The Shadow Economy Is Luring Workers Out of the Labor Force

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The recent jobs report from the Bureau of Labor Statistics contained some very good news last week, noting a drop in the national unemployment rate from 7.3% in October to 7% in November, the lowest since jobless rates began heading upward in late 2008. Not so great was the labor-force-participation rate, which represents the number of persons 16 years of age and older who are either working or actively looking for work. As you can see from this graph from the BLS, this metric had declined precipitously since 2008.

Source: Bureau of Labor Statistics.

Although the labor-participation rate did rise slightly month over month -- from 62.8% in October to 63% in November -- it is still very low; the last time the rate sat at 66% was October 2008. Considering the drop in the unemployment rate, the simultaneous increase in the labor-participation rate seems surprisingly low.

Where are these workforce dropouts going? There are a variety of reasons for leaving the labor force, but I believe that one is gaining on all the others: people are joining the underground economy, a shadowy world of undocumented labor that has seen astronomical growth since the Great Recession.

The three big reasons aren't big enough
The conventional wisdom usually asserts that there are three main reasons for workers to leave the workforce: retirement, entering or returning to college, or collecting disability insurance payments. But none of these scenarios seem to account for the persistently low labor-force-participation rate.

While retirement certainly takes people out of the active workforce, the fact is that the unemployment rate for workers aged 55 years and older is the lowest it has been for the past year -- a measly 4.9% in November -- and the lowest of all other age groups. This would belie the notion that older folks are retiring in record numbers, or are looking for work and are unable to find it.

The higher-education model makes sense to some degree, but it has been five years since the labor-force-participation rate began its precipitous drop. Surely those who returned to school to obtain a graduate degree must be job hunting by now, as are many who pursued a four-year diploma.

As for disability, the Heritage Foundation has noted that 6% of adults collected Social Security disability benefits in 2012, but that isn't a whole lot more than the 5.3% that did so back in 2007.

The shadow economy is absorbing more discouraged workers
That leaves the underground economy, which is growing by leaps and bounds. In 2009, the shadow economy was valued at approximately $1 trillion; by 2013, it is commonly assessed to have doubled to $2 trillion. That's a lot of off-the-books activity, which has both positive and negative consequences for the traditional economy.

On the one hand, the untaxable status of the income generated creates a huge loss for government coffers, both in income taxes from the worker, and payroll taxes from the employer. On the other hand, the underground economy's existence has provided money for those unable to procure employment in the traditional economy -- money that is spent just like any other and is therefore helping the formal economy recover.

While most people are drawn into the so-called "gray" economy due to necessity, the sector may continue to grow despite a brightening economic picture. After all, people have always done legitimate, legal work under the table -- and it's a lucky thing that this underground economy exists since much greater suffering would have ensued if that backstop had not been available. It's a necessary safety net for those who truly have no other options.

But the situation highlights how it is in government's interest to keep the gray economy to a minimum. This would be best accomplished less by punishment, and more with public-private job creation initiatives. Publicly held firms, in particular, would do well to help prop up the formal economy -- after all, those untaxed dollars aren't likely to find their way into the stock market. Shedding a little more light on the shadow economy could be just what the fledgling job-market recovery really needs.

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