GLOBALIZATION 2001: CONTROLLING IT
Another Failure of the
Washington Consensus
on Transition Countries
Inequality and UndergroundEconomies
J. Barkley Rosser, Jr., and Marina Vcherashnaya Rosser
Western policymakers have long worried about
undergroundeconomies in transition nations and less
about income inequality. But the authors argue that
growing income inequality is an important cause of the
growth of an undergroundeconomy.
New Russian in Mercedes-Benz store: "I would like to see your most
expensive car."
Mercedes-Benz store manager: "Didn't you just buy one in here
yesterday?"
New Russian: "Yes, but the ashtray is already full."
J. BARKLEY ROSSER, JR., and MARINA VCHERASHNAYA ROSSER are, respectively, pro-
fessor and associate professor of economics at James Madison University. The authors wish to acknowledge useful inputfrom Ehsan Ahmed, John Bonin, Simon Commander, Branko Milanovic, and
the late Lynn Turgeon. None of them are responsibleforany errors, omissions, or misinterpretations
in this article.
Challenge,
vol.44,no.2,March/April
2001,
pp.39-50.
© 2001
M.E.
Sharpe,
Inc.Allrights
reserved.
ISSN
0577-5132/2001 $9.50
+0.00.
Challenge/AMrch-April 2001
39
Rosser and Rosser
IT
IS well known that income distribution in many of the tran-
sition economies has become sharply more unequal during
the transition process that began at the end of the 1980s.1 By
and large, the attitude of most policymakers in Washington and
in many international institutions has been that, although this
phenomenon is somewhat unfortunate, it is a necessary outcome,
to be expected and, within bounds, to be desired. The centrally
planned economies were viewed as having too much equality
and not offering sufficient incentives for growth opportunities.
It has been considered inevitable that, in moving to market capitalism, there would be increases in inequality as these incentives became available according to this Washington consensus.
The main concern has been that if this increase became too great,
a political backlash would halt or reverse the transition process
and bring back the former system. That some transition economies such as Russia now have unequal distributions of income
that exceed even that of the United States2 is viewed more as an
annoyance than as a problem that must be resolved.
On the other hand, the especially rapid growth of the underground economy in the transition economies is viewed somewhat more seriously,3 although perhaps as a more extreme case
of a more general global problem.4 This underground economy
is seen as undermining state finances, as those participating in
the underground economy avoid paying taxes. Nonreporting of
income is perhaps the most widely agreed-upon way to identify
underground economy activity. The budget deficits that can arise
if large proportions of economic activity are not reported, and
therefore not taxed, can become a problem, at least in the eyes of
any international lending institutions that have demanded that
the nations in question agree to reduce their budget deficits as a
condition of lending them money. It is also understood that the
crime and corruption that often accompany such underground
activities can corrode the political legitimacy of the system, and
40
Challenge/March-April2001
Failureof the Washington Consensus on Transition Countries
may even spill over into the high-income, nontransition economies as they become havens for money laundering and related
scams and scandals, some of which may even potentially affect
the solvency of Western financial institutions.
It has only dimly begun to be recognized that there may be a
link between these two problems. It is clear that a decline in the
fiscal health of a transition economy may lead it to cutbacks in
social safety net spending, especially when international lending institutions are demanding such cutbacks as part of the
economy's getting its budgetary house in order. It has been less
clearly understood that this relationship may well be a two-way
street, with causation possibly working in the opposite direction as well. Increasing income inequality itself may well contribute to the growth of the underground economy in the
transition economies.
The role of the underground economy in the transition economies is a matter of considerable controversy. Although widespread publicity connects it with outright criminal activity and
associated money laundering in Western banks, it may well perform a socially beneficial function in economies that are overly
regulated, or in which rent-seeking bureaucrats, who may be
officially enforcing the overly strict regulations, engage in bribery
and corruption. 5 In such situations, the only way entrepreneurs can
form what would be viewed as legitimate enterprises is to hide them
from the "grabbing hand" of the corrupt authorities. 6 Efforts to bring
the underground economy aboveground would lead to "throwing
out the baby with the bathwater."7 The hope of this view is that
current underground economy participants will provide a foundation for a functioning aboveground economy in the future, much as
the notorious "robber barons" of the nineteenth-century United
States became the fathers of respected corporations and philanthropic institutions. Even if they do not, their activities may stimulate the aboveground economy through multiplier effects.8
Challenge/March-April2001
41
Rosser and Rosser
Although it is recognized that in some transition economies
there may still be such levels of excessive regulation and associated bureaucratic corruption (Russia and Ukraine standing out
as examples), the apparently rapid growth of the underground
sector has come to be viewed with concern by most policymakers,
both within the countries in question and internationally, if only
because of the fiscal implications. Some observers have suggested
that countries may face two very distinct alternatives: a "good
equilibrium" of not much underground economy and a functioning and honest public sector or a "bad equilibrium" of a large
underground economy and a poorly functioning public sector
unsupported by tax revenues. Some have suggested that this
contrast between outcomes relates to ideas regarding the behavior of mafias and social capital, where there are increasing returns to people who obey the law and involve themselves in
socially worthwhile activities. However, if such behaviors fall
below certain critical levels, then the opposite phenomenon can
emerge-a breakdown of law enforcement and the emergence
of socially damaging behaviors. 9
This theory suggests that if the underground economy reaches
some critical threshold level, it can simply overwhelm the
aboveground economy and come to dominate it. Such an argument fits in well with the idea of sharply diverging possible outcomes with regard to the underground economy. Furthermore,
it becomes clear in the context of transition economies that the
enormous changes these economies have experienced may push
them over such thresholds and toward patterns of extensive underground economic activity that remains underground and becomes a self-reinforcing phenomenon.
What factors might push an economy beyond such a critical
threshold? The original literature on underground economies,
dating from the late 1970s and early 1980s, focuses upon their
emergence in advanced market capitalist economies. This early
42
Challenge/March-April2001
Failureof the Washington Consensus on Transition Countries
literature argues that higher taxes and higher social transfers
lead to larger underground economies as people face incentives
to avoid taxes and be unemployed so as to receive social transfers.' 0 The implication of such arguments is that if high taxes and
large social transfer payment programs are associated with greater
income equality, then one should expect to see income equality
associated with a larger underground economy. Never in this traditional literature is it suggested that the relationship might run
in the opposite direction, that an increase in inequality might
lead to increases in the size of the underground economy.
Such a possibility for the transition economies has now been
suggested, with a finding that there is a strong correlation between the size of the underground economy and the degree of
income inequality, as measured by the Gini coefficient in 1994.11
Of course, these economies have experienced profoundly unusual and disruptive circumstances, with large-scale institutional
transformations and upheavals of many sorts. Many of them
had massive declines in output and hyperinflationary outbreaks,
as well as wars, political instability, and various other extreme
events. That such events could lead to breakdowns of social solidarity and increases in alienation and general disillusionment is
not at all surprising.
Some of these elements appear also to be connected to the rise
of the underground economy.12 However, the only one that appears to be connected to the size of the underground economy
more strongly than the size of the Gini coefficient, at least as of
1994, is the cumulative decline in output from 1989 to 1994. The
maximum rate of inflation also plays a role, but not as great as
the Gini coefficient. Other variables that might be predicted to
have an influence either are much weaker or do not even have
the expected effect. Thus, democratic rights appear to be insignificantly negatively correlated with the size of the underground
economy, while economic freedom has a negative bivariate corCh;Xllenge/March-April 2001
43
Rosser and Rosser
relation but a significant positive correlation with the size of the
underground economy in a full multiple regression. Although
maximum tax rates on capital appear to be significantly positively correlated, maximum tax rates on labor actually appear
to be negatively correlated with the size of the underground
economy, in contrast with most of the existing literature. 13
These findings coincide with a broader reevaluation of transition policy that has been taking place. Whereas at one point most
international officials advocated "shock therapy" approachesin which all transition problems, ranging from macroeconomic
stabilization through institutional restructuring to privatization,
were to be attacked simultaneously and with equal vigor-it is
now clear that for some of these problems, especially privatization,
a more gradual and careful approach may well be called for. The
relatively successful case of Poland, which stabilized the
macroeconomy quickly but has been slow to carry out
privatization, is an important example. The speed of privatization
has been especially linked with the rise of the underground
economy and corruption. Many economies that implemented
rapid privatizations, such as Russia's, discovered that these policies resulted in insider takeovers, corrupt asset stripping, and
other dysfunctional outcomes.14
Table 1 presents a summary of data relevant for this discussion. There are very serious problems in measuring the relative
sizes of underground economies in any economy, much less in a
transition economy where previously stable relationships are
breaking down or otherwise changing. Thus, it may be that the
most widely accepted estimates of the size of the underground
economy in advanced market capitalist economies rely upon estimates of the use of currency compared to GDP.15 But for transition economies, such estimates are not very meaningful given
the enormous restructurings the financial sectors of these economies have experienced. Rather, examining patterns of electricity
44
ChaJlenge/March-April2001
Failure of the Washington Consensus on Transition Countries
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45
Rosser and Rosser
usage has been the most commonly used method for the transition economies, although any method has its limitations in any
economy, and it must be recognized that such measures ultimately involve attempting to measure the unmeasurable.
Table 1 presents data for eighteen countries on the size of the
underground economy in 1994 (UE) as a percent of GDP and
the change from 1989 to 1994 in the size of the underground
economy (dUE); the Gini coefficient in 1994 (GC) and its change
from 1989 to 1994 (dGC); the cumulative percentage decline in
output from 1989 to 1994 (CD); the maximum annual rate of
inflation after 1989 (IR); an economic freedom index in 1994 (EF)
and a democratic rights index in 1994 (DR), both 0-100, with a
higher number indicating more economic freedom or democratic
rights; and the effective marginal tax rates on labor income (LT)
and capital income (CT), respectively."6
Much of what one sees from this table fits the conventional wisdom of the Washington consensus. Thus, we find the more reformed and democratic countries in Central Europe, such as
Poland, Hungary, the Czech Republic, Slovakia, and Slovenia, to
have somewhat smaller underground economies and greater
macroeconomic stability. They also generally have more income
equality and tend to have higher tax rates on labor income but
not on capital income. Russia, Ukraine, Moldova, and Georgia all
have larger underground economies and considerable macroeconomic instability. They generally have higher income inequality
and higher capital income tax rates (Georgia's is unknown).
But there are a number of apparent anomalies. The Baltic
countries are somewhat mixed in their patterns, not even resembling each other on some of these variables. The Central
Asian countries are mixed, with Uzbekistan showing a pattern
that makes it look more like one of the Central European countries, at least on the economic variables.' 7 And notoriously undemocratic and unreformed Belarus shows up with both a
46
Challenge/March-April2001
Failureof the Washington Consensus on Transition Countries
relatively small underground economy and a relatively equal
distribution of income.
Furthermore, there is good reason to believe that income distribution policies, especially in the form of social transfers, vary
greatly among these countries. Thus, the very low reported Gini
coefficients in Slovakia and the Czech Republic may not be accidents or mere artifacts of high tax collections due to small underground economies. Studies suggest that their transfer policies
have been much more effectively targeted toward the poor and
those impacted negatively by the transition, policies such as generous unemployment benefits and family assistance.' 8 The programs in somewhat less equal Poland and Hungary are reported
to target the middle class, especially their generous pensions,
whereas the transfer programs in Russia are reportedly regressive in effect, making even more unequal a distribution of income that has become sharply unequal during the transition.' 9
All these findings suggest that the original Washington consensus may have been mistaken to ignore income distribution
policies or even to applaud increases in inequality, as appears to
have been the case. It is clear that quite a few people in some of
the institutions that developed that consensus have been documenting the large increases in income inequality in many of the
transition economies, even as their superiors so far seem to have
largely ignored these findings. Likewise, these people have documented that social safety net policies, by their nature, have in
fact influenced the outcomes regarding income distribution. We
also now see that income inequality itself may help to increase
the size of the underground economy through social alienation
and general dislocation, especially in conjunction with macroeconomic instability. Given that a large underground economy
makes it hard to raise tax revenues to pay for a social safety net,
there is a potential negative feedback effect that it would be wise
to avoid. Thus, there appears to be a case for a serious reconsidChAllenge/March-April 2001
47
Rosser and Rosser
eration of policies with regard to income distribution in the transition economies in light of this apparent interaction with the
underground economy. Not only political legitimacy, but economic stability, may call for more vigorous efforts to maintain
income equality in the transition economies.
Notes
1. For example, see Frances Stewart and Albert Berry, "Globalization, Liberalization, and Inequality: The Real Causes," Challenge 43, no. 1 (January-February
2000): 44-92; Branko Milanovic, Income, Inequality, and Poverty in the Transitionfrom
Planned to Market Economies (Washington, DC: World Bank, 1998); and Simon Commander, "The Impact of Transition on Inequality," Economics of Transition5 (1997):
499-504.
2. See Timothy Smeeding, "America's Income Inequality: Where Do We Stand?"
Challenge 39, no. 5 (September-October 1996): 45-53.
3. See Simon Johnson, Daniel Kaufmann, and Andrei Shleifer, "The Unofficial
Economy in Transition," Brookings Papers on Economic Activity 2 (1997): 159-221.
Other terms for this sector include "unofficial, informal, shadow, irregular, subterranean, black, hidden, and occult."
4. See Friedrich Schneider and Dominik H. Enste, "Shadow Economies: Size,
Causes, and Consequences," Journalof Economic Literature38 (March 2000): 77-114.
5. A study showing that in Russia, Ukraine, Poland, Slovakia, and Romania
bureaucratic corruption is strongly associated with firms hiding output from the
authorities is Simon Johnson, Daniel Kaufmann, John McMillan, and Christopher
Woodruff, "Why Do Firms Hide? Bribes and Unofficial Activity After Communism,"
Journalof Public Economics 76 (June 2000): 495-520.
6. See also in this regard Andrei Shleifer and Robert W. Vishny, The Grabbing
Hand: Government Pathologiesand Their Cures (Cambridge: Harvard University Press,
1998); and Eric Friedman, Simon Johnson, Daniel Kaufmann, and Pablo ZoidoLobat6n, "Dodging the Grabbing Hand: The Determinants of Unofficial Activity in
69 Countries," Journalof Public Economics 76 (June 2000): 459-493.
7. This position is presented in Patrick K. Asea, "The Informal Sector: Baby or
Bath Water? A Comment," Carnegie-Rochester Conference Series on Public Policy 45
(December 1996): 163-171.
8. This argument appears in Dilip K. Bhattacharya, "On the Economic Rationale
of Estimating the Hidden Economy," Economic Journal 109 (June 1999): 348-359.
9. Such arguments have been made in comparing northern Italy and southern
Italy, as by Robert D. Putnam, Making Democracy Work: Civic Traditions in Modern
Italy (Princeton: Princeton University Press, 1993); and also in a more abstract form,
using increasing returns and path dependency arguments from complexity theory,
by Maria Minniti, "Membership Has Its Privileges: Old and New Mafia Organizations," ComparativeEconomic Studies 37 (winter 1995): 31-47. In the sociology literature, such arguments have long been made regarding threshold levels in mass
48
Challenge/March-April2001
Failure of the Washington Consensus on Transition Countries
behavior, with Mark Granovetter providing a classic example in "Threshold Models of Collective Behavior," American Journalof Sociology 58 (1978): 1420-1443.
10. Examples of this early literature include Edgar L. Feige, "How Big Is the
Irregular Economy?" Challenge 22, no. 1 (January 1979): 5-13; and Bruno S. Frey
and Werner Pommerehne, "The Hidden Economy: State and Prospect for Measurement," Review of Income and Wealth 30 (March 1984): 1-23. This view led to arguments that welfare states were simply in a hopelessly frustrating situation whereby
their efforts to redistribute income would backfire as tax revenues fell; e.g.,
Manfred E. Streit, "The Shadow Economy: A Challenge to the Welfare State?"
Ordo Yearbook 35 (1984): 109-119.
11. A correlation coefficient of .76 between the size of the underground economy
and the Gini coefficient in 1994 for sixteen transition economies was found by J.
Barkley Rosser, Jr., Marina V.Rosser, and Ehsan Ahmed, "Income Inequality and
the Informal Economy in Transition Economies," Journalof Comparative Economics
28 (March 2000): 156-171. They also found a correlation coefficient of .705 between
changes in the size of the underground economy and changes in Gini coefficients,
with both of these correlations being significant in bivariate regressions. The Gini
coefficient varies between 0 and 1 with higher values indicating greater inequality.
12. Details of these relationships can be found in J. Barkley Rosser, Jr., Marina V.
Rosser, and Ehsan Ahmed, "Multiple Unofficial Economy Equilibria and Income
Distribution Dynamics in Systemic Transition," mimeo (Harrisonburg, VA: Department of Economics, James Madison University, 2000), available at http://
cob.jmu.edu/rosserjb. One important caveat to the relationships reported in the
text is that there is a problem with using the cumulative decline in output as such
because it is already distorted by changes in the relative size of the underground
economy, larger such changes automatically increasing the size of that reported
cumulative decline. As reported in this article, if one replaces the cumulative decline variable with an adjusted cumulative decline that accounts for the changes
due directly to increases in underground economy, that variable ceases to be significant, with the maximum rate of inflation becoming more significant than the
Gini coefficient, which remains very significant.
13. Despite the early literature, some studies have found that even in the
nontransition economies, tax rates on labor income may not be positively correlated with the size of the underground economy, with such factors as the complexity of the tax code possibly playing offsetting roles, as found by Friedrich Schneider
and Reinhard Neck, "The Development of the Shadow Economy Under Changing
Tax Systems and Structures," FinanzarchivN.F. 50 (1993): 344-369.
14. A compelling discussion of this problem with a discussion of the positive
example of Poland is provided by Marshall I. Goldman, "Reprivatizing Russia,"
Challenge43, no. 3 (May-June 2000): 28-43.
15. A classic example of using the currency demand approach to estimate the
size of the underground economy in the United States is Vito Tanzi, "The Underground Economy in the United States: Estimates and Implications," Banca Nazionale
Lavoro Quarterly Review 135 (December 1980): 427-453. Schneider and Enste,
"Shadow Economies," provide a thorough overview of various methods of estimating the size of the underground economy.
16. For all countries except for Kyrgyzstan and Slovenia, the size of the under-
Challenge/March-April2001
49
Rosser and Rosser
ground economy as a percent of GDP is from Johnson, Kaufmann, and Shleifer,
"The Unofficial Economy in Transition," who model electricity use as a function of
GDP. The estimates for Kyrgyzstan and Slovenia come from a study of household
consumption of electricity by Maria Lack6, "Hidden Economy-An Unknown Quantity? Comparative Analysis of Hidden Economies in Transition Countries, 198995," Economics of Transition8 (2000): 117-149. The Gini coefficients and changes of
these are from Rosser, Rosser, and Ahmed, "Income Inequality," which represent
combinations of estimates from a variety of studies. The cumulative decline in output and maximum annual inflation rates are both from Stanley Fischer, Ratna Sahay,
and Carlos Vegh, "Stabilization and Growth in Transition Economies: The Early
Experience," Journal of Economic Perspectives 10 (spring 1996): 67-86, although the
cumulative decline in output number has been adjusted to account for misreporting
due to changes in the size of the underground economy. The economic freedom and
democratic rights indexes for 1994 are both from Peter Murrell, "How Far Has the
Transition Progressed?" Journalof Economic Perspectives10 (spring 1996): 25-44. The
effective marginal tax rates on labor and capital incomes are both from Lack6, ""Hidden Economy." In some cases, the beginning or ending years are not exactly 1989 or
1994, but the nearest available, given the data sources.
17. Considerable doubts have been raised about the underground economy estimates for Uzbekistan in particular, a nation with a long history of reported corruption. See Marshall I. Goldman, "Comment on Johnson, Kaufmann, and Shleifer,"
Brookings Papers on Economic Activity 2 (1997): 222-230. Romania's numbers may
also be suspect due to structural changes in its electricity sector, as may be
Kyrgyzstan's for the same reason.
18. See Michael Forster and Istvan Gy6rgy T6th, "Poverty, Inequality and Social
Policies in the Visegrad Economies," Economics of Transition5 (1997): 505-510.
19. See Commander, "The Impact of Transition on Economy."
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Challenge/March-April2001
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TITLE: Another failure of the Washington consensus on
transition countries: inequality and underground
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