Measuring the Informal Economy, with a Literary Twist

Novelist Victor Hugo offered insightful analysis of the underground economy in his 1862 novel Les Misérables: “when work is lacking, when the trade is nil, the taxpayer resists the tax by shortage, exhausts and exceeds the deadlines, and the State spends a lot of money in duress and enforcement fees. When work abounds … the tax is easily paid.” In Rethinking the Informal Economy and the Hugo Effect (NBER Working Paper 31963), Francesco Pappadà and Kenneth S. Rogoff develop a novel measure of the size of the off-the-books economy in the countries in the European Union, and they test Hugo’s conjecture about its cyclical variation. Drawing on estimates of compliance with the value-added tax (VAT) over the period 1999–2020, they find that the size of the informal economy varies more widely among member states than previous approaches have indicated.

Their new measure, Evading Value Added Duty Economy (EVADE), compares actual VAT revenues with the amount that ought to have been collected based on consumption data in national household surveys. The revenue shortfall provides a metric for gauging the size of each nation’s informal economy.

A new metric for the size of the informal economy suggests it is smaller than previously thought in most European countries, but larger in Italy, Spain, and Greece.

This measurement approach differs from previous yardsticks in several ways, especially in being more transparent, algorithmic, and straightforward to compute. It applies a uniform approach to all nations, and accounts for goods that are covered by special tax rates as well as more stringent enforcement of VAT on imports as a result of border controls. This means that it can be used to “compare across countries with very different trade compositions and choices of politically favored consumption goods.”

EVADE estimates of the size of informal economies are small for most European countries, including relatively affluent nations such as Belgium (at 5 percent of GDP, the smallest), Sweden, and Ireland, and lower-income countries such as Croatia, Latvia, Hungary, and Bulgaria. It shows larger informal economies for Italy, Spain, and especially Greece, which at 36 percent of GDP has the largest informal economy. EVADE’s estimates for Germany (13 percent) and France (14 percent) are similar to previous estimates that applied different methods.

Earlier measures of the informal economy were more difficult to use for high-frequency analysis of countercyclical patterns. Such patterns arise, for example, when workers laid off in the formal economy during a recession take jobs in the informal one. The researchers label the countercyclical nature of informality the “Hugo Effect.” They calculate that a 1 percent increase in the growth rate of GDP — instrumented by the global financial cycle — leads the informal economy to contract by 0.60 basis points.

The researchers stress that their work builds on previous findings that document the economic significance of the informal sector in many countries. “These findings suggest that the monetary and fiscal authorities should take more seriously into account the informal economy, and the possible consequences related to its countercyclical behavior.”

— Steve Maas

The researchers would like to thank the Molly and Dominic Ferrante Fund at Harvard University for research support.