Why is China’s Underground Economy So Small?

Written By Mu Xin and Wei Cui

Posted on April 13, 2020

A rarely discussed aspect of China’s economic growth is the apparent small size of its underground economy. Until the last decade, at least, there was little controversy that China was a developing country. Even now, China belongs at best to the world’s cohort of “middle income” countries. Yet some studies show that as early as in the 1990s, China enjoyed a small underground economy comparable to much more developed countries.

In a World Bank policy research paper from 2010, for example, Schneider et al (2010)estimated, for the period 1999-2006, that China had the smallest shadow economy among developing countries, one that represented only 12.8% of China’s GDP. By the same estimation, China had the 8th smallest shadow economy among 120 countries in the world. This ranking included many developed countries: for example, Canada placed 15thin the same ranking, with 15.6% of its GDP underground.

In an updated study published by the IMF in 2018, Medina and Schneider (2018)estimate the size and development of the shadow economies of 158 countries over the period 1991-2015. Again, the authors conclude that China has a particularly small shadow economy compared with other developing countries: its underground economy was the 19th smallest among 158 countries studied, placing ahead of countries like Belgium and Denmark.

The difficulties of measuring the shadow economy are easy to imagine. And the macroeconomic methodologies used for such measurement can be quite abstract. Instead of explaining them, we can point to similar conclusions drawn by other authors using sufficiently different methods. For instance, Elgin and Öztunali (2012)offer their own model to estimate the size of shadow economy in 161 countries during 1950-2009. They found that China shadow economy declined from 34.06% of GDP in 1952 to 11.53% in 2008. The average shadow economy size in China over 1990–2006 was 15.54% of GDP, making it the 12th smallest among 161 countries studied—again coming out ahead of countries like Canada, Germany, and France.

Alm and Embaye (2013)estimate shadow economies across countries over the 1984-2006 period, using yet another method. They calculate that China’s shadow economy had an average size of 21% of GDP from 1990 to 2006. In their study, high-income countries tend to have lower proportions of their GDP underground than China, but China’s level is not far from that found in Italy and Greece. Overall, China ranked 25th in terms of having a small shadow economy, falling behind only Japan, Korea and Singapore among Asian countries.

These conclusions may seem puzzling in two ways. First, people who have lived in China will have had many direct experiences with Chinese businesses or individuals evading taxes and dodging regulations. Cash transactions used to be extremely common before the arrival of smartphone payments, as is informal labor. Indeed, some scholars have warnedthat informal work may have been recently on the rise. Surely, the use of cash and the extent of informal work seem lower in countries like Canada. Are the studies cited above wide off the mark?

One important idea may go some ways to dispel this first puzzle. It is useful to distinguish between two types of informality, firm informalityand labor informality. The first refers to firms not registering for tax purposes or generally not reporting their operations to government offices. The latter refers to registered firms hiring workers informally, not reporting all of their operations on the books or to the government, and so on. In a 2018 article, the Oxford economist Gabriel Ulyssearefers to this distinction as between the extensive v. intensive margins of formality. Whereas the decision to register for tax purposes is basically discrete, the decision to hire more or fewer informal workers (or report greater or lesser revenue to the government) is continuous. Many firms that have entered the formal sector may continue to practice labor informality.

Applying this distinction to China, it is possible that China has a level of labor informality that is typical of developing countries and very different from what is observed in developed countries, but, at the same time, has a low level of firm informality. High labor informality is what one tends to experience firsthand in China, whereas low firm informality, being based on discrete decisions, may be less salient. It may be that the estimates of a relatively small underground economy in China are picking up the effects of low firm informality.

Professor Ulyssea’s 2018 article demonstrates that because of the firm v. labor informality distinction, different policies for reducing “the informal sector” may have very different impacts on the levels of output, wages, productivity and welfare in an economy. Reducing the cost of business registration will not have the same effects as enforcing registration requirements more rigorously; the effects of cutting payroll tax rates are not quite the same as enforcing payroll tax compliance. In ongoing research at UBC, we are exploring the application of the distinction to China because of these rich implications.

A second puzzle generated by estimates of China’s small underground economy is the following: How did China achieve this outcome? If cross-country comparisons of informality are rather obscure, explanations of the emerging patterns are even more so. Scholars who offer these comparisons have suggested various possible explanations, but have tested the explanations only in very ad hoc manners.

One such explanation, however, offered by Buehn and Schneider 2012, struck us as being potentially quite relevant in China:

“A closer distance to economic agents and higher frequency of face to face contacts between bureaucrats and economic agents (firms and workers) increase the probability of detection and deter shadow economic activities, all things being equal.”

One of us has written about the very high level of decentralization in law enforcementin China. Tax administration in China, for example, is very much about face-to-face contact. It may be that the structure of the Chinese administrative state is particularly effective at reducing firm informality. Further exploring this possibility is another theme of our current research.






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