Unobserved Economy

Unobserved economy is the part of a country's productive activity that is missed by the regular surveys, registers and tax records used to compile national accounts. Statisticians usually call it the non-observed economy. It includes legal activity that is deliberately hidden, illegal production, small informal businesses, goods and services households produce for their own use, and output that is missed simply because data collection has gaps.

The concept belongs to official statistics rather than law enforcement. Its purpose is to make gross domestic product exhaustive, so that it covers all production inside the boundary set by the System of National Accounts (SNA). It overlaps with, but is broader than, the shadow economy studied by economists and the informal economy studied by labour statisticians.

Imagine a town trying to count how much bread is baked each year. It asks the registered bakeries, which send in their figures. But some bakeries under-report sales to save tax, a few sell from unlicensed kitchens, many families bake their own loaves at home, and one new bakery opened after the survey list was printed. The official count is too low, even though every number it does include is honest.

The unobserved economy is the bread that never reached the count. Statisticians do not ignore it; they look for clues elsewhere, such as how much flour was sold or how many people say they work in baking, and add an estimate so the final total is as complete as possible.

Concern about missing output grew in the 1990s, when countries in central and eastern Europe moved to market economies and large amounts of private activity escaped the old reporting systems. In 2002 the OECD, together with the International Monetary Fund, the International Labour Organization and the statistical committee of the Commonwealth of Independent States, published Measuring the Non-Observed Economy: A Handbook. It gave national statistical offices a shared vocabulary and a set of methods, and it remains the standard reference.

The European Union later made exhaustiveness a formal requirement for the national income figures used to calculate member states' contributions to the EU budget, and in 2014, when the European System of Accounts 2010 came into use, EU countries began including certain illegal activities, such as drug dealing, in their national accounts.

The 2002 handbook groups unobserved activity into five areas:

• Underground production. Legal activities concealed from the authorities to avoid tax or social contributions, or to escape regulation, such as unreported sales or undeclared wages. This is where questions of tax avoidance and tax evasion arise.
• Illegal production. Goods and services that are forbidden by law, or legal activities carried out by unauthorized producers, such as unlicensed medical practice or smuggling. Proceeds often move through money laundering channels.
• Informal sector production. Output of small unregistered household businesses, many run by own-account workers who employ people in informal employment.
• Production of households for their own final use. Crops grown for the family table, homes built by their owners, and similar output that never passes through a market.
• Statistical deficiencies. Activity missed because business registers are out of date, surveys exclude very small firms, or respondents leave questions unanswered.

National accounts are adjusted upward by an exhaustiveness adjustment, which in its simplest form is:

If a country's surveys and tax data directly capture output worth 480 billion in local currency, and the statistical office estimates 60 billion of missing activity, exhaustive GDP is 540 billion. The adjustment equals $60 \div 540 \times 100 \approx 11.1\%$ of the published total.

Common methods include the labour input method, which compares the number of people who say in household surveys that they work in an industry with the number reported by businesses; commodity flow and supply-use balancing, which check whether the goods available for use match the goods recorded as produced and imported; and the use of tax audit results to scale up under-reported turnover. Estimates of illegal markets such as drugs often start from consumption surveys and police data.

• Economic ratios. Debt, deficits and tax revenue are usually quoted as a share of GDP, so a missing slice of output changes how indebted or highly taxed a country appears.
• Cash demand. Unobserved activity tends to be settled in cash, which is one reason banknote demand can stay high even as card and mobile payments spread.
• Money flows. Hidden earnings are often moved through informal value transfer systems and informal remittances, which affects balance of payments statistics as well as compliance work.
• Policy design. Governments pursuing formalization use these estimates to judge how much activity could be brought into the tax net.

By definition the unobserved economy cannot be measured directly, so every estimate rests on assumptions, and methods differ between countries, which makes comparisons difficult. Large upward revisions, sometimes made when a country updates its base year and its source data at the same time, can surprise markets and raise questions about earlier figures. Including illegal activity in GDP has also been criticized on ethical grounds, although statisticians respond that the aim is consistent measurement, not approval. Finally, the statistical figures are usually much smaller than the economists' model-based estimates of the shadow economy, because the two measure different things and use different methods.

• Organisation for Economic Co-operation and Development (OECD)
• United Nations Statistics Division: National Accounts