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The size of the underground economy in Japan

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This paper empirically analyzes the size of the underground economy in Japan. The results show that (i) the size of the underground GDP peaked in the early 1990s but has been declining since; (ii) the underground economy reached its peak in around 1992, approximating 25% of nominal GDP; and (iii) two laws (the Act for the Prevention of Wrongful Acts by Members of Organized Crime Groups and the Act Regulating the Adult Entertainment Business, etc.) successfully worked to reduce the size of the underground economy.
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The Size of the Underground Economy in Japan
Koji KANAO
(Kobe University)
Shigeyuki HAMORI
(Kobe University)
Abstract
This paper empirically analyzes the size of the underground economy in Japan. The results
show that (i) the size of the underground GDP peaked in the early 1990s but has been
declining since; (ii) the underground economy reached its peak in around 1992,
approximating 25% of nominal GDP; and (iii) two laws (the Act for the Prevention of
Wrongful Acts by Members of Organized Crime Groups and the Act Regulating the Adult
Entertainment Business, etc.) successfully worked to reduce the size of the underground
economy.
Keywords: underground economy, Japanese economy
1
1. Introduction
Tax evasion, drug dealing, gambling, fraud, prostitution, smuggling, and other economic
activities that are hidden from public authorities and go unreported in official economic
statistics are generally referred to as the "underground economy." The development of an
underground economy can give rise to significant problems. To begin with, it creates
difficulty in determining the status of activities in a real economy. If economic activities are
examined using GDP statistics that do not account for the underground economy, then the
actual size of the economy will be estimated to be smaller than that of the underground
economy, and there is a strong possibility that macroeconomic conditions will be incorrectly
assessed. The existence of an underground economy also results in a smaller tax base and tax
revenues, and could contribute to fiscal deficits. Reflecting the importance of analyzing
underground economies, much research (Gutmann 1978, Feige 1979, Gutmann 1979, Tanzi
1980, Feige 1982, OECD 1982, Tanzi 1983, Tanzi 1986, Hayashi 1985, and Kadokura 2001)
has been carried out in this area, beginning with the pioneering work of Gutmann (1977).
Gutmann (1977) estimated the size of the underground economy on the basis of the
following four hypotheses.
(1) All underground economy transactions are performed in cash.
(2) In the period in which the underground economy was nonexistent, its size for each
year is established on the basis of the ratio of currency to demand deposit.1
(3) Excess currency demand is entirely due to the underground economy.
(4) The velocity of circulation is the same for both the underground and aboveground
economies.
On the basis of these hypotheses, Gutmann (1977) concluded that underground
economies are approximately 10% the size of their aboveground counterparts.
Feige (1979) advocated an analysis approach based on the perspective that the velocities
of circulation can be different between aboveground and underground economies. Feige’s
approach (1979) made use of Fisher’s equation of exchange to calculate the sizes of
underground economies on the basis of the velocities of money circulation, demand deposits,
and other exchange media.
Tanzi (1980) proposed an analysis approach based on the demand for currency equation.
On the basis of the view that changes in currency demand are the result of underground
economies, this approach builds on the one by Gutmann (1977). To estimate the demand for
currency equation and to calculate the size of the underground economy, it uses a set of
explanatory variables that includes variables considered to be related to the underground
economy. Tanzi (1980) reported that underground economies are 2%~7% the size of
aboveground economies.
1 Gutmann (1977) used 1939 and 1941 as benchmark years.
2
Hayashi (1985) used the abovementioned three approaches to estimate the size of
Japan’s underground economy. Using Gutmann’s (1977) approach, Hayashi estimated the
underground economy to be approximately 4.4% the size of the aboveground economy in
1983. Applying Feige’s (1979) approach, it was estimated to be 58.8% the size of the
aboveground economy in 1982. Moreover, using Tanzi’s (1980) approach, Hayashi estimated
the underground economy to be 7.9% the size of the aboveground economy in 1983.
Kadokura (2001) also used the approach developed by Tanzi (1983) to analyze the size
of Japan’s underground economy. He determined that the underground economy was
approximately 4.5% the size of the aboveground economy in 1999 and that it had been
shrinking after it reached its peak during the bubble era.
Estimating the sizes of underground economies has significant implications for policy
management and economic forecasting. The purpose of this paper, therefore, is to expand on
the analysis approach proposed by Tanzi (1983) and calculate estimates related to the size of
Japan’s underground economy. This paper makes the following two contributions.
First, the paper takes into account the nonstationarity of time series—something that has
not been done in previous research—and calculates estimates after performing unit root and
cointegration tests. These steps allow for the calculation of statistically acceptable estimates.
We used the unit root test propounded by Dickey and Fuller (1979) and the cointegration test
proposed by Johansen (1988).
Second, to analyze the impact of legal measures on the underground economy, this paper
uses dummy variables to capture the impact of two laws and integrates them in the model it
employs to estimate and analyze the size of the underground economy. The two laws
represented as dummy variables are the Act for the Prevention of Wrongful Acts by Members
of Organized Crime Groups, which came into effect in 1992 and which was expected to have
a great impact on the underground economy, and the Act Regulating the Adult Entertainment
Business, etc., which underwent a major revision in 1984.
2. Basic Model
The basic model is composed of two equations: the demand for currency equation and an
equation to calculate the size of the underground GDP. These two equations are given as
follows.
01 2 3
45
log log( ) log( ) log( )
log( ) log( )
tttt
ttt
CTGGNCY
WORK JR u
α
αα α
αα
=+ + +
+
++
(1)
()
()
*
*
ˆ
ˆ
1
tt
tt
ttt
CC
UGDP GDP
M
CC
−− (2)
3
where t
C represents funds; t
TG , taxes; t
GN , real income per capita; t
CY , the average
propensity to consume; t
WORK , an index for hours worked; t
J
R, the unemployment rate;
t
u, an error term; UGDP , the underground GDP; GDP , nominal GDP; 1
M
, the money
supply; C
ˆ, the currency demand forecast value (when the actual value is used); and *
t
C, the
currency demand forecast value (when a value set for this study is used).
The demand for currency equation is represented by (1), and the equation to calculate
the size of the underground GDP, by (2). At this point, it is important to bear in mind that the
demand for currency in (1) is essentially the one to be used in the underground economy. In
(2), the numerator and denominator of the second term on the right-hand side represent the
demand for currency in the underground and aboveground economies respectively. M1 is
used because of the hypothesis that only cash transactions are performed in the underground
economy. The numerator to denominator ratio is taken to be the ratio of the underground
economy to the aboveground economy, and multiplying this ratio by the GDP gives an
estimate of the size of the underground GDP.
3. Data
Annual data for 1971–2007 were used for this study. The data sources are shown in Table 1.
This study used two dummy variables to explicitly consider the impacts of two laws.
1t
D is the dummy variable for the Act for the Prevention of Wrongful Acts by Members of
Organized Crime Groups, which came into effect in 1992.
01992
111992
t
t
Dt
<
=
2t
D is the dummy variable for the Act Regulating the Adult Entertainment Business, etc.,
which underwent a significant revision in 1984.
0 1984
21 1984
t
t
Dt
<
=
As a preliminary analysis, unit root and cointegration tests were performed. The augmented
Dickey-Fuller (ADF) tests produced results of I(1) (integrated or order one process) for each
variable. In addition, the results of the Johansen tests indicated the existence of cointegrating
relationships.
4
4. Empirical Results
Taking into account the nonstationarity of variables, we used the dynamic ordinary least
squares (DOLS) approach proposed by Stock and Watson (1993) to estimate (1). This
approach, represented in (3), produces estimates by adding lead and lag differences for each
explanatory variable.
11
11
log log( ) log( ) log( ) log( )
log( log( ) log( ) log( )
12
KK
tt ti t ti
ii
KK
ttitti
ii
ttt
CTG TG GN GN
WORK WORK JR JR
DD u
−−
=− =−
=− =−
=+Δ + +Δ
++Δ ++Δ
++ +
∑∑
∑∑
)
         (3)
Given the small sample size,
K
in (3) was set as 1. Empirical results based on (3) are given
in Table 2. As these results clearly show, the coefficients of each explanatory variable are
statistically significant at the 5% level.
Having established the above, the size of the underground economy was calculated
using (2). The results are presented in Figure 1, wherein the solid line indicates the size of the
underground economy with explicit consideration of the dummy variables, while the wavy
line indicates the size of the underground economy without consideration of the dummy
variables. The difference between the two shows the suppressive impact of the two laws on
the underground economy. Figure 1 clearly shows that the size of the underground economy
peaks in 1993 when the dummy variables are considered, and in 1994 when they are not
considered. Furthermore, the underground economy is shown to be at its peak at 120 trillion
yen when the dummy variables are not considered, and at 111 trillion yen when they are
considered. At these levels, the underground economy is estimated at approximately 25% of
the nominal GDP. The suppressive impact of the two laws on the size of the underground
economy was at its highest in 1992.
5. Concluding Remarks
Tax evasion, drug dealing, gambling, fraud, prostitution, smuggling, and other economic
activities that are hidden from public authorities and go unreported in official economic
statistics are generally referred to as the "underground economy." For this paper, data for
1971–2007 were used to estimate the size of Japan’s underground economy.
This paper makes two key contributions. First, it considers the nonstationarity of time
series, which previous studies have not done, and calculates estimates using the dynamic
5
OLS approach. Second, it considers the impact of laws on the underground economy by
including two dummy variables in the model it employs for estimating and analyzing the size
of the underground economy. One variable is for the Act for the Prevention of Wrongful Acts
by Members of Organized Crime Groups, implemented in 1992, and the other is for the Act
Regulating the Adult Entertainment Business, etc., revised in 1984.
Empirical results indicated that the size of the underground GDP peaked in the early
1990s and has been declining since; this finding is consistent with that by Kadokura (2001).
However, this study also estimates the underground economy to have reached a maximum
size, approximating 25% of the nominal GDP, a scale much greater than that estimated by
Kadokura (2001). Furthermore, the results of this study showed that the two laws referred to
above contributed toward reducing the size of the underground economy.
References
Dickey, D.A. and W.A. Fuller (1979) “Distribution of the Estimators for Autoregressive Time
Series with a Unit Root” Journal of the American Statistical Association 74, 427-31.
Feige, E.L. (1979) “How big is the irregular economy?” Challenge 22, 5-13.
Feige, E.L. (1982) “A New Perspective on Macroeconomic Phenomena. The Theory and
Measurement of the Unobserved Sector of the United States Economy: Causes,
Consequences and Implications” in International Burden of Government by M. Walker,
Ed., Fraser Institute: Vancouver, 112-136
Hayashi, H. (1985) Measurement of the Underground Economy, Statistical Data Bank.
Stock, J.H. and M.W. Watson (1993) “A Simple Estimator of Cointegrating Vectors in Higher
Order Integrated Systems” Econometrica 61, 783-820.
Johansen, S. (1988) “Statistical analysis of cointegration vectors” Journal of Economic
Dynamics and Control 12, 231-254.
Organisation for Economic Co-operation and Development (1982) The Hidden Economy and
the National Accounts. Paris: OECD Occasional Studies.
Gutmann, P.M. (1977) “The subterranean economy” Financial Analysts Journal 34, 26-27.
Gutmann, P.M. (1978) “Are the unemployed, unemployed?” Financial Analysts Journal 34,
26-29.
Gutmann, P.M. (1979) “Taxes and the supply of national output” Financial Analysts Journal
35, 64-66.
Cagan, P. (1958) “The demand for currency relative to the total money supply” The Journal
of Political Economy 66, 303-328.
Kadokura, T. (2001) “Time series analysis of the size of Japan’s underground economy and
comparisons among Japan’s prefectures” Japan Center for Economic Research,
http://www.jcer.or.jp/academic_journal/jer/PDF/46-8.pdf.
Vito, T. (1983) “The underground economy in the United States: Annual estimates,
6
1930–1980” IMF Staff Papers 30, 283-305.
Vito, T. (1986) “The underground economy in the United States: Reply to comments by Feige,
Thomas, and Zilberfarb” IMF Staff Papers 33, 799-811.
7
Table 1 Source of Data
Variable Source
Cash Currency Bank of Japan
Tax
Household Disposable Income
Nominal GDP
Real GDP
Nominal Final Expenditure of Household
Cabinet Office, Government of Japan
Population Ministry of Internal Affairs and Communications
Index of Hours Worked
Unemployment Rate Ministry of Health, Labour and Welfare
8
Table 2 Empirical Results of Dynamic OLS
Note: *Significant at the 5% level, **Significant at the 1% level.
Variable Coefficient t-Statistic
C 47.27932 10.0407**
LOGTG 6.863756 3.4778**
⊿LOGTG(-1) -1.14008 -1.5577
⊿LOGTG -4.426354 -6.1839**
⊿LOGTG(1) 1.564145 1.0993
LOGGN 0.931785 3.9374**
⊿LOGGN(-1) 0.76185 2.4324*
⊿LOGGN 0.025984 0.0527
⊿LOGGN(1) 1.446208 2.2069*
LOGWORK -6.55082 -4.9860**
⊿LOGWORK(-1) 0.486923 0.92
⊿LOGWORK 1.745332 1.703
⊿LOGWORK(1) -1.997062 -2.9373**
LOGJR 0.638489 16.0960**
⊿LOGJR(-1) -0.003868 -0.0759
⊿LOGJR -0.279132 -6.3656**
⊿LOGJR(1) 0.37512 3.0754**
BOTAI_DUMMY -0.067316 -1.9251*
FUEI_DUMMY -0.085178 -3.4143**
Number of observations
Adjusted R-squared
Durbin-Watson stat
35
0.9991
1.4252
9
0
10
20
30
40
50
60
70
80
90
100
110
120
U
G
D
P
(
t
r
i
l
l
i
o
n
y
e
n
)
year
UDGP w/o Dummies UDGP w/ Du mm ies
Figure 1 Size of Underground Economy
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