When Americans look at the underground economy in the Soviet Union and other communist countries many of them do so from a perspective of American moral superiority. Since an economy run on communist principles cannot supply the jobs, goods, and services that its people need, they say, otherwise law-abiding citizens are forced to retreat into the underground illegal economy. As producers they must violate the law to meet their state-imposed production quotas; as consumers they must buy on the black market or violate the law in other ways to get what they want. The existence of an underground economy within the Soviet bloc proves that communism does not work. It is economically and ethically bankrupt.

What then is one to conclude when one notices a similarly large underground economy within the United States, an economy in which producers and consumers do not report income, pay taxes, or observe the laws regulating business? Philip Mattera’s study of underground economies cites experts who claim that the underground economy within the Soviet Union may produce as much as one tenth of its GNP. In an excellent chapter on the size of the underground economy within the United States he concludes that America’s underground economy accounts for 8 to 10 percent of its GNP. This includes many thousands of workshops, stores, construction projects, even small factories, whose owners and employees avoid most taxes and pay no attention to government regulation. Those who maintain that the underground economy proves the moral bankruptcy of communism as it is practiced in the Soviet Union might ask whether the underground economy proves the moral bankruptcy of capitalism as it is practiced in the United States. It too seems unable to deliver the jobs, goods, and services its people need and they too have retreated into the underground economy to get what they want.

In Mattera’s view, today’s underground economy in the US is necessary to provide the jobs that the legal economy is failing to provide. Mattera believes that the “informal economy,” with its “off the books” jobs and businesses, “is an aspect of the contemporary crisis of capitalism.” It “provides some gainful opportunities for those people [the unemployed] who might otherwise have to rely on increasingly unreliable government support.” “A profound power shift in class relations is taking place and the informal economy is contributing mightily to it.”

The underground economy, moreover, “offers, at least for some people, the closest thing available to that free choice of activity…. It does not compare with the traditional left-wing vision of a completely free and abundant society, but it does have the advantage of being readily available.”

The refusal to make some separation between the underground economy (legal activities carried out in illegal ways) and crime (illegal activities) makes it impossible to see the former in relationship to the current crisis of the economy as a whole…. The informal economy is important as a transformation of mainstream activities of modern capitalist society rather than as an evasion of the underworld, which, however large, remains marginal.

From the perspective of “new right” economists such as Arthur Laffer and their spokesmen such as Jack Kemp, the underground economy arises not from a failure of capitalism to provide jobs for the poor but from an economy that is overregulated, much as the Soviet Union is overregulated. In both nations, they say, entrepreneurs are throwing off the chains of overtaxation and overregulation by going underground. Not only most taxes, but child-labor laws, home-labor laws, minimum wages, and safety regulations are manifestations of government interfering with the economy in ways that it shouldn’t. From their perspective, the government should make few laws limiting the operations of the market. Government’s main legitimate function is to enforce property rights. Taxes should be collected to pay for national defense, but taxes for virtually all other purposes infringe a citizen’s right to keep what he or she earns. Those who covertly evade such laws in the Soviet Union are not criminals but potential liberators. Those who do so in the US cannot be condoned, of course, by advocates of “law and order”; if enough of them violate the law, however, the law will either be changed or it will die because it cannot be enforced.

How should one react to the growth of underground economic activity? Is it evidence that something is wrong with the entire economic system and that the system ought to be changed—as both writers identified with the left, such as Mattera, and advocates of the new right would tend to argue? Or, notwithstanding evident failures of the economic system, is it best understood as a general decline in personal morality, a failure of people to observe elementary standards of civic virtue?

To answer these questions we must understand that the underground economy is only one field of illegal economic activity.* Even leaving aside street crime, what everyone would define as white collar criminal activities also seems to be growing. Some of the largest investment banks have recently pleaded guilty to laundering cash for those who wish to conceal their money from the Internal Revenue Service; one of the largest brokerage houses, E.F. Hutton, engaged in check kiting and defends itself by claiming that other brokers do the same. When it comes to property rights, so beloved of the new right, ordinary citizens widely photocopy material under copyright and buy records from pirates who do not pay royalties. It is difficult to draw a line, as Mattera asks us to do, between legal activities done in illegal ways and activities that are simply illegal. To murder someone with a gun and to kill someone in a fireworks factory by ignoring the safety laws, as happened this summer in Ohio, are not the same thing but the results were the same.


Every society has some dishonest people; too much dishonesty, however, can destroy a society. When historians claim that the decline and fall of Rome was set in motion by corruption from within rather than by conquest from without, they are not talking about Caligula making his horse a member of the Senate, but about a more fundamental corruption. Rome fell, it can be argued, because Romans lost their civic virtue.

Citizens manifest civic virtue by meeting the letter and spirit of their public obligations even if they have reason to question them. They may try openly to change those obligations or they may reject them openly on grounds of conscience and accept the consequences; but meanwhile one of those obligations is the payment of taxes. In all of the talk about shifting to modified flat taxes and raising taxes to reduce budget deficits, what is missing is the realization that the United States tax system is rapidly decaying owing to gross failure of the population to recognize the obligation to pay taxes.

Twenty-five years ago when I was a student, my professors of public finance used to make fun of the Italians and French for cheating on their income taxes. Today cheating on income tax in America is if anything greater than in France and Italy. And it isn’t just the illegal heroin smugglers who are cheating on their income taxes. For every dollar of tax not paid on illegal income the Internal Revenue Service estimates that nine dollars of taxes are not paid on legal income. Unreported legal income reached $250 billion in 1981; by now it is considerably higher.

But other standards of honesty change along with those on taxes. On my first trip to Europe twenty-five years ago I remember thinking that European locks were much more impressive than American locks. I had never seen such securely bolted doors and windows. Traveling to Europe this year I couldn’t help noticing the relative flimsiness of both the lock upon my hotel-room door and the lock that I was issued when I rented a bicycle. By American standards for bicycle locks the European lock wasn’t even a lock.

Social interest in promoting honesty is so weak that even our government now promotes tax evasion. To encourage citizens of foreign countries to buy more US government bonds, the US government stopped requiring withholding taxes on interest owed to foreigners in 1984 and started issuing bearer bonds, for which no record of ownership is kept. Essentially, the US government is helping foreigners to cheat on their taxes so that it can borrow money at a slightly lower interest rate. But if the US government helps foreigners to cheat on their taxes should it be surprised when Americans also cheat?

Tens of billions of dollars in interest and dividends are not reported on US tax forms. When the Federal government attempted to prevent such cheating two years ago, it was successfully opposed by the banks, which did not wish to see funds now held in bank accounts diverted to taxes. In this very narrow interpretation of their self-interest, bankers were unwilling to help the Federal government use the only efficient technique for collecting taxes owed it. Civic virtue was nowhere to be seen in the banking industry.

Such corruption is now spreading to wage earners. Some of them have discovered that they can also cheat by raising their number of claimed dependents to a level where nothing is withheld from their income. At that point, they simply stop filing their annual income tax returns. If millions of others are doing this, as in fact they are, the chances of getting caught are small.

The problem with extensive tax loopholes is not just that they unfairly assess different tax rates on people with the same income but that they help create a social system that destroys civic virtue. The average citizen who doesn’t use tax loopholes sees President Nixon, for example, paying no taxes because he invoked special legal loopholes for giving personal papers to libraries (this loophole has now been closed and the law that closed it was probably in effect before President Nixon made his gift). If the “big guys” can easily make use of legal loopholes, the average citizen thinks that he will create for himself some illegal loopholes, such as not reporting income. The US Treasury now loses more in illegal loopholes ($90 billion) than it does in legal ones ($65 billion). What it loses from both, if it could be collected, would almost balance the budget.


In the United States entire industries such as farming or real estate have become tax scams. Consider farming during 1980—a year in which net farm income totaled $22 billion according to the Department of Agriculture. To the IRS, however, while slightly more than one million farmers reported net incomes of $9.9 billion, another 1.5 million reported net losses of $11.7 billion. Farmers reported less than half of their total net income. The number of people who used farms as tax shelters for urban income was greater than that of those who reported profits; on a net basis, $1.8 billion in urban income was sheltered behind farm losses—much of it phony accounting losses on pleasure farms. If the US had simply abolished taxes on farming and prevented farms from being used as tax shelters, more taxes would have been collected than were in fact collected.

In collecting revenue both the perception and the reality of fairness are necessary, since without them there is no efficient way to collect taxes from a hostile citizenry. Tax evasion by dishonest citizens and the use of special loopholes each raise the taxes that must be paid by the honest taxpayers who don’t use loopholes. These people eventually begin to see themselves as “suckers” paying what others should be paying. When they do, we reach the point that historians claim started the decline of Rome. Internal corruption destroys civic virtue and threatens the republic.

No modern tax system or society can work without honest voluntary compliance and cooperation from nearly all of its citizens. This is the fundamental problem that is not confronted by either the new right or by Philip Mattera or by others who find much that is admirable in the rise of the underground economy. The Internal Revenue Service can collect taxes from the dishonest few, but it cannot collect taxes from a dishonest majority or even a large minority. When everyone begins to feel that he is a “sucker” if he pays taxes, it is only a matter of time until the tax system collapses. America is close to this point.

From this perspective, Ronald Reagan’s tax reform proposal is deeply flawed. Although it does increase “horizontal equity” (those with the same income will more likely be paying the same taxes), it leaves some of the most egregious loopholes for people with high incomes (for example, special provisions for capital gains) and will still produce millionaires, although a small number, who pay no taxes. Given this situation it is unlikely that President Reagan’s plan will set the example that needs to be set with respect to tax evasion. Simply lowering taxes in 1981 did nothing to stop tax evasion. Once one has become something of a crook and has learned that one can pay little or nothing, why should one start to pay taxes simply because rates have been reduced?

Mattera admits that tax evasion is often associated with other types of illegal activities. Employers who don’t pay taxes are more likely than others to evade the labor laws—to employ people in unsafe conditions, for example, at less than the legally mandated wage. (About 8 percent of the US labor force is so employed.) Similarly, businesses that don’t pay taxes are more likely than others to evade the environmental laws and to engage in such practices as dumping dangerous chemicals down the public sewers at night. The underground economy, as Mattera argues, may meet strongly felt needs for jobs and income—and for less restrictive regulation. But it poses deeper problems as well.

In recent years some of those on the right have endorsed a “libertarianism” that is indistinguishable from anarchy. An “anything goes” economy, in which pure self-interest is celebrated, is one that becomes increasingly chaotic and drawn to illegality. There are clear pragmatic reasons why civic virtue (honesty, obeying the rules—even if they are the wrong rules) is vital if any society is to be successful. Dishonest societies are intrinsically inefficient societies in which incomes tend to decline. In 1984 there were 603,000 security guards on private payrolls and 756,000 policemen on public payrolls in America. All of these people had to spend their time guarding old output rather than producing new output. If Americans had not needed them to guard old output, the US could have had a much larger force producing new output and a much higher standard of living.

How can civic virtue and the standards of personal behavior be improved in a democracy? Here both those on the right and those on the left, such as Mattera, may be partly right. Mattera is right to imply that a society that has not guaranteed a job for everyone willing to work has failed as a society and needs to reorganize itself to make it possible for all citizens to find work. The conservatives are right in believing that regulations that serve no important social purpose should be kept to a minimum. Prohibitions on working at home are an example of regulations that serve no useful purpose yet deprive people of the right to make a living. So do some of the laws that prohibit minors from working or that set unrealistic minimum wages. Many such laws should be abolished. But most of us can recognize without difficulty rules that serve important social functions, such as stopping poisonous chemicals from being dumped near where we live. I know of no one who would want his children to grow up on Love Canal.

Both the positive and negative aspects of the underground economy can be seen in Italy—the subject of one of Mattera’s chapters and the country with what is probably the world’s largest underground economy. According to Mattera, between 1972 and 1979 three million new homes were provided with electricity by the state-owned utility ENEL, while only 1.5 million new building permits were issued in the same period. More than half of the new homes were built in violation of the law.

Northern Italy is economically one of Europe’s fastest-growing regions. The underground economy has formed symbiotic relationships with the legal economy. Skilled workers moonlight in the underground economy to add to their take-home income, but these workers cannot be called exploited. They are paid cash wages that often exceed what they are paid in their aboveground jobs. By contrast, in southern Italy, one of Europe’s most backward regions, a much larger and more corrupt underground economy smothers economic development. Private payoffs to the Mafia and local bosses are so large and the dishonesty so extensive that legitimate businesses cannot prosper even in the underground economy. Some blame the gap between northern and southern Italy on the quality of the workforces in the two regions. Yet when the Italians of southern Italy came to the United States they rapidly became one of America’s most successful economic groups, most of them through work in honest occupations.

No one will completely eliminate the underground economy, but it is far from being a beneficial trend. What is odd is that few economists are willing to address the underlying problems of community and group behavior it poses. In their standard models of competitive free market behavior, many economists join extreme libertarians in assigning little importance to the effect of community. For them, economic activity is individual activity—nothing more, nothing less. In refreshing contrast, Robert Frank, who teaches economics at Cornell University, is interested in how the attitudes people have toward the communities where they live and work affect their economic behavior. His illustrations mostly concern behavior within firms, but most of his observations are as pertinent to the larger society as they are to firms.

One can argue, as many economists now do, that societies should not enforce safety regulations in the workplace. Workers should be informed of the risks they face but they should be allowed to work in risky situations if they knowingly choose to do so. On this view, everyone gets to make his own “trade-off” between more income and less safety and there is no reason to impose community values to determine what the “right” trade-off would be.

By contrast, Frank argues in Choosing the Right Pond that we pass such laws for at least two reasons. The laws protect us from ourselves. They prevent people from behaving in ways that might seem rational if done by them alone but that are socially corrosive and destructive if done by many people. For example, we establish rules so that we don’t destroy one another by unbridled competition. If some are willing to work in unsafe environments, they can make it necessary for others, if they want to find a job, to work in unsafe environments.

A second purpose of law is to create a community of shared values. By passing and obeying laws we tell each other what behavior is correct and inculcate values in the young. Without attention to shared values, there can be no success because there are no common objectives. There are some very good reasons why no group of people has ever successfully organized themselves along absolutely libertarian principles. One implication of Frank’s book is that firms, communities, and even nations that worry about creating community values and societies that are more than mere statistical aggregations of individuals end up more efficient than those that don’t worry. Voluntary cooperation, he argues, is central to economic success and it does not occur among people each of whom is narrowly interested only in himself.

How does Frank arrive at such a view? He starts by showing that any inquiry into group behavior must address much more complex questions than the traditional economist has been willing to face. To what extent is man a herd animal interested in peer group respect? The “pecking order,” for Frank, is not just a barnyard phenomenon, but one that he suspects is rooted in the cultural and biological processes of evolution. According to him, status is important: he writes that “people come into the world equipped with an inner voice urging them to rank as high as possible in whatever social hierarchy they belong to.” In setting up models of economic behavior, he says, economists “almost always assume at the outset that a person’s sense of well-being, or utility, depends on the absolute quantities of various goods he consumes, not on how those quantities compare with the amounts consumed by others.” Everyone else knows, he writes, that “people are much more concerned about how the economic pie is distributed than about how large it actually is.” That is, they tend to feel deprived relative to the people who have a somewhat larger share than they do.

In his analysis of the quest for status Frank examines one of the fundamental postulates of conventional economic theory—that people are paid in accordance with their “marginal productivity,” i.e., the added amount of value their efforts contribute to the firm they work for. He examines the working records of groups of real-estate salesmen and automobile salesmen whose individual productivity can be clearly measured (how many homes or cars did the person sell?) and then asks whether they were paid what economic theory says they should be paid. What he finds is that the most productive salesmen are paid more than the least productive salesmen but not anywhere near enough more to compensate them for their much higher productivity. Relative to their actual productivity, workers with high productivity are underpaid and low-productivity workers are overpaid. Economic theory tells us that underpaid workers would simply take their abilities to be highly productive elsewhere (a different real-estate firm, a different automobile dealer) where they would be fairly compensated for their actual productivity. They did not do so. Why not?

Frank’s answer is that they are interested in being at the top of a pecking order in a particular setting of work and that they can only be at the top of a pecking order if others are willing to be at the bottom. “Local status,” Frank writes, “is like various more concrete things, in that it has a price and can be traded for material things that have value.” This means that those at the bottom have to be compensated—given some of the earnings of their more productive fellow workers—for being willing to stay in a pecking order where they are at the bottom. The top real-estate and auto salesmen purchase status by being willing, in effect, to pay less successful workers to stay and accept their low status. The high-productivity workers could get more income, but to do so would be to lose their local status as the most productive salesmen.

In these examples Frank has deliberately picked jobs where there is little need for teamwork. If he had picked other jobs he might have found what professional athletic teams have found. One can pay the stars more but there is a limit on how much more. If that limit is exceeded, those who are less successful than the stars feel badly treated, refuse to offer their wholehearted voluntary cooperation, and the team’s performance suffers.

The social and economic stratification that one finds in the suburbs is produced by a similar process. No one really wants to be the poorest person in a neighborhood of much richer people. Similarly, because they want the respect of their peer group (and not just the population in general), rich people don’t want to move into neighborhoods where the rest of the population is much poorer than they are. Too great an economic gap creates the feelings of envy and social hostility that make life unpleasant. One wants status but within relatively narrow boundaries. According to Frank, if one is well down in the pecking order at work, then one naturally tries to find other activities where one can have status. While some goods are fixed in supply (only one president, only so many houses by the sea), the human animal is very imaginative when it comes to conceiving new kinds of status. For those who long to win a marathon, a bike race, or a swimming meet but don’t have the athletic talent to do so, some athletic entrepreneurs created the triathlon. The best society, in his view, is probably one that provides situations where most of its citizens can be at the top of some pecking order at some point in their lives.

There are also limits on how much anyone would want to be seen as taking advantage of other members of the community. Consider, as Frank does, the phenomenon of ticket scalping. Why does it occur? Why don’t those who organize championship sporting events or concerts of popular rock stars set prices so high that they just fill their stadiums instead of setting prices so low that there is a huge demand for tickets at prices far above those originally set by the promoters? To set prices below what they could charge is to fail to “maximize” profits. In some sense they deliberately let others make profits on their activities when it would be easy to capture those profits themselves.

Frank’s answer is that people have an aversion to being taken advantage of in what they perceive as “unfair” prices. Regular customers would be offended if they were suddenly charged much more than the normal price. Management cannot offend them without risking their future business. If someone is going to exploit a customer, far better that the exploitation seem to come from an outside ticket scalper than a rock star or a member of the team.

With the onset of foreign competition, particularly from workers who seem willing to work harder than our own, some managers of American firms have become interested in incorporating the observations of books such as Choosing the Right Pond into the management of their work force. For example, General Motors in its Buick City production plant is trying to emulate the Japanese system with its stress on team productivity instead of individual productivity. Participatory management becomes important both for what it saves in white-collar overhead and for what it does for the individual worker’s sense of being part of a team.

As yet, however, our politicians and officials have not become interested in incorporating such observations into public life. To do so would mean paying attention to the role of social organization in producing a high-quality economy. Just as nobody can create a product of high quality out of low-quality components, so nobody can create a high-quality economy out of inputs of low quality. And most of the fundamental inputs—the skills and attitudes of the labor force, the amount of savings and investment, the level of research and development—are a product of social organization, not simply of individual brilliance.

No one should be surprised that a society preaching nothing but individualistic values will eventually be inhabited by those who believe in nothing but such values. When that happens people stop obeying the law; for example, running stoplights becomes a common occurrence, as it has today. The individualist may go through a red light because he thinks it is rational for him to do so. He will arrive at his destination sooner. If someone is killed, it will be a pedestrian. But each of us is at some time a pedestrian.

This Issue

November 21, 1985