The underground economy is driving a hole in the collection of income taxes, social security, unemployment and Medicare to the tune of hundreds of billions of dollars annually within the United States. Yet significant questions remain about how big the problem is, as well as what should be done about it. Dire lessons can be learned from countries that have allowed tax evasion to become the norm. With estimates of rates ranging from 30-48% in countries like Greece, Italy and Romania, it isn’t surprising that the remaining tax base is completely insufficient to keep government afloat.

While the U.S. doesn't rise to that level (yet) when it comes to fraud as well as businesses evading obligations, including taxes, the gap raises a number of significant issues:

• Failure by individual businesses, and in fact, large portions of entire industries, to appropriately report and pay taxes results in a revenue gap forcing cuts in services or other significant decisions. Studies show that most of the federal budget deficits in recent years would have been eliminated completely if income taxes were accurately reported and paid.
•  When businesses don’t contribute to social security, unemployment or workers’ compensation coverage, as well as fail to follow health and safety rules, their employees are put at risk of bodily and financial harm. This can result in a long-term drag on other social services, exacerbating the financial gap noted above.
• A business that fails to pay local, state and national taxes can gain a cost advantage of 30-40% over their honest counterparts. Within some industries that have tight margins, like restaurants or groceries, that can be the difference between continued operations and bankruptcy. In other industries, where there is bidding and price competition, ranging from construction to janitorial services, they undercut legitimate competitors and win the work.
• As the title implies, there is another impact – the firms that don’t pay into these taxes and provide coverage like unemployment and workers’ compensation end up raising the tax rates for all the others. This “hidden tax” is something that states in the U.S. are starting to study and pay more attention to as they address the underground economy. One way to think of this is the same way that studies from the insurance industry show that fraud is increasing our auto insurance rates by 10% overall, and higher in some areas.

Within the U.S., the Internal Revenue Service (IRS) publishes a study on the “tax gap” every 5 years. The last study, released in 2012, showed a total gap of 16.9%. In other words, only 83.1% of income taxes were reported and paid. Not surprisingly, compliance rates were much higher among individuals that drew regular paychecks working for a separately-owned company that reported those to the government. The worst compliance rates were amongst self-employed businesses and farms.

During my time with the underground economy task force in Washington State, we utilized the methodology from the IRS to estimate our own gaps, just looking at business revenue and income taxes, unemployment and workers’ compensation. Net underreporting stood at $704 million annually, but we all knew this was underestimating the size and scope of the problem.

While some businesses actively evade compliance, others are unwittingly non-compliant due to the sheer complexity of the laws. Compounding this problem of non-compliance is the growth of the disruptive economy.  As companies that allow informal relationships and part-time business spread, like UberX and Airbnb, existing gaps widen significantly.  Some Uber drivers don't consider what they are doing to be "business" at all, and tend to fail to report that as income.  Added to that is potential fraud in failing to disclose their commercial business to their insurance companies, which would generate much higher rates, and the problem begins to compound.  These innovative developments in the new economy and  new customer interactions, driven by technology,  should be supported but laws, regulations, and education need to catch up quickly to prevent a rapid spread of the gray economy.

Recently, I had the opportunity to join a roundtable in the province of Ontario, Canada, that brought together regulators and public officials, the Chamber of Commerce, economists, and individuals that represent this disruptive economy, including the Canadian CEO of Airbnb.  The discussion was lively, and we came up with many opportunities to improve.  Hearing Airbnb say "please regulate us" was a breath of fresh air, and represented their desire to be good corporate citizens that just want clarity.

This background definitely leads to more questions – what are the problems, and where do they stem from? What can government do to help stem the tide? In the next two parts of this blog series, I will address those areas as well. In the meantime, please follow me on Twitter @CarlHammersburg and join the conversation.