The Moral and Practical Dilemmas of an Underground Economy: Some excerpts

Yale Law Journal, 6/1/1994
Symposium: The Informal Economy
The Moral and Practical Dilemmas of an Underground Economy
By Richard A. Epstein

All sorts of activities, some desirable and some unsavory, are part of the underground economy. The physician who takes cash for a Saturday office visit is working off the books; so is the waiter who reports some but not all tips as income; so too is the maid who pays no taxes on her wages. But the underground economy is far more vast than these examples suggest, for it embraces much more than the unreported, unrecorded, or informal economy.(1) It includes industries that rely on illegal aliens and businesses that are completely outlawed, such as the trade in narcotic drugs. Indeed the trade in medicinal drugs belongs on the list, for medicines that are banned in the United States but licensed overseas are doubtless smuggled into this country for use by desperate patients. Surely one could multiply this list of examples many times over.


The Personal Dilemmas of an Underground Economy


One of the major problems associated with maintaining a just civil order is that of assurance. How do I know that, when I obey the law, other people will obey it as well? The issue here is not unique to large social arrangements; it infects each and every social arrangement that requires cooperative behavior among parties. The routine executory contract also involves mutual assurance that if A performs first, he can count on legal force to insure that B will perform thereafter. If the second stage cannot be secured then the first will not be undertaken; the entire arrangement unravels, and all potential gains from trade are lost. If B can obtain A’s performance under contract and then avoid the obligation for return performance, so much the better for her–in the short run. But strategies of this sort do not work twice, even if they work once. It is in the interest of all sides to have strong contracts, and strong contracts depend on public coercion.

Complex social arrangements are, if anything, more fragile than bilateral contracts, and it is here that the underground economy takes its moral toll. Let us suppose that two individuals are competing with each other. One prerequisite for a level playing field is that both parties be bound by the same legal rules and constraints. A system which requires B to labor under restrictions that do not bind his rival A is patently unfair and has consequent corrosive effects on moral sentiments. The formal law cannot tolerate such invidious distinctions. But the issue goes beyond the question of formalities and also reaches the question of compliance. Assume that there is a heavy tax or an inspection requirement imposed on A and B. The obligation is heavy, so A decides that it is better to venture off into the underground economy than to comply. He hires workers off the books or disposes of his solid wastes in a clandestine fashion, no questions asked. What now is B to do? We all know what the “right” answer is: B should continue to comply with the law because it is the law, and the breach of the obligation by A does not justify a parallel breach by B. Socrates would have insisted that all obligations are unconditional, such that A’s nonperformance of his duty does not excuse B from performing hers. B’s remedy (if there is one) lies in the effective enforcement of the law against A. Once A’s deviation from the law is punished, B is left with the net advantage from compliance. A will know that this will happen and will not deviate in the first place, and the right equilibrium emerges.

It is a pretty picture, but it presupposes what we know is not the case. The system of enforcement is likely to be rickety and uncertain. A may well escape both the burden of the obligation and the sting of its enforcement. Crime now pays, and B finds herself at a competitive disadvantage because she has obeyed the law. She is now faced with the sort of dilemma that no citizen should ever have to face: comply with the law and be driven out of business, or cheat in order to keep up with the competition. What B will do is unclear. But if C and D decide to imitate A, then B’s position will soon become more precarious. And if they do not, then B has a chance to gain a big advantage for herself by imitating A. Either way, when large numbers are involved, the entire system starts to unravel, and everyone has a plausible social defense: “We had to do it to stay in business, in order to meet the competition.”

How then will the public react to these excuses? A good deal depends on the perceived justice of the situation. If A and B decide to act illegally when taxes are low, when regulations are reasonable, and when contracts are fully enforceable, they are stripped of much of the rhetorical protection behind which they otherwise could take refuge. They start to look greedy rather than beleaguered. The set of informal social sanctions begins to undermine their behavior rather than prop it up. But if the rules in question are perceived as genuinely stupid and perverse, as all too many rules are, then public cynicism will undermine the moral force of the legal system, sapping just laws as well as unjust ones.

Society must, therefore, develop a moral climate in which we offer as few soothing excuses and rationalizations for illegal conduct as possible. To do that, government must avoid the excesses of regulation that have become part and parcel of the modem legal order. We must not pass laws that disrupt the operation of normal competitive markets. We must minimize the level of progressive and special taxes. We must ensure that fines for environmental and similar harms are in proportion to the harms caused, and not greatly in excess of the damage created. And we must stop the endless cycle of saying that the use of subsidy (treatment, protection, or whatever) justifies the need for coercive restriction at the opposite end. If the government took these steps, the question of the underground economy would not disappear; only the elimination of law could achieve so utopian a result. But because people would have greater respect for the legal rules, the underground economy would dwindle.


Illegal Drugs

Thus far, I have concentrated my attention on the unreported or informal economy, but no discussion of the practical and moral dilemmas of the underground economy is complete without at least one forlorn stab at the illegal economy. To be sure, no one with any sense would wish to take a firm position on the trade in illegal drugs, which has led to a booming underground economy free of all taxation and regulation. But for academics without a well-developed sense of prudence, at least some general response is appropriate. For libertarians, the set of prohibitions looks like an obvious target: the government spends massive revenues in order to suppress private consumption choices that are no better and no worse than the preference for fine wine or fatty food. At the very least, there is much to be said in favor of a policy of legalization coupled with taxation, much as is done today with cigarettes. Legalization would reduce the level of private violence in the smuggling and sale of these substances, and taxation would provide needed public revenues to boot.

Yet the proposal, however attractive, runs into a blizzard of opposition by countless government officials and voters, who just want to say no. The underground economy is surely an issue; yet as before, it does not end the discussion but only begins it. One question that must be asked is what society will look like if legalization takes place. Are there sales to minors? Do we maintain the facilities for detoxification of people who overindulge with drugs? Do we allow employers to condition employment, or schools to condition admission, on the willingness to forbear from the use of drugs in the workplace and the school yard, or even in the home? It is not obvious that legalization will produce the desired levels of satisfaction if children, both young and unborn, are exposed to toxic poisons; if drug users act on aggressive impulses; and if huge portions of an otherwise intelligent population become inert. Perils run in both directions.

I have one heretical proposal about how to deal with the issue: Tackle both sides of the issue at the same time–the willingness to create the underground economy by making drug sales illegal, and the willingness to subsidize that economy by creating programs that provide assistance and rehabilitation to all those who suffer from drug use. Punish without excuse anyone who commits any independent crime, from murder to shoplifting, while under the influence of drugs, just as we do with alcohol. Punish the sale or distribution of drugs to minors. Punish drug use by pregnant women that results in damage to offspring (and think seriously about sterilization as a credible means to make sure that it never happens again). Enforce all private agreements that limit the consumption or use of drugs, so that public enforcement is replaced by a private refusal to deal. Remove all other legal prohibitions on the sale and use of drugs. And refuse to treat without payment anyone who suffers ill effects from the voluntary use of drugs. It is an open question whether the removal of the penalties would be counterbalanced by the removal of the implicit subsidies for the use of drugs.

And subsidies there most surely are. Current drug policy provides that persons who are reformed alcoholics or reformed drug users are handicapped persons protected by the Americans with Disabilities Act.(31) The net effect is to give an implicit subsidy to drug use by preventing other persons from refusing to deal with individuals whose past histories suggest that they will have troubled careers. There is no reason to have the state impose criminal sanctions on drug users. It is quite enough to allow private parties to administer their own business sanctions by cutting these individuals out of some fraction of the employment market. The net effect should be to increase the costs of various kinds of addiction and to reduce significantly the likelihood of its occurrence.

The same logic applies to medical care for those who have drug-related afflictions. Viewed ex ante this amounts to a subsidy for those who take drugs. So understood, the current policies externalize a very large portion of the cost to society at large. We thus have policies of massive punishment and policies with nearly as massive subsidies; each is run by a major bureaucracy committed to its own policy in isolation but unable and unwilling to look at the combined effect of the creation and then the subsidization of the underground market. A policy that removed most of the sticks and all of the carrots would likely create howls of protest and would surely result (as do current policies) in the death and suffering of many. But in the long term, the policy could work well if it reduced the number of people who become addicts in the first place. Ratcheting down on both coercion and subsidy looks preferable to today’s futile effort to maintain both programs at a fever pitch and at public expense.