Europe’s “Shadow Economy” and its Effects on Tax Revenue

Let’s be honest, no one likes to pay taxes. But this aversion to giving up some of our hard earned money is usually offset by our desire to maintain a well-ordered society and infrastructure. Nevertheless, the “bad guy,” so to speak, in each country is usually the tax collector. In the United States both Uncle Sam and the IRS often get the bad rap. In Europe, it is a rather similar affair. While naming each European country’s “bad guy” would take more time than it’s worth, talking about the growing “shadow economy” is worthy of the time.

A shadow economy is the untraceable economy of a nation that is not taxed because it is much harder to keep track of. Usually, this is because cash is used to avoid a paper trail. In Europe, the shadow economy is worth billions and growing. This is because European countries, in trying to deal with the continuing economic crisis threatening the EU’s monetary union, have enacted tax rate hikes and severe budget cuts in an attempt to reduce their debt. But cutting the budget and increasing taxes tends to have a number of negative consequences, if not balanced correctly. For one, less spending could weaken and reduce the size of the economy. Increasing taxes would sap the income of individuals and businesses preventing further spending. But increasing taxes too much also has the consequences of drawing the ire of the public and forcing them to seek out the shadow economy by using cash. Ultimately a vicious cycle where the more tax revenue is lost due to people defecting to the shadow economy, the higher the tax rates go. In effect, it is a self-fulfilling prophecy.

As of late, budget cuts have come under scrutiny because the economies of many countries have weakened considerably. In Greece, for example, the threat of a return to the Greek Drachma, the former national currency before adopting the Euro, forced them into painful austerity measures in hopes of reducing the budget deficits and bring the country back on track for growth. But the opposite has occurred; more slow growth and more losses. This has been felt all over the EU.

Now, taxes are coming under fire for similar reasons. A report released by a UK think tank indicates that as the tax rates increase, shadow economies will also increase resulting in more lost revenue and circling back to even higher tax rates. Instead of attempting to shut down the shadow economies directly, the report argues, governments should lower tax rates to build public confidence in the system. This, in turn, will reduce the shadow economy to the benefit of increased tax revenue for the government at lower tax rates. The UK’s own shadow economy now exceeds 150 billion pounds ($230 billion) and is equivalent to 10% of the nation’s GDP!

This “vicious” cycle can be turned into a “virtuous” one the report says, simply by lowering taxes. Legislators are no doubt watching with interest to see what happens from across the pond.