The Non-Observed Economy in Israel

Under embargo until September 10th (Thursday) at 6:00 AM

Click here for the full study (in Hebrew) 

Estimating the size of Israel’s non-observed economy – also known as the black or shadow economy – is important in order to evaluate the extent of tax evasion and in order to choose effective tools to counter the phenomenon. Unreported economic activity erodes the tax base, and is likely to lead to greater public debt and a decrease in the scope and quality of public services.

A new Taub Center study conducted by Dr. Labib Shami estimates the size of the non-observed economy in Israel and finds that its share of GDP has been declining in recent years. Moreover, there has been a substantial fall in the extent of tax evasion coming from the non-observed economy, alongside a continuous rise in the share of vice crimes, particularly prostitution and drug dealing, over the past two decades. In addition, the study finds that indirect taxes and transfer allowances – child allowances, unemployment benefits, and income assurance – contribute to the expansion of the non-observed economy in Israel.

In light of the findings, it is reasonable to assume that the outbreak of the coronavirus crisis, which has increased eligibility for unemployment benefits and grants to the self-employed, will lead to an expansion of the incidence of tax evasion and the share of non-observed economy in the country.

The non-observed economy includes all economic activity where the resulting income evades the tax authorities and government supervision. The OECD defines the non-observed economy as having four main components: clandestine production (the production is legal but hidden from the tax authorities); illegal production; production in the informal sector (of unregistered organizations that produce beyond their personal needs); and unreported economic activity that is not included in GDP calculations due to deficiencies in the government data collection system.

According to estimates, the non-observed economy represents about 12% of economic activity in Anglo Saxon countries, between 20% and 30% in Southern Europe, and some 40% in developing countries. This extensive unreported economic activity reduces government revenues and causes distortions in economic measures like GDP.

The OECD survey of member country’s non-observed economies estimated the extent of the non-observed economy in 2008 in Israel at about 6.6% of GDP (about NIS 70 billion in 2008 prices), though it is important to note that “illegal production” in the non-observed economy was not included in Israel’s reporting for the purposes of the survey.
According to this survey, it appears that 45% of Israel’s non-observed economy in 2008 (not including the share of illegal activity) was from activities that were not recorded due to defects in data collection, about 33% was from clandestine production, and almost 22% was production in the informal sector. Other international estimates place the size of the non-observed economy in Israel between 1995 and 2015 between 23% to 19% of GDP.

Estimating the size of the non-observed economy in Israel using the currency demand  approach

The Taub Center study used the currency demand approach modified for the Israeli economy. Dr. Shami used the ratio between cash withdrawals from the public’s personal checking accounts and total non-cash transactions. This approach allows measurement of the demand for anonymous payments against every shekel used to pay transactions that are traceable.

The model is based on four central assumptions: (a) that all business transactions in the non-observed economy are based on cash transactions; (b) that the level of private consumption and disposable income have an impact on the demand for cash: as private incomes rise so do expenditures and the amount of cash holdings are larger; (c) that as the individual’s tax burden rises, individuals will try to conduct business in ways that evade paying those taxes; and (d) that there is a positive correlation between criminal activity and the demand for cash.

A reduction in the share of tax evasion from the non-observed economy in Israel, alongside a substantial rise in the share of criminal activity; transfer allowances contribute to the expansion of the non-observed economy

The Taub Center study is the first to include the influence of the type of tax (direct, indirect, or transfer payments) as well as the impact of illegal activities on the size of the non-observed economy in Israel. According to the study, the size of the non-observed economy in Israel declined from 14% in 1996 to 10% in 2018, which falls between the earlier estimates by the OECD and other researchers.

This works out to a non-observed economy of NIS134 billion in 2018. The share of non-observed economy is estimated to have reached its peak during the world-wide economic crisis of 2008, when, according to the model used by Dr. Shami, it reached 18% of GDP. It is likely that during the current economic crisis, the extent of which is not yet completely known, the share of the non-observed economy will grow.

According to the research, in the past decade, the share of tax evasion in the economy has been trending downwards and, in 2018, stood at only 1% of GDP. This is the result of a downward trend in the amount of cash withdrawals from personal checking accounts alongside a rise in the extent of non-cash business transactions since 2016. These trends, together with a decline in the tax burden over the past decade, are reflected in a sharp decrease in the share of tax evasion in the non-observed economy in Israel during this period.

According to the Taub Center model, as well as other studies in Israel, indirect taxes and transfer allowances to households – child allowances, unemployment benefits, and income assurance payments – contribute to the expansion of the non-observed economy. The reason for this is that income-based benefits encourage those seeking these benefits to evade reporting income in order to ensure their entitlement. In addition, indirect taxes, like VAT, may also contribute to a decline in non-cash transactions and a preference to pay with cash.

However, alongside the decline in the share of tax evasion, the share of criminal activity in the non-observed economy rose over the past two decades, and in the past two years its share of the non-observed economy has grown to 90%. This increase corresponds to a rise in the share of criminal cases for vice crimes (prostitution and drug dealing) out of all police investigations. This share rose from about 5% in 1996 to 12% in 2018.

In the past few years, policy makers around the world are advancing the idea of eliminating cash transactions in order to depress unreported economic activity and to prevent the use of income from illegal activities to purchase goods in the formal economic sector.

So, for instance, a drug dealer would be required to show a legal record of income in order to purchase a car. Limiting the use of cash will spur economic growth and strengthen the central banks in the wake of economic shocks, and may lead to improvements in the economic and social benefits received by all citizens in the future.

As of the first of January 2019, a new law went into effect limiting the use of cash in accordance with the recommendations of the Locker Committee (2014), whose goal was to fight the black market economy and reduce black market capital. The law sets an upper limit for the use of cash in transactions of NIS 11,000 for a business and NIS 50,000 for a private individual, and limits the use of blank or open checks.

Dr. Labib Shami of the Taub Center warns, though, that “despite the positive effects of limiting the use of cash, implementing the policy improperly can hurt the weakest populations and deepen the gaps between the rich and the poor, since not everyone has equal access to bank accounts.”

Dr. Shami continues: “As in the world-wide economic crisis of 2007-2008, the coronavirus crisis is likely to affect the non-observed economy in Israel. What is more, social distancing policies put in place in Israel have caused the immediate slowing of economic activity in both the non-observed and the formal economic sectors.

The budget that has been allocated to lessen individuals’ economic distress in 2020 (NIS 135.5 billion) has been distributed through grants, some of which have eligibility requirements, like a 25% drop in activities from the beginning of the crisis until June 2020 relative to 2019. At least in the short term, this condition is likely to encourage small business owners to hide income in order to meet the requirements, and thus to increase the size of the non-observed economy.”

Alongside this, small businesses operating in the informal sector and workers employed in the non-observed economy will not benefit from grants related to the coronavirus crisis since their incomes are unreported to the authorities. It is likely that the financial damage to these groups will impact businesses in the formal sector and affect their incomes as well.

According to estimates by the International Labor Organization, about 2 billion people – more than 60% of the workers in the world – are employed informally. These workers are without rights or a social safety net, and programs to save the economy do not take them into consideration. It is reasonable to assume that they will be especially harmed by the current crisis.

“Estimates of the scope of the non-observed economy, and within it, the extent of tax evasion, are important to help authorities act to eradicate the phenomenon to the benefit of the entire country,” says Professor Avi Weiss, President of the Taub Center.

The Taub Center for Social Policy Studies in Israel is an independent, non-partisan socioeconomic research institute. The Center provides decision makers and the public with research and findings on some of the most critical issues facing Israel in the areas of education, health, welfare, labor markets and economic policy in order to impact the decision-making process in Israel and to advance the well-being of all Israelis.

For details, or to arrange an interview, please contact Anat Sella-Koren, Director of Marketing, Communications and Government Relations at the Taub Center for Social Policy Studies in Israel: 050-690-9749.