spiro, who adds, “once people see themselves as being cheated by government, they feel justified in ‘cheating back.’ ” Josh the contractor justifies his revolt with a frequently used image: “Government is a bunch of robbers wearing ties, robbers under the cover of law.”

So federal and provincial governments are cranking up their war on the UE. Lebouthillier explains: “We want to ensure that Canadians are treated fairly and that all pay their rightful share to national revenue.”

Will there be bigger penalties for UE participants? Nothing of the sort is currently in the works, but the Canada Revenue Agency, for example, is stepping up its means of catching more tax dodgers by refining its understanding of the UE and increasing the number of UE specialist teams from 20 to 35. Lebouthillier has also put in place an advisory committee on the clandestine economy that brings together representatives from many concerned economic sectors: construction, restaurants, SMEs, retail, etc.

Quebec is fiercely attacking the UE, notably in the construction industry. In the wake of Law 35, penalties were dramatically pumped up: $32,000 to $163,000 for someone operating without a licence and $16,000 to $81,000 for someone who has an inappropriate licence. “Before that, penalties ranged only in the hundreds of dollars,” says Sylvain Lamothe, spokesperson for the construction regulator. “In certain cases, they were multiplied by 10.”

The UE is now in the sights of governments more than ever. 

About the Author

Yan Barcelo


Yan Barcelo is a journalist in Montreal.

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