On the Use of the Hidden Economy Estimates

Author(s): D. K. Bhattacharyya
Source: Public Choice, Vol. 118, No. 1/2 (Jan., 2004), pp. 169-181
Published by: Springer
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 Public Choice 118: 169-181, 2004. 169
© 2004 KluwerAcademic Publishers. Printed in the Netherlands.

On the use of the hidden economy estimates

D.K. BHATTACHARYYA*
InformalEconomy Research Centre, London,England and IZA,Bonn, Germany

Accepted 3 December 2002

Abstract. The linkages between the recorded economy and the hidden economy are still
largely unknown. In this paper we establish one of the linkages by observing the import-
ance of the 'hidden economy' estimates in explaining the variation in consumer durable
expenditures. The experiment was conducted with the published 'hidden economy' estim-
ates in Bhattacharyya(1990). It is observed that the estimated demand function for durable
purchasesis less complex than the demand functions appearedin the existing literature.The
estimatedequation raises a number of public policy issues, which are not apparentfrom other
existing literature.

1. Introduction

In recent years, there has been worldwide concern on the accuracy of the
measurementof the Gross Domestic Product(GDP). The reasons for concern
vary considerablyfrom country to countryand dependon the socio-economic
condition of the country. At the moment, a numberof pilot studies are be-
ing conducted under the general umbrellaof a 'exhaustiveness study of the
GDP/GNP measurement'initiated by the EuropeanUnion and by the United
Nation. The fruits of these investigations will not be available in the near
future. At the same time, different authors continue to produce estimates
for unrecordedGDP/GNP under the names 'undergroundeconomy', 'hidden
economy', 'unrecordedeconomy' etc., for differentcountries and for differ-
ent periods. A non-exhaustive list of such estimates includes Feige (1979),
Tanzi (1983), and Aigner et al. (1988) And Bhattacharyya(1990). However,
these researchershave made very limited use of these estimates in terms of
econometric or policy modelling. Potentially, the uses of the 'hidden eco-
nomy' estimates can be classified into three categories: (1) they provide an
* An earlier version of this paper was presented at the Royal Economic Society's annual
conference. Later versions were presented at the IEA WorldCongress and at the Far Eastern
Meeting of the Econometric Society. I have benefited from the comments received from the
participantsof the conferences. Comments from Professor FriedrichSchneider and a referee
of this journalhelped me to clarify some of the majorissues in the paper.Kevin Lee made elab-
orate comments on the first draft of the paper,which helped me to improve the presentation.I
am responsible for any errorsremaining.
170

indication to the governmenton the size of the missing tax revenues;(2) they
provide useful informationto policy makers in evaluating the effectiveness
of their policies and regulations;(3) the information contained in these es-
timates can be profitablyused by the empirical researchersand theorists in
their modelling activities. All three possible uses of the 'hidden economy'
estimates are not developed in this paper. Instead we examine its uses in
empirical modelling of consumer expenditure on durable goods and closely
associated policy issues.
The 'hidden economy' estimates, and the associate standarderrors,pub-
lished in Bhattacharyya(1990)' are used in this paper to estimate the model
under study. At the conceptuallevel, the 'hidden economy' estimates are an
aggregate of several sub-activities, which are not included in the recorded
GDP. However, similar aggregationproblems also exist when we use pub-
lished GDP in empiricalmodelling. Hence, the use of the 'hidden economy'
in empirical modelling is justifiable and we use the 'hidden economy' as an
income streamdifferentfrom GDP.Thus in our model we assume that for the
representativeindividualthe recordedGDP is the income with certaintyand
the 'hidden economy' is the income with uncertainty.2

2. A model of the demand for consumer durables

A glance through the existing literature suggests that the modelling the
demand for consumer durableshas proven to be a difficult task. This is ap-
parent from the works of Stone and Rowe (1957), Ball and Drake (1963),
Cuthbertson(1980), Muellbauer(1981) and others.3 However, one common
inference that can be drawnfrom the past studies is that the income variable
has significant effect on the demand for durable goods. As we interpretthe
'hidden economy' estimates as the unrecorded GDP, these estimates have
direct effect on the consumerdemand as a component of income. However,
in the specification of the model, we use the 'hidden economy' estimates as a
separatesource of income for the following reasons:
1. The 'hidden economy' can be considered as tax evaded income as that is
implied by the estimated 'tax evasion' function in Bhattacharyya(1990);
2. the tax evaded income is treated as a separate source of income in the
consumer's spending plan as the time pattern of receiving this income
differs from the recordedincome;
3. the uncertaintyassociatedwith the tax evaded income makes the 'hidden
economy' differentfrom the recorded income;
4. as the standarderrorsof the 'hidden economy' estimates are known, the
uncertainty of the hidden income is open to explicit modelling in our
empirical analysis.
 171

It is already established in the literaturethat different sources of income

have different propensities to consume (see, Holbrook and Stafford (1971)
and Pollak, Shelly and Wales (1996)). Following this trend,we specified the
model where the recorded income and the 'hiddeneconomy' are treated as
two separate sources of income. The desired level of expenditure on con-
sumer durables is determined by a number of variables, which have been
suggested in Muellbauer(1981) and Bhattacharyya(1978). The specification
of the model can also be justified by intuitive economic reasoning. Thus, the
desired level of expenditureon consumerdurableis written as

Z*t= f(Ht, Hzt,Yr,t, Yh,t, At, Rt) (1)

where,
Zt = the level of durable goods that the individual desires to
purchaseat time t;4
Pt = the price index of consumer non-durablegoods at t;
Pzt = the price index of consumer durablegoods at t;
It = Pt / Pt+1;
Hzt = Pt / Pzt;
Yr,t = the real recordedincome at t;
Yh,t = the real value of the risk discountedhidden income at t;
At = the real value of the liquid assets at t;5
Rt = the short-term rate of interest at t.
This specification encompasses a wide varietyof alternativemodels (e.g.
'the relative price model', bank credit and interest rate models' and 'li-
quid assets models') which have been investigated as separate models in
Curthbertson(1980). Thus, our model includes intertemporalprice substi-
tution, durableand non-durableprice substitution,effects of different sources
of income, effects of bankcredit and the effect of liquidasset holdings6 on the
demand for durable goods. The total asset holdings can be approximatedas
the accumulationof past savings from both recordedand unrecordedincome.
We also assume that individuals hold their recent savings as 'liquid' assets
before transferringinto non-liquid assets. Combining these arguments and
assumptionsthe desired expenditureon durablegoods can be written as,

Zt = f(It, Hzt, Yr,t, Yh,t, Yr,t-1, Yh,t-1, ......., Rt) (2)

The desired level of expenditureon durablegoods is not directly observ-
able. Following the standardapproachin the empiricalliteraturewe assume
that Zt can be approximatedby D(L)Zt, where D(L) is a polynomial in the
172

lag operatorL and Zt is the actual expenditureon durable goods at constant

prices.

3. The empirical verification of the model

The past literature(see Cuthbertson,1980) and the economic theory suggest

that income is the major determinantof the expenditure on durable goods.
Therefore, it is necessary to establish the role of the 'hidden economy' es-
timates in defining the income variable. The primaryquestion is should we
treat the 'hidden economy' as a separate source of income or should this be
added with the recordedincome? The answer depends on the time-structures
of the real 'hidden economy'7 estimates and the real recorded income. The
time-structuresof the two income series are estimated using a distributed
lag (ADL) approachwhile emphasizing 'parsimony'.The estimatedrelations
obtained using the U.K. data for the period 1960-2nd quarterto 1984-4th
quarterare:8

Yr,t= 0.7916Yr,t-1 + 0.5970Yr,t-4 - 0.3818Yr,t-5;

(S.E) (0.079) (0.089) (0.097)
(3)
Adj. R2 = 0.98; LM-x28~)
= 12.48; Ljung-Box-Q(s) = 8.73;

ADF (4 lags) = -5.59; AIC = 16.80; Schwarz Bayes IC = 14.04

Yh,t= 1.1934Yh,t-1 -0.4586Yh,-3 +0.4205Yh,t-4 -0.1554Yh,t~;

(S.E) (0.074) (0.140) (0.122) (0.045)

Adj. R2 = 0.996; LM-x284)= 12.58; Ljung-Box-Q(s) = 12.62; (4)

ADF (4 lags) = -10.66; AIC = -1.12; Schwarz Bayes IC = -3.85

The diagnostic statistics in the fitted equation suggest that the fitted time-
structures of the two series are reliable. It is also clear from the fitted relations
that the time structure of the recorded real income is distinctly different from
the time-structure of real 'hidden economy'. Hence, we have also empirical
support to treat the two income series as incomes from two different sources.
The fitted relations (3) and (4) also given us a very important statistical in-
formation. The long run solutions for the first difference of both series are
approximately zero.9
The model is estimated in a log-linear form in their first differences follow-
ing the 'general to specific' rules followed in the time-series econometrics.
 173

The real 'hidden economy' estimates are obtained by deflating the series
by consumer price index. The 'hidden economy' estimates are intrinsically
stochastic in nature. Hence, in the empirical analysis the 'hidden economy'
estimates are replaced by risk discounted 'hidden' income. The risk discoun-
ted 'hidden' income is calculatedin two differentways. In the firstexperiment
we assumed that only the 'hidden economy' estimates are available and the
individualsmake their purchasedecision on the basis of expected unrecorded
(hidden) income and actual recorded income. The expected unrecorded in-
come is derived by multiplying the 'hidden economy' estimates by a where
0< a <1. This means as a risk-averterthe individualdraw the spending plan
with a reductionon total budget due to the uncertaintyof the 'hiddenincome'.
The discounting factor a may vary from individualto individual but we as-
sume that a is fixed over time. The second approachtaken to obtain the risk
discounted unrecorded economy utilises the standarderrors of the 'hidden
economy' estimates. Here we used the mean-varianceframeworkto obtain
the risk discounted unrecorded income. This method in conjunction with
'certaintyequivalence' principle suggests thatthe risk discountedincome will
take the form Yht - b.Var(Yht),where b is an unknownparameter.
We startedwith a very general specification that is conformable with the
model specified at (2). At the startwe included the currentand eight lagged
values of the recorded income, the unrecordedincome ('hidden economy'
estimates) and the expenditureon consumer durables.All other variables in-
cluded in the model are defined in the specificationof the model. However, we
also addedtwo dummy variablesTHD and SPD in the model. We called THD
as Thatcherdummy to identify her period of Premiershipand the SPD to take
into account the oil crisis of 1972/73. After fitting the model with all eight
lags of the variables we omitted the terms which are statistically insignificant
and then refitted the truncatedmodel with the data.After repeateduse of this
procedurewe obtain the final fitted equation. However, to provide a clearer
picture of the procedure used here, we present below the fitted equation that
we obtainedjust before choosing the final fitted line. The estimatedexpendit-
ure function for durablegoods obtainedby includingthe first definition of the
risk-discountedunrecordedincome. The fitted model is:

A1Zt = - 0.0072 + 1.0337A1yr,t - 0.1057Alyr,t-1

(S.E) (0.008) (0.282) (0.312)

- 0.2139A1yh,t + 0.6567Atyh,t_1 - 0.5325A1it

(0.264) (0.238) (0.550)
174

+ 1.3009A1hzt - 0.1020Airt - 0.1354AlZt_4

(0.646) (0.043) (0.073)

+ 0.1257AiSPDt + 0.0685A1THDt
(0.015) (0.060) (5)
^
Adj. R2 = 0.539; = 0.056; Durbin-h = -.825;
LM-x8)
= 10.77;

Ljung-Box-Q(8) = 8.77; ADF (4 lags) = -10.373; ARCH = 0.330

Chow Test (break at 1975:4) = 1.431; Jarque-Bera test = 2.10;

Log likelihood = 144.255

(All the lower case letters are logarithm of the capital letters defined earlier
and is the first difference operator).
A1
The diagnostic statistics suggest that the model fit the data well. The adjusted
R2 of 0.539 is quite respectable for a first difference model when compared
against the existing results in the literature (see Hendry, 1995). It is also pos-
sible to infer that the fitted model is free from dynamic as well as functional
misspecification. In the estimated relation (5) we still have two insignificant
variables namely and Yh,t which are omitted from the model in our final
yr,t-1
selection for the best fitted equation. In (5) the estimated parameter associated
with 7t is also insignificant but we retained this variable in the final choice
of the estimated model mainly to avoid distortion of the theoretical model.
We started with eight period lagged variables of yr,t, Yh,t and zt but ended
up in a situation where only currentrecorded income and one period lagged
'hidden economy' and four period lagged durableexpenditures are statistic-
ally significant. This confirms that the recorded income and the unrecorded
income ('hidden economy' estimates) are two distinct series and the effect of
the 'hiddeneconomy' estimates cannot be replicatedby the recordedincome.
Hence, it is clear that the explaining or predictive capacity of the fitted model
would have been reduced if the 'hidden economy' estimates were not used as
an explanatory variable. It may have been possible to obtain well-fitted equa-
tion in terms of diagnostic statistics but most likely with a very unrealistic lag
structure for the recorded economy. The oil price rise dummy had significant
effect on the durable purchases whereas the Thatcher period dummy had no
significant effect on durable purchases.
In our final search for the estimated model we omitted all the insignificant
variables in (5) except 7t as this will distort the theoretical specification of
the model. Thus, the estimated model for durable purchases becomes:
 175

AIzr = - 0.0098 + 0.8901Alyr,t + 0.5920A1yh,t-1

(S.E) (0.008) (0.208) (0.198)

- 0.3884Alzrt + 1.5323Aihz,t - 0.0964Airt

(0.462) (0.611) (0.042)

- 0.1371Alzt_4 + 0.1235A1SPDt
(0.072) (0.015) (6)

Adj. R2 = 0.543; & = 0.055; Durbin-h = -1.138; LM-x8) = 12.50;

Ljung-Box-Q(s) = 9.24; ADF (4 lags) = -10.73; ARCH = 0.258
Chow Test (break at 1975:4) = 2.192; Jarque-Bera test = 1.503;

Log likelihood = 143.056

The estimated relation (6) is our final choice of the fitted model in the
'generalto specific' modelling approach.The diagnostictests suggest that the
estimated model have no obvious misspecificationerror.There is also slight
improvementin terms of Adj.R2 and other test statistics for internalconsist-
ency. The fitted model in (6) not only satisfies relevant statistical tests but
also validate the predictions of the economic theory.The positive estimated
coefficients for the recorded income and the unrecordedincome confirmthat
the both series have affected the durableexpenditurelike an income variable.
One of the interesting feature of the fitted equation is the significant effect
of the one period lag 'hidden economy' on durableexpenditure. This fits the
general predictionof tax evasion theory that the tax-evaded income is gener-
ally not spent on receipt. The significanteffects of the income (recordedand
unrecorded)also supportedby the theory and past findings. The statistically
significanteffects of the non-durableand durableprice ratio, the interestrate
and the one year lagged expenditureon durablegoods fit the predictions of
the theory as well. Finally, we find that the intertemporalprice effect though
not significanthas the correct sign, and the significantDummy variableSPD
suggests that for sudden rise of oil price resulted in a higher expenditurefor
durablegoods. As in our definition of durablegoods transportis not included
the significant SPD may mean transferof expenditurefrom car to durables.
Anotherinterpretationcould be that with the announcementof VATincreases
promptedpeople to spend more on durablegoods. Thus the overall inference
we can draw that the durable expenditurefunction fits well with the data
used in this study and the 'hidden economy' is one of the major determining
variable.
176

The stochastic nature of the unrecorded income (as measured by the 'hid-
den economy' estimates) is introduced in our model by discounted income.
Thus far, we calculated the discounted income without taking into account the
variance of the 'hidden economy' estimates. In the estimated model presen-
ted here an alternative form the discounted income is introduced. Thus the
discounted income is measured by Yht - b.Var(Yht). The logarithm of this
discounted income is approximatedby Yht- b (Var(Yht)/ht) and we estim-
ated the model with (Var(Yht)/Yht)as an independent variable as b is not
identifiable.This new variableis denoted by Lt at time t. The estimatedmodel
parallel to (5) is:

Alzt = - 0.0067 + 1.0349Alyr,t + 0.0946A1yr,t-1

(S.E) (0.009) (0.289) (0.319)

- 0.2312A1yh,t + 0.6701Alyh,t_1 - 0.5264Airt

(0.277) (0.257) (0.562)

+ 1.2972A1hzt - 0.1063Airt - 0.1369A1zt_4

(0.678) (0.044) (0.073)

+ 75.6192A1pt - 92.6554A1ut_1
(137.7) (133.3)

+ 0.1258AISPDt + 0.0755A1THDt
(0.015) (0.061) (7)
^
Adj. R2 = 0.530; = 0.056; Durbin-h = -.666;
LM-x28)
= 10.38;
= 8.51; ADF (4 lags) = -10.211; ARCH = 0.471
Ljung-Box-Q(8)
Chow Test (break at 1975:4) = 1.338; Jarque-Bera test = 2.25;
Log likelihood = 144.536
In terms of diagnostic tests the fitted equation (7) is very similar to the
fitted equation (5). The individual significance test results from the fitted
model (7) are very similar to the results obtained from the fitted equation
(5), particularly for all the common variables. However, the newly introduced
variables /Lt and Lt-1 are not significantly different from zero. However, in
the final choice of the model that is parallel to (6) we included gt-1 as an
explanatory variable as this is part of the discounted income Yh,t-1 in our
measurement of discounted income.
The final version of the estimated durable expenditure function with gt-i
is:
 177

Aizt = - 0.0095 + 0.8875Aiyr,t + 0.5866Aiyr,t-1

(S.E) (0.008) (0.210) (0.204)

- 0.3884A1rct + 1.5323A1hz,t - 0.0964Airt

(0.462) (0.611) (0.042) (8)

- 0.1371AlZt_4 - 9.7930A1Mt-1 + 0.1235AiSPDt

(0.072) (83.66) (0.015)

Adj. R2 = 0.538; 8^= 0.056; Durbin-h = -1.120; LM-X~8s

= 12.33;
= 9.23; ADF (4 lags) = -10.72; ARCH = 0.245
Ljung-Box-Q(8)
Chow Test (break at 1975:4) = 1.98; Jarque-Bera test = 1.518;

Log likelihood = 143.064

The fitted model in (8) is very similar to the estimated model in (6). The
additionalvariable gt-1 in (8) is statisticallyinsignificantand thus suggesting
that the variance of the estimated 'hiddeneconomy' has no significant addi-
tional information.However, the implied estimate of 'b' from this equation
is 16.69. This is much lower than the estimates of 'b' implied by estimated
relation (7). The implied estimate of 'b' from (8) suggests that within our
sample the risk-discountedincome from unrecordedincome will be positive
and thereforea plausible solution.

4. Conclusion

The primary aim of the paper was to establish a link between the recorded
economic activities and the 'hidden economy'. However, the empirical res-
ults imply that the presence of the 'hidden economy' has wider implication
to economic management and consequently on public policies adopted by
governments.
The empirical results provide supportsfor some of the assumptions made
in the tax evasion theories. The significantpositive effect of the 'hidden eco-
nomy' on consumer expenditures on durablegoods confirms earlier findings
of Holbrook and Stafford(1971) and supportsthe recentconjecture of Pollak
et al. (1996). The inclusion of the 'hidden economy' also improved the dy-
namic specification of the model. From the past studies it can be seen that to
obtain satisfactoryfittings to the data higher differences of income and other
variables were included in the specification. In a continuous time model this
implies highly nonlinear model of consumerexpenditurewhereas our model
178

in first differences suggests a linear model and can adequately explain the
data. The parsimonious model established here would be particularly helpful
to researchers who want to examine the public policy issues discussed below.
It is possible to identify a number of policy issues from the results presen-
ted in this paper. However, the most contentious issue for governmental policy
appears to be the significant effect the 'hidden economy' on the durable ex-
penditure. Suppose, the government decides to stop tax evasion and succeed.
In that situation there will be immediate short-run fall in demand for durable
goods. This will bring sudden contraction in the manufacturing of durable
goods. This in turn will reduce the employment level in the manufacturing
industry for durable goods. As all the industries in the manufacturing sector
are interlinked this one government action will slow down the growth of the
whole economy. On the other hand as shown in Bhattacharyya (1994) the
presence of tax evaded income will lower the multiplier effect in the economy.
This implies that in adopting any policy on tax evasion the government has
to undertake an elaborate cost/benefit analysis for that policy. This implies
that to maintain the welfare of the society government may have to consider
certain level of tax evasion is an optimum choice. Even if the government
consider a gradual reduction of tax evasion the question of optimal speed
of reduction remains. These public policy issues came to the surface only
through the empirical results presented earlier.
In this paper we examined one of the many possible uses of the 'hidden
economy' estimates and illustrated some policy issues. We hope that this
paper will encourage other researchers to examine other uses of the hidden
economy. In conclusion we want to re-iterate two most important findings of
this paper.
1. Only the lagged 'hidden economy' estimates affect the durable ex-
penditure. This fits well with a prediction of tax evasion theories where it is
assumed that the individuals do not spend the tax-evaded income immediately
to reduce the probability of detection.
2. We established that the specification of the durable demand function
has been simplified by the inclusion of the 'hidden economy'. Therefore, we
conjecture that the inclusion of the 'hidden economy' estimates will improve
other macro relations and will be significant additional information to the
model builders. As an example, in Bhattacharyya (1996b) we observe that the
inclusion of the 'hidden economy' estimates improved the fitted government
expenditure functions.
Finally, we would like to point out that in Bhattacharyya (1990) the 'hid-
den economy' estimates are available along with their standard errors. Hence,
researchers working on models with uncertainty may be able to examine the
importance the standard errors in the individuals' decision, which we failed
 179

to establish in this paper. We expect to report some other uses of the 'hidden
economy' in our forthcoming papers.

Notes
1. The results presented in this paper are based on slightly revised estimates of the 'hidden
economy' of the U.K. for the period 1960-1984. These estimates are available from the
author on request. Estimated equations based on the data published in Bhattacharyya
(1990) are also available from the authorwhich would demonstratethat the results presen-
ted in this paper are not significantly distorted by the revised estimates of the 'hidden
economy'.
2. The 'hidden economy' estimates can be used in a wide range of econometric studies. A
numberof such studies are published in the Economic Journal(1999).
3. Examples are given only from the studies relating to the U.K. A large number of other
studies for the US and elsewhere have tackled the problemof specifying the model in a
very similar fashion.
4. In defining durable goods we exclude all form of transports(cars, planes etc). In the
empirical analysis the real expenditureon durablegoods is taken as Zt.
5. In the formal derivation of the model from an intertemporalframework the total asset
holdings appears as an explanatoryvariable in the durabledemand function. In our spe-
cification the non-liquid assets are excluded on the ground that the liquidation cost of
non-liquid assets is very high which makes it less importantvariable in the consumers'
decision for durablepurchases.
6. In our empirical study we do not use directly measuredliquid asset data instead we use
an alternativemeasure of liquid asset holdings.
7. The real 'hidden economy' estimates are obtainedby deflatingthe series by the GDP price
deflator.
8. The period of analysis is dictated by the availability of the 'hidden economy' series. As
our primaryobjective is to establish the importanceof the 'hidden economy' estimates in
econometric modelling and in understandingof economic relations,the period of analysis
is not the primarycriterionhere.
9. In the terminology of modern time-series econometrics the first difference of both the
series are I (0). For our empirical analysis this is a very convenient result. In fact, before
estimating the durable demand function all variables appearingin the model were tested
for stationarity.Except the interest variable the first difference of all other variables are
stationary.Although the interestrate variabledid not pass the exact test the firstdifference
of the variable it failed the test very narrowly.

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 181

Data sources

* The 'hidden economy' estimates are very close to the figures that were repor-
ted in Bhattacharyya(1990). The exact figures are available in Bhattacharyya
(1996a).
* The price indices are collected from the Departmentof Employment Publica-
tion, Retail Price Indices 1914-1986, HMSO, London.
* Short-terminterest rates are collected from Financial Statistics as the London
clearing banks' base rate.
* Data for expenditures on durablegoods and recorded income are taken from
the Economic Trends, 1992 Annual Supplement.