## Monday, March 15, 2010

### Estimating Ireland’s Black Economy

In a nice little paper from 1997 published in the now defunct Irish Banking Review, Gabriel Fagan produced the following estimates of Ireland’s Black Economy from 1963 to 1995.

Fagan’s 1997 paper is available here.  Fagan also wrote a more detailed paper that was published in The Journal of the Statistical and Social Inquiry Society of Ireland.  This paper published in 1994 is available here.

The estimates provided above are based on the monetary approach to estimating the black economy.  The assumption is that there are ‘excess currency holdings’ in the economy over and above what is necessary for the volume of transactions reported in the National Accounts.  The next step is that this extra currency in circulation is used in the black or cash economy so as to avoid detection.

Fagan (1997) estimated the following equation

where C is the amount of currency in circulation, M1 is the narrow money supply (currency plus deposits), Y is Gross National Product, R is a long government bond interest rate and T is a measure of the tax burden (total tax revenue as a proportion of GNP).  Fagan (1997) also included a time trend and reported the following results

Fagan used the increase in currency holdings as a results of increases in the tax burden to produce the estimates of the black economy up to 1995 provided above.

Updated data on the same variables used by Fagan is provided here.  This dataset has observations from 1960 to 2007.  Using this new dataset a version of Fagan’s original equation is estimated.

The full results are available here which suggest that all may not be well with the model specification.  We will ignore these and use this simple model to find an estimate of the black economy.

We can do this by using the following steps.

1. Find the change in proportion of the money supply held as currency in the economy that are the results of changes in taxation.
2. Estimate the volume of these excess currency holdings.
3. Find the volume of currency needed for the transactions reported in the national accounts.
4. Calculate the velocity of circulation in the formal economy.
5. Use 2 and 4 to find the level of income in the black economy.
6. Find the percent of GNP that this estimate comprises.

An updated spreadsheet with all of these calculations is available here.  Here is a graph of the estimates from Fagan (1997) and those calculated here.

Although there are difference from 1960 up to 1980, the two series track each other through most of the 1980s and for the years in the 1990s for which Fagan estimates are available.  This is highlighted in this graph.

From the new estimates we see a downward trend in the size of the black economy during the Celtic Tiger period.  This continued up to 2003, for which there is a black economy estimate of just 5.6% of GNP.  A rise since then gives a most recent estimate for 2007 of just over 8.5% of GNP.