Could Covid-19 expand Israel’s shadow economy?

Israel’s non-observed or “shadow” economy – that is, economic activity not reported to the state – appears to have declined in recent years, but the economic crisis triggered by the coronavirus outbreak might reverse this trend.

The non-observed economy, by definition, includes all economic activity where the resulting income evades the tax authorities and government supervision. According to OECD standards, this includes legal production that is hidden from the authorities, illegal production, informal production conducted by unregistered agents, and economic activity that goes unreported due to deficiencies in government data collection.

Measuring the size of the non-observed economy is not a simple task, precisely because this economic activity goes unreported. Yet estimating its size is an important step in estimating the scope of tax evasion in an economy and in choosing the tools to combat it. Non-compliance with a country’s laws and regulations has a major effect on the economy and reduces the efficiency of its systems.

Furthermore, economic activity that goes unreported erodes the tax base, which is liable to enlarge the size of the public debt and reduce the size and quality of the public services provided to the country’s citizens. According to estimates, the non-observed economy represents about 12% of economic activity in Anglo Saxon countries, 20%-30% in Southern Europe, and 40% in developing countries.

A model built by Taub Center Senior Researcher Dr. Labib Shami measures the size of Israel’s non-observed economy using what is called the “currency demand approach.” This approach assumes that business transactions conducted in the shadow economy tend to use cash. Thus, by examining the ratio between total cash withdrawals from the public’s personal checking accounts and total non-cash transactions, the model allows us to estimate the use of anonymous payments relative to traceable transactions accomplished through bank transfers, checks, or credit cards.

The model shows that the size of the non-observed economy in Israel declined from 14% in 1996 to 10% in 2018, resulting in a non-observed economy of NIS 134 billion in 2018. Even though the size of the non-observed economy declined overall during this period, the model also shows that it peaked during the world-wide economic crisis of 2007-2008, reaching 18%-19% of GDP.

During that period of economic distress, there was a sharp drop in non-cash payments in Israel and a slowdown in the growth of GDP, while at the same time the amount of cash withdrawals continued to grow. This trend points to a higher-than-average use of cash that is not reflected in reported GDP; hence, a larger non-observed economy.

Given what happened in 2007-2008, it is reasonable to assume that during the current economic crisis, the extent of which is not yet completely known, the share of the non-observed economy will grow as well. For example, the relief packages in response to the coronavirus crisis may incentivize under-reporting of income. This is because a lot of the grants being distributed to lessen individuals’ economic distress have eligibility requirements – you must make below a certain amount or experience a drop of a certain percentage in turnover to qualify to receive the grant.

This is likely to encourage small business owners to hide income in order to meet the requirements, and thus to increase the size of the non-observed economy. In addition, restrictions on reopening businesses leads to many small business owners and service providers operating under the radar. Small businesses and workers already operating in the non-observed economy are also likely to suffer from the economic implications of the coronavirus. Since they do not report their incomes to the authorities, they do not qualify for and cannot benefit from the small business grants the government is distributing to ease economic distress during these unprecedented times.

Understanding and estimating the size of Israel’s non-observed economy will only become more important as the economic implications of the crisis continue to unfold. Keeping a tab on the scope and characteristics of the phenomenon will help us know where to look for it, how to combat it, and how much to invest to hold it in check in the coming years.