"System D" and taxation

I came across an interesting blog post over at Naked Capitalism this week, talking about the virtues of the so-called "Système Débrouiller" (or System D), which has become the shorthand name for the world's underground economy. Citing a TED talk from journalist Robert Neuwirth, Lambert Strether writes:

If [System D] were united in a single political system, one country, call it The United Street Sellers Republic, the USSR, or Bazarristan, it would be worth 10 trillion dollars every year, and that would make it it the second largest economy in the world after the United States.

At first glance, that's an eye-opening statistic, one that immediately makes us think of black markets and tax cheats and wink-and-a-nod cash transactions in parking lots or back alleys (and to be fair, that's in large part what Neuwirth is talking about there).

But I think that's the wrong image to evoke, and I'll instead refer back to a post of mine from earlier this year that discusses another piece of the puzzle (I was going to write a whole new blog post about this issue, but then I realized I'd already done a pretty good job of laying out the basic points, so I'm self-plagiarizing for the sake of reiteration and redundancy). The bolded emphasis is new, added by me today.

Ultimately, the strength of a state depends entirely on its ability to collect taxes from its citizens. One could argue that the United States is relatively strong in this regard (its "Black Economy" is nowhere near the levels of Italy and Greece), but it still does not collect nearly enough tax to pay its annual bills. If it in fact tried to raise its tax rates in order to close that gap—as Italy is now trying to do, in effect—it might find that the "Black Economy" would grow significantly as a result. 

Those who argue that raising tax rates would harm economic growth are therefore certainly correct, although perhaps not in the way they might imagine. Instead of actually decreasing the overall amount of economic activity, a higher tax rate might just lead to a decrease in the amount of "official" economic activity, as more and more transactions went off the record. It's quite possible (if not probable) that's what happened in Italy over the last decade, which would help explain the nation's pitiful "official" economic statistics. 

If citizens (of any nation) begin to feel that their tax burden is too high—or that their government is misusing their tax dollars—they will always find ways to avoid paying their tax bill. Sometimes this will be through outright misrepresentation and fraud, but often it will be much more subtle and therefore much harder to prove. If a mechanic fixes a friend's car for free, with the understanding that his doctor friend will return the favor in the future by dispensing free medical care, the level of "economic activity" (in terms of favors exchanged) is the same whether or not cash actually changes hands. But in one case, the government can collect taxes on the transactions, and in the other case, the government cannot (at least not easily). 

The choice to do these transactions "on the record" or "off the record" depends entirely on the mechanic and the doctor's respective faith in their government, and whether they feel that their leaders are operating in good faith with respect to taxation. Unfortunately, once that good faith bond has been broken, it can be incredibly difficult to restore, as Italy and Greece are now learning. As the U.S. tries to solve its own deficit and debt problems, it too will end up facing a similar dilemma—how can it extract more money from its citizens without pushing more economic activity down into the underground, beyond its reach? 

The strength of the state, ultimately, is only as good as the citizens' belief in that state and its leaders. Break that bond, and the state can suffer even as many of its citizens continue to thrive—at least in the short run. But in the long run, both the state and its citizens suffer together, and that's where Italy and Greece now find themselves.

"System D", at least originally, referred not to a "black market" economy as we've come to know it, but simply to what might more correctly be termed the "MacGyver economy" or the do-it-yourself economy.

If we as citizens want to avoid adding dollars to the official GDP statistics (and therefore creating taxable moments), one way to do so is to be more resourceful and do a lot more things for ourselves (or with help from our friends). If we all grow our own foods and cook them and eat them at home, there's nothing there that will ever be captured by a government GDP statistic—and yet, we've all got ourselves a full belly, same as if we went to the grocery store and loaded up a cart with fruits and veggies.

The simple fact is, the government can only measure and tax transactions for which there is some record, or where some sort of exchange (of currency) was made. What can the government do about an informal exchange of favors?

Have you ever helped a friend move? Have you ever called up your doctor friend and asked him what he thinks about your aching knees and hacking cough? Have you ever invited a friend over for drinks and asked her for some free off-the-record financial advice? All of these things have economic value, and yet they'll never be part of the formal, measured, taxable economy—none of these are taxable moments, and it's nearly impossible for the government to track the transactions down, with no record of their occurrence.

But ultimately, is there really any fundamental difference? Is our nation really any more prosperous in one case versus the more formal alternative? I'd say no, and that in fact the system in which we trust each other and exchange favors without a record may even be stronger than the alternative—a community (however small) that trusts each other implicitly and doesn't require the keeping of records is a strong community indeed.

Ultimately, this is all an issue of trust. if you think your neighbor is unlikely to hold up his end of the bargain, you'll force all of these transactions onto the record in order to protect yourself. But if you instead think it's the GOVERNMENT that's unlikely to operate in good faith, well that's a whole different issue, isn't it?

Over the next several decades, I think this dynamic will be an important one not just in Europe but throughout the world. Do we trust each other as citizens more than we trust the government, or vice versa? If it's the former, then I wouldn't expect tax revenues to be picking up any time soon, regardless of the actual level of economic activity being performed. Should be interesting to watch.

[Naked Capitalism]