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The World Bank
Topic B: Overcoming the informal sector (underground economy) in developing countries.
Director: Santiago Ruiz (MS), Daniel García (HS)
Moderator: Eugenia Salinas (MS), Isabella Vela (HS)
I. Committee Background
Established in 1944 with the purpose of aiding in the reconstruction process of warstricken states, the World Bank, now employing over ten thousand individuals, endeavors to
“reduce poverty and support development” of nations across the globe [About – What we do &
About – History]. Composed of the International Bank for Reconstruction and Development
(IBRD) and the International Development Association (IDA), the World Bank, along with three
other organizations, forms part of the World Bank Group, which dedicates solely to the motive
of reducing poverty [FAQ’s – About the World Bank].
The World Bank aims both to put an end to extreme poverty, attempting to have no more
than 3% of the global population living on less than $1.25 per day, as well as achieving monetary
equality for poverty-stricken individuals by fomenting income opportunities for the bottom 40%
in terms of economic prosperity – all before 2030 [About – What we do]. Since 1947, the World
Bank has conducted 12,133 projects in 173 countries [Projects & Operations]. Presently, it is
carrying out a total of over 1,800 projects, mostly in developing countries – with a prime focus
on the Sub-Saharan African and South East Asian regions – ranging from raising health
awareness to rebuilding cities destructed by natural disasters [World Development Indicators].
Additionally, the World Bank, in its attempt to increase institutional transparency and access to
fundamental information, has revamped its virtual network, which now functions as its prime
statistical platform.
The Bank, as an independent agency, is owned by its 188 member states; each member
state’s Finance Minister holds a seat on Board of Governors – the policy making body that elects
twenty of twenty-five Executive Directors; the remaining five Executives are appointed by each
of the Bank’s largest shareholders: Germany, the United Kingdom, the United States, France,
and Japan. Meetings of the Board of Directors are chaired by the President, who is elected by the
Executive Directors every five years, with the opportunity of enrolling in renewable terms.
Prerequisites for becoming a member of the World Bank are outlined in detail under the Charter
of the IBRD, but the most important clause is that a state must first be a member of the
International Monetary Fund [FAQ’s – About the World Bank].
II. Introduction and Description
Description and Definition of the Topic
The underground economy consists of businesses that remain undetected and are
therefore unregulated by the government. These are also known as shadow economies or black
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markets. The most common underground activities practiced globally include: sexual
exploitation, prostitution, transportation providers, drug and alcohol dealers, weapon trade,
organ trafficking, copyrighted media, and the illegal trade of timber. Unlike the official
economy, the underground economy is not counted as part of the Gross Domestic Product
(GDP) and thus avoids government regulation, which are laws that control how businesses
operate.
The main reason why people get involved in the shadow economy is because they want to
avoid such regulations like income tax, social security, legal working hours, and minimum wages
(Schneider, 2007). Also, people without the necessary documents or permits enter the informal
economic sector due to the fast and easy way they make profit. Taking all of this into
consideration, the participants in the underground economy are not contributing to the
economic and social well being of their nation but are using their revenue to extend their illicit
underground activities for their own benefit. This issue contributes towards the deterioration of
a nation; unauthorized and illegal activities do not allow a developing nation to grow.
The Problem
It has been proven that businesses in the informal sector increase government
corruption in developing countries. It also creates economic instability because they unfairly
compete with official businesses since they do not pay taxes, which functions as a nation’s
revenue, used to improve a country’s state. Because of the fact that they are not taxed, there is
an increase in the taxes that the businesses in the official economy should pay, which is highly
unfair for the legal sector. Additionally, because informal economies do not respect minimum
wage or maximum hours, their labor is cheaper than that of the formal sector’s. Thus, it is
essential to eradicate these shadow economies in order to improve a country’s political,
economic, and social wellbeing. Furthermore, in certain Latin American countries, it has been
proven that the official GDP per capita of a nation decreases as the GDP of the informal sector
rises.
Although there are several negative effects of the existence of informal economies, this
issue remains highly controversial seeing as the informal sector possesses advantages the formal
sector does not offer. For instance, it offers countless jobs that help people overcome poverty,
which is especially appealing to impoverished women. In some cases when the shadow
economies produce goods they help increase the exports of a country and aid its participation in
the global market. However, it is very difficult for a nation to combat this issue because the
people in the shadow economy, like their businesses, remain unknown and undetected by the
government. Additionally, many nations try to solve this issue by imposing more regulations;
yet, they fail to understand that the underground economy is formed in order to avoid
government regulation, so additional regulation creates incentives to get involved in the
underground businesses and thus forms a larger informal sector.
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III. History of the Topic
Underground economies have been present since the rise of ancient civilizations such as
the Egyptian and Roman Empires. Just as in the contemporary world, the citizens had to abide
by the rules imposed by the authoritative leaders, so they went underground in order to escape
strict regulation (Sennholz, 2003). It the informal sector of the economy wasn’t formally
explored until the 1950s, when leading economists Nicholas Kaldor and Phillip D. Kagan began
investigating the issue (Williams, 2010).
When economists first began to investigate about the underground economy during the 1950s,
they believed that the informal economy would be dominated by the capitalist economy that
persists; however, their hypothesis was proven incorrect. Instead of disappearing, the
underground economy quickly expanded and grew immensely. Thus, the International Labor
Organization (ILO), which focuses on the promotion of working conditions and employee rights,
mounted several missions in order to combat informal economies. The first mission was in
Kenya in 1972 where agents saw first-hand the detrimental effects a growing shadow economy
has on a developing country’s economy. The ILO agents realized that a developing country’s
unregistered businesses will never disappear if the nation does not achieve a fully-grown or
prosperous economy (Informal Economy: History and Debates 2014, November 7).
As income, investment, and employment increased globally, the prices, regulations and
taxes did as well. From 1965 to 1980 the marginal tax rate for a family of four earning the
median income rose from 17 to 24 percent in the United States. Along with the rise in income,
the pressure to earn a higher living increased, and thus families resorted to unregistered or in
some cases, illegal businesses. Taxes are only one of three main impediments that lead
individuals to participate in informal businesses, along with regulations and prohibitions. The
increase in business regulation eventually gives rise to contraband in many products.
The Latin American economic crisis of the 1980s quickly brought the region into a
recession. Consequently, the size of the informal economy drastically increased because workers
were laid off from their jobs and the newly unemployed were willing to work in unregistered
businesses as long as they had a job and earned money. A similar event occurred in Asia during
the 1990s when millions of people lost their jobs and sought to work in the shadow economy.
(Informal Economy: History and Debates 2014, November 7).
In 2005, the Organization for Economic Cooperation and Development (OECD)
recorded that the size of the shadow economy for 96 developing countries was 36.7% of the
GDP. Among the highest ranks were: Bolivia with 67.2%, Georgia with 66.4%, Zimbabwe with
64.6%, Panama with 62.2%, and Nigeria with 59.5%. Due to their large informal sector, these
countries suffered both political and economical instability; economists have observed that as
the size of the shadow economy increases so does the government’s corruption.
Currently, the size of the shadow economy in several central European nations has
quickly expanded as a result of the financial debt crisis that took hold in 2009. Because Greece is
in the midst of a financial crisis and recovery, its shadow economy reached its highest peak with
a size of 25% of the GDP and Bulgaria at 31.9% in 2012. Other countries such as Cyprus recorded
up to 53% and Spain 18.8% (Shadow Economy and Undeclared Work 2014, November 7).
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Historical Case Studies
United States of America
During World War II there was a boom in the United State’s shadow economy. Having
just barely made it out of the Great Depression, an economic crisis that resulted in thousands
becoming unemployed, citizens resorted to illicit businesses to earn an income. Since then, the
underground economy has continued to rise. From the years 1940 to 2010, the percent of
unreported income to reported income rose from 12 to 24 percent (Achtenberg, 2013). As the
economy developed, new jobs were created and the labor force began expanding exponentially.
But as the labor force growth took flight, the labor regulations and enforcement failed to keep
up. Between 1980 and 2007, the amount of minimum wage and overtime inspectors lowered by
31 percent, while the labor force increased by 52 percent. The incongruity in numbers and
regulators incentivized workers to leave the legal workforce and resort to the jobs provided by
the underground economy. Currently, it is estimated that the income created by the informal
sector in the United States could be up to 2 trillion dollars, accounting for a 450 to 500 billion
annual tax gap (Achtenberg, 2013).
Argentina
Argentina is one of the South American countries that suffer greatly from the pressing
issue of overcoming the informal economy. Argentina’s underground economy even has a code
name; “The Blue Market.” In fact, the informal economy in the country is 61% greater than
the country’s official economy. This problem spiked back in November of 2011, and ever since
then the government has tried to decrease its black market numbers. The Argentine
government has begun to institute capital controls, aimed at restricting the flow of US dollars.
US dollars are highly demanded in the country right now, being the main cause for the
underground economy. This is because of inflation and capital flights that have steadily eroded
the value of Argentina's peso since Cristina Fernández de Kirchner was named president.
Argentina is a very clear example of what underground economies look like, they are very hard
to overcome.
Bolivia
In 1999, Bolivia’s underground economy was the biggest in Latin America calculated to
be 67% of its GDP (Schneider, 2007). However, it reached its greatest size in 2008 when it was
the second largest underground economy in the world generating 70.7% of GDP (The Countries
with the Biggest Shadow Economies 2014, November 8). In 2008, Bolivian president Evo
Morales issued several reforms on the conditions, wages, and income of corporate businesses
and their employees. The minimum wage increased 127%, which incentivized people to work in
the favorable conditions of the formal sector. Because income rose steadily, the purchasing
power increased by 41%; this meant that money had more value and thus people could afford to
buy more things with less. All of the economic reforms that president Evo Morales issued
improved the formal economy, which encouraged people to leave behind the underground
economy for a legal and prosperous one. According to data presented by Morales to the
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Legislative Assembly, in 2011, the richest 10% of the population had thirty-six times more
income than the poorest 10%, down from ninety-six times more in 1997. Also, from 2005 to 2011
the poverty rate decreased 26% and the extreme poverty rate fell by 45%; due to this, a million
people joined the middle class. Both the decrease in income inequality and poverty rates reflect
a smaller underground economy because less people are struggling economically and seeking
income wherever they may find it.
Another important factor that helped boost the economy was Bolivia’s state-run
policies, where 34% of the national economy is state run. The nation ordered the renationalization of some key sectors including mining, hydrocarbons, telecommunications, and
energy; however, Morales still encourages private investment. The plethora of revenue gained
from the industries is being used to fund expansionary and welfare programs that increase the
average quality of life of the Bolivians. Educational and healthcare programs are also being
created and there is an increase in the coverage of basic services such as water, light, and food.
As a result of Bolivia’s economic improvement, people lead better and more stable lives
(Achtenberg, 2013).
Georgia
The biggest current shadow economy relative to official economic activity, in percentage
terms, is the former Soviet republic of Georgia. The last year in which data was available, 2007,
put this country’s shadow economy at 72.5%, an astounding number. In 2004, Georgia made a
major change in their tax regime where the country switched from a complex and multi-faceted
tax system to a much simpler tax system with a reduced number of taxes and relatively low tax
rates. The reform also included adopting a low flat rate of 12% for personal income tax. This
means that no matter the amount of income every citizen pays the same percentage of tax. This
change toward a flat tax is usually done with the intention of stabilizing shadow economy,
seeing as tax evasion is an enormous contribution to shadow economy. The Georgian
government also conducted reforms that will improve tax enforcement in order to prevent tax
evasion and the growth of the GDP in shadow economy.
Past World Bank Actions and Resolutions
The informal sector of the economy is a very complex topic, due to the fact that it is the
result of a combination of various unfavorable factors. The World Bank has dutifully recognized
this, and thus, has focused on designing and implementing solutions for a wide variety of issues
(Topics 2014, November 7).
The World Bank seeks to reduce the underground economy at a global scale by
improving the conditions of people living in lower socioeconomic conditions. Strengthening
agriculture, improving education, stabilizing the private sector, and ensuring transparent
governance are some of the major goals The World Bank has set for the near future. For each
specific area, The World Bank has developed a unique plan of action (Topics 2014, November 7).
In the case of Agriculture, which according to data from The World Bank’s official site
could help reduce poverty for 75% of the population living under this condition, programs that
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focus on ensuring the conservation of arable land, improve the productivity of farmers, and
reduce inequality have become the base of the Bank’s actions. Last year, it employed $8.1 billion
in new commitments to agriculture (Agriculture Overview 2014, November 7).
In 2000, The World Bank published the report “Voices of the Poor”, which concluded
that the best chance people living in poverty had to escape from it was to gain income through
the creation of their own businesses or through employment in large corporations. In order to
ensure the viability of both possibilities, there must be a thriving private sector, which is mainly
obtained through the implementation of properly formulated government policies. For this
reason, The World Bank seeks to help in the development of regulations that foster
entrepreneurship and growth, facilitate the capacity of firms to offer better and cheaper services
to the poor, and support the economies of developing countries in order to make them resistant
to financial shocks. Conferences and workshops are held multiple times every year for these
purposes (Financial and Private Sector Development 2014, November 7).
Ensuring transparent governance and progress in worldwide access to education are
probably the two most challenging areas. Nevertheless, through the efforts of groups composed
by experts on each topic, The World Bank has been able to provide advice to nations who wish to
improve in these areas. Overall, the efforts of The World Bank have resulted in a worldwide
increase in school attendance by approximately 50 million children between 1999 and 2012,
while the tools suggested by the aforementioned groups of experts have been adopted in several
countries. Though progress must still be achieved, signs of improvement are encouraging.
IV. Points of View
Pakistan
Pakistan’s economic growth has slowed, expanding only 2.4 percent in the year ending
June 2011. Although the documented economy is having its lowest growth in decades, the
towering demand for cars, houses and other commodities demonstrate that the underground
market is booming. Pakistan is the country with the third largest shadow economy as a share of
GDP at 36%, behind Russia and Brazil. The informal sector employs 54 million workers, over 75
percent of the total nation’s workforce. Only 25 percent of Pakistan’s economy is taxed, with one
of the lowest tax-to-GDP ratio, calculated at 8.6 percent in June. 1.5 million people file tax
returns, less than 1 percent of the population. In this extensive tax evasion 800 billion rupees
are lost per year. This year the Pakistan government acquired 1.7 trillion rupees in taxes, failing
to close the budget gap currently at 6.3 percent of the country’s GDP. The rise in the
underground economy generates problems for the government, impeding them from being able
to successfully implement fiscal and monetary policies. As the underground economy continues
increasing the legal economy becomes harder to control (Mangi, 2012).
India
India’s economy is the third largest in Asia; however, it is still considered a developing
country. India has a ratio of 127 unregistered businesses for every registered one, which is the
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second largest ratio in the world after Indonesia (Bora, 2014). For the past decades, India has
shown little to no improvement in this issue. In a 2010 study conducted by the World Bank, it
was recorded that India’s shadow economy earned 20% of its GDP, which was the same as in a
study conducted in 1985. The reason why India has been lacking improvement so much is
because of the high levels of government corruption, which often get involved in the informal
sector in the form of small bribes and wholesale scams. In 2013, India proposed several projects
in order to tackle the problem. India began to cross-check bank and credit-card records to avoid,
identify and address any type of illicit activity. It will also conduct a series of studies on corrupt
government officials that are or have been active participants in the shadow economy. By
publicizing the reports on the corruption of government officials, India will help dispel a
widespread view that officials are the ones that most benefit by the black market. The large
informal sector in India has hampered economic development, and urgent reform is necessary
(Evasive Action: India's Shadow Economy 2014, November 10).
Egypt
Egypt is recognized as a developing country across the globe. This is majorly in part to it
being the country in Africa with the second largest shadow economy. Currently, Egypt has
approximately 68% of its GDP not in the official record. This number is huge, and has indeed
alerted the country’s government. This has not been a recent trend, as it has been around for
way too long. Crucial information was found from a study composed by the World Bank. A total
of 2.7 million enterprises employing an estimated 5 million workers and representing 66% of
total non-agricultural employment are not part of the private sector. The issue in the country is
that the wealth and most of the purchasing power is highly concentrated in the hands of a small
percentage of the country's population, thus bringing further economic hardships to the
majority of Egyptians could lead to frustrations, riots and political instability.
Philippines
In the late 1940’s following World War II, the Philippines had the potential for rapid
economic growth. The years that followed were a disappointment for Philippines’ economy
because the high expectations did not materialize and from then till present time the Philippines
is still considered a developing country. Several reasons are contributing to the economical
struggles that the Philippines currently face which includes its underground economy. With the
percentage of Philippines’ GDP in shadow economy being 48.4% it is no wonder that the
Philippine government has decided to take action in solving the issue. Global Financial Integrity
alleges that crime, corruption, tax evasion, smuggling, and illegal activities have cost the
Philippines over $133 billion dollars from 1990 to 2010. The nation’s president, Benigno
Aquino, has held a successful campaign to raise revenues to gain control of public debt as well as
get rid of several corrupt officials who contributed to almost half the countries GDP to being in
underground economy by embezzling, committing tax fraud and using their positions in the
government to conduct illegal activities like arms and drug dealing as well as accepting bribes.
The nation’s president is also enacting several economic reforms that consist of; stricter
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banking regulations, enforcing economic transparency, enforcing stronger customs and audits,
expanding the definition on money laundering, carefully reviewing every transaction with
various tax havens, and hiring more outsiders to cleans the bureaucracy.
V. Possible solutions
The underground economy is a very complex issue to solve. Some may think that
imposing harsher regulations, such as control of market entries, prices, and wages, will help
improve a country’s position on this issue, but it actually leads to a greater underground
economy. That is because of the fact that the underground economy was built in order to escape
regulation and taxation. Some governments have passed laws or bills that strengthen and create
a favorable formal sector in the economy. For example, the United States implemented the
Earned Income Tax Credit (EITC), which is advantageous to the moderate-income working
people. This benefit lowers the tax amount that a working individual owes; however, people are
only eligible for the EITC if they are part of the formal economy (EITC, Earned Income Tax
Credit, Questions and Answers 2014, November 20). When a nation implements solutions that
give benefits to the workers in the formal economy, participants in the underground economy
will prefer to work in legal businesses where they will advantageous of the new policies. The
government may also do this by improving the quality and conditions of working institutions.
Johannes Koettl, senior economist at the World Bank, argues that the time and effort of
the government is crucial in order to solve this issue. Establishing trusts between a nation’s
government and its citizens is also very important; the correct way to do this is by establishing
transparency of payments and transactions. Seeing that powerful government officials are key
players in the underground economy, combating corruption or testing suspicious officials of
their involvement in the underground economy will be very effective way to minimize the
problem. Cooperation between the government, its people, and other countries is essential
because an underground economy affects the developing nation as a whole and may also affect
other economies as well (Rowland, 2012).
VI. Current status (Present day case studies)
Greece
In the year 2013, it was calculated that 24% of the entire economic activity within Greece
took place in the underground sector, escaping regulations and tax. After the 2012 recession, the
economy decreased by 30%, currently leaving the government in a 174% of debt of GDP. Even
more than in other countries, the citizens in Greece feel that their taxes are not put to good use.
According to reports from Transparency International, Greece’s public sector is one of the most
corrupt in the European Union. Moreover, there is also an elevated amount of self-employment,
commonly leading to an increase in the underground sector. With a 43% of labor costs
implemented by the Greek government, citizens are incentivized to seek labor in ways other
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than official. Naturally, this soaring shadow economy is also diminishing government profits.
According to a recent study, for each increase in the percentage of shadow economy to GDP,
there is a .4 percent increase in the debt-to-GDP ration. Before joining the euro, Greece reduced
their debt by implementing policies leading to high inflation. Now, the European Central Bank
controls the monetary policies, and this is no longer an option. As Greece faces hard times, their
only choice is to slowly diminish the shadow economy through sustained economic expansion.
USA
The underground economy of the U.S. is estimated to be about $970 billion, or nearly 9%
that of the real economy. The scary and worst part is that it should soon pass $1 trillion. The
sheer growth of the underground economy in the U.S. is cause for concern. Largely fueling the
underground economy is the nation's swelling ranks of low-wage illegal immigrants. The
government puts this population at 8.5 million, but that may represent a serious undercount.
One solution they are pushing for is that the IRS collects all the taxes it is owed from the
underground economy, which could be quite helpful. The US wants to push ahead with tax
reform this year, including the creation of a national sales tax and reduction of income taxes. In
theory, a sales tax would capture the underground economy. Although very far from Greece or
Spain, countries who have around 20% of their GDPs taken by their respective underground
economies, the US is certain of its position and hopes to reduce its gray economy. The World
Bank does not predict a light at the end of the tunnel any time soon. Tara Vishwanath, the World
Bank economist for the Middle East and North Africa, predicts that shadow economy is
increasing primarily because, the younger generation who has just entered the labor market
cannot seem to find formal jobs that are registered with the government, so they are forced to
resort to informal, private sector jobs. The World Bank is concerned with the fact that Egypt
does not have young, fast-growing firms, which the Bank identifies as the backbone of job
creation in several other countries. All this means that the Egyptian people do not have formal
employments but instead have poor-quality jobs with no social security or written contract.
Informal employment, which is an enormous contributor to tax evasion and other methods of
embezzlement, has increased from 30.7% to 40% in the past decade.
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