The Underground Economy of Unreported Income

Learn about the "underground economy" where businesses and individuals don't report—or pay taxes on—income from both legal and illegal activities.

By , J.D. · USC Gould School of Law

The "underground economy" consists of income earned under the table and off the books. It can include income from both legal and illegal activities.

But just how big is the underground economy? Huge. It has been estimated that the worldwide underground economy amounts to $2 trillion per year. That's two-thousand billion dollars upon which no taxes are paid to governments around the world. The IRS says that the United States lost $500 billion in taxes in one year because of unreported income.

Who Is Part of the Underground Economy?

The underground economy includes millions of workers who would like to have legitimate "on the books" jobs but who can't find them. Their only alternative is to work off the books and accept payment in cash. This practice is especially common in certain occupations such as construction, domestic work, and small food establishments.

Businesses that pay their workers in cash avoid having to pay their share of payroll taxes—7.65% of employee salary up to an annual ceiling. They also don't pay unemployment insurance or workers' compensation premiums, which can cut their payroll costs by 20% to 30%.

Off-the-books workers also avoid having to pay their share of Social Security and Medicare taxes. However, if they don't pay enough into the system, they won't qualify for Social Security when they reach retirement age.

Cash-Intensive Businesses

Another major component of the underground economy is cash-intensive businesses such as liquor and convenience stores, beauty salons, restaurants, bail bond companies, car washes, laundromats, taxicabs, and clothing stores. Owners of cash-intensive businesses often pocket cash payments from customers to avoid having to pay sales taxes and/or income taxes.

Many offer discounts to customers who pay by cash instead of credit cards. It has been estimated that owners of small businesses with substantial cash revenue fail to pay about half their taxes.

Owners of small retail businesses often end up with hordes of unreported cash that they never deposit in the bank so as to avoid detection by the IRS. They use the cash to buy new inventory, pay for living expenses, or buy expensive items such as jewelry, rugs, antiques, clothing, and furniture. Some hide huge wads of cash in safe deposit boxes.

Such tax evaders are often aided by "don't ask, don't tell" tax preparers who help them file "creative" tax returns.

Do Tax Evaders in the Underground Economy Get Caught?

Because of relatively low IRS audit rates, most workers and businesses involved in the underground economy don't get caught. Moreover, due to the lack of accurate records and other factors, cash businesses are difficult to audit.

Bottom Line

The end result of the underground economy is that workers and businesses that report all of their income end up having to pay higher taxes to make up for the shortfall from those who don't pay their share. Moreover, businesses that operate honestly and pay all required payroll taxes are at an economic disadvantage when they try to compete with tax scofflaws.

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