Economic impact of illicit transactions debated.

ECONOMIST Daniel Flaming and policy analyst John Roman have both spent considerable energy studying the underground economy. But their conclusions couldn't be any more different. Flaming, who comes from a labor perspective as executive director of the L.A.-based Economic Roundtable, believes that the underground economy is bad for both the workers involved and for society as a whole. In L.A., for example, he has calculated that low-paid workers who don't file federal income tax returns are losing out on $1.4 billion a year in earned income tax credits. Roman has done research on drug courts and crime for the Urban Institute's Justice Policy Center in Washington. In "The Shadow Economy, " co-written with University of Cincinnati professor Graham Farrell and the Universitty College of London's Matthew Fleming, he questions the assumption that the underground sector is a detriment to the mainstream economy.

Question: There's been a lot of talk about the underground economy, but no one seems to completely understand it. Why?

Flaming: Because it's difficult to understand something when you don't know what's there. We know about parts of the underground and informal economies of L.A. But we need to conduct more studies to determine its size.

Roman: Part of the problem is that the term "underground economy" has a pejorative notion to it. I'm not sure it should. There is the illicit side, such as drugs, as well as the activity that occurs because people are trying to evade paying taxes on income, like gambling winnings. But then you have people who work through informal networks in their community, who conduct business through barter or other activities. It may be unrecorded, but it doesn't exactly have to be a negative.

Q: So how can its size be estimated?

Flaming: In our study, we used nine different approaches. Data from employers, such as payroll reports to the government, are the most reliable and most detailed. From those details, we know formal employment is stagnant. We have slightly fewer jobs than in 1990. Then there's the monthly federal survey, where the government goes into people's homes and asks how many are working. In L.A., there is a distinct and growing gap between the payroll numbers and the number of households with working members. That trend is different than in the other parts of the country, where these data points are coming together.

Roman: The methods are very crude. You can look at what people spend and what they report and notice the differential. In the U.S., it's easy to do because we don't collect a lot of data well, but we do collect tax data well. You can also look at their savings compared to income. That's what the IRS does. In developing countries, you look at the volume of goods consumed versus income level. If a country consumes a greater amount of goods than its income would be able to support, then it stands to reason that it has a significant informal economy.

Q: How reliable is the data?

Flaming: In the circles we move in, the data is reliable. But a lot of people not in our circle aren't in that data. And that group is growing.

Roman: The data we have doesn't really measure what's being studied. It's hard to get the data we need because it's information people in the underground economy have no interest in reporting. It's even more difficult if the activity is illegal. For example, I can't estimate the value of cocaine and then input from that what the size of the market is and how it distorts the market. Its price is based on the risk of trafficking in it because it is illegal. If cocaine were a legal drug, the price would be much cheaper and it would probably be nominal in terms of GDP.

Q: Do you think the underground economy is a positive or negative element? And why?

Flaming: It's ah economic model that harkens back to an era where people moved from one employer to another. The old free labor model. But it doesn't work in a skilled economy such as ours. It creates a strain on employers in the formal economy, because they have to carry the costs of the social contract: Medicare, public assistance programs, workers' compensation insurance funds, which those in the underground opt out of paying. For workers, they're notable to collect the benefits that they are due under the system. They need those earned income tax credits to survive.

Roman: When Matt, Graham and I were writing, I was thinking, "What if one out of five people are taking money under the table, is this a good thing?" And I don't know. Some of the issues are definitional. What's really the problem here? There is a potential problem because people aren't paying income taxes to support government services. But if you think it through, you'll come to the conclusion that most of the people involved in this activity are the least likely to make enough money to be paying a lot of those taxes. If they were working formal minimum-wage jobs, they probably won't be paying taxes. They'd qualify for public assistance. So they have little effect on the public system. There may even an unintended benefit because they're not going to claim public assistance.

Q: What positives are there?

Flaming: There is significant disinvestment in the formal economy. But at the same time, we have these informal entrepreneurs who are growing. This is a good thing. But now we have to find a way to fold them into the formal economy.

Roman: As someone who studies crime, you're studying young men who are unemployed, cannot qualify for most forms of public assistance, and they're in and out of prisons. So they have a hard time getting work. Most of them don't have a lot of formal education. So to survive, they get informal jobs through informal networks. If they're involved in activities that aren't criminal, it's a good thing to a certain extent because they're earning a living.