Limitations of GDP – the informal economy

Been covering this topic with my A2 Economics class. Below is a recent video from Venezuela outlining the size of the informal sector. It is estimated that 50% of the workforce make some sort of living from selling items on the street usually for US$. This explains one of the limitations of GDP as a measurement of a country’s standard of living.

The informal economy is generally associated with low productivity, poverty, high unemployment, and slower economic growth. It is also more prevalent in low-income countries because as countries develop, the easier it is for workers to transition to the formal sector. At the same time, it provides employment and income to people who would otherwise not find employment, or it supplements their income from employment in the formal, regulated sector. IMF The Global Informal Economy: Large but On The Decline. 30-10-19

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on GDP and its limitations. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Greece’s other economy.

Underground economyThe Economist recently wrote about Greece’s informal economy. Here are some interesting points from the article:

* 24% of all economic activity went undeclared in 2013. After the recession the the economy shrank by 30% – government debt is 174% of GDP

* Greeks feel that their taxes are wasted – you only have to think back to the hosting of the Olympic Games in 2004. Greece’s ‘tax morale’ is the fourth lowest of 26 countries and its public sector is renowned for being the most corrupt in the EU.

* What has been the catalyst for the informal economy is the fact that Greece has a high level of self-employment – this makes it easier to evade income tax. Also government levies account for 43% of labour costs, compared with the rich-country average of 26%.

However it is important to remember that over 25% of Greeks are officially unemployed and the informal economy is a lifeline to many of them. Over two thirds of shadow earnings are spent instantly with companies that do pay tax. The best way to encourage Greeks to declare tax would be a sustained economic expansion. If there is growth and falling unemployment the temptation to go underground should dwindle.

Cartoon from ‘The New Yorker’ magazine.

A2 Revision – GDP calculations and the Indian shadow economy

You will no doubt come across the 3 methods of calculating GDP that is in the macro syllabus of most courses. Here are the main features of each.

National Income measures the value of output produced within the economy over a period of time. One of the key economic objectives of government is to increase the level, and rate of growth, of national income. Before we start to analyse why economic growth is so important, it is important to be able to define the key concepts.


Under new definitions introduced in the late 1990s, Gross Domestic Product is also known as Gross Value Added. It is defined as the value of output produced within the domestic boundaries of the NZ over a given period of time, usually a year. It includes the output of foreign owned firms that are located in NZ, such as the majority of Trading Banks in the market – ASB, National, ANZ etc. It does not include output of NZ firms that are located abroad. There are three ways of calculating the value of GDP all of which should sum to the same amount since by identity:



This is the sum of the final expenditure on NZ produced goods and services measured at current market prices (not adjusted for inflation). The full equation for calculating GDP using this approach is:

GDP = Consumer expenditure (C) + Investment (I) + Government expenditure (G) + (Exports (X) – Imports (M))

GDP = C + I + G + (X-M)

This is the sum of total incomes earned from the production of goods and services. By adding together the rewards to the factors of production (land, labour, capital and enterprise), we can see how the flow of income in the economy is distributed. The rewards to the factors of production can be loosely summarised in the following table:

Factor Reward
Land – Rent
Labour – Wages and Salaries
Capital – Interest
Enterprise – Profit

Only those incomes generated through the production of a marketed output are included in the calculation of GDP by the income approach. Therefore we exclude from the accounts items such as transfer payments (e.g. government benefits for jobseekers allowance and pensions where no output is produced) and private transfers of money.

The income method tends to underestimate the true value of output in the economy, as incomes earned through the black economy are not recorded.


This measures the value of output produced by each of the productive sectors in the economy (primary, secondary and tertiary) using the concept of value added.

Value added is the increase in the value of a product at each successive stage of the production process. For example, if the raw materials and components used to make a car cost $16,000 and the final selling price of the car is $20,000, then the value added from the production process is $4,000. We use this approach to avoid the problems of double-counting the value of intermediate inputs. GDP will, therefore, be equal to the sum of each individual producer’s value added.

Problems of accuracy:
Officially data on a nation’s GDP tends to understate the true growth of real national income per capita over time e.g. due to the expansion of the shadow economy and the value of unpaid work done by millions of volunteers and people caring for their family members. There may also be errors in calculating the cost of living

The scale of the informal “shadow economy” varies widely across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy may be in the region of 15% of GDP.

cashIndia’s cash economy

It is believed that in 2009 Indians held more money is Swiss banks than people from all other countries combined.
– A 2010 study by the World Bank has suggested that India’s shadow economy is equivalent to 20% of GDP.
– Research indicates that 85% of jobs in India are typically cash orientated.
– Only 42,800 people declare income of over 10m rupees a year – only 2.5% of Indians pay income tax.
Mumbai has a huge stock of empty apartments held as investments, their owners unwilling to to sell for fear that the proceeds might enter the formal economy and be taxed.

Source: The Economist. March 23rd 2013

Sex and Drugs and Italy’s GDP

EI-CH575_OUTLOO_NS_20140608150304The Italian statistical body recently announced that it will include prostitution, drug trafficking, and alcohol-and-tobacco in its calculation of GDP. However Italy is just complying with international accounting standards and reporting illegal economically productive activity is required under European Union rules. But as it is part of the informal economy how do you actually measure drug deals, prostitution etc and therefore its contribution to a country’s GDP?

Holland’s Coffee Shops

Coffeeshops are establishments in Holland where the sale of cannabis for personal consumption by the public is tolerated by the local authorities. Holland already counts cannabis sales as coffee-shop revenues and the EU is looking for greater comparability in the GDP figures which is used to distribute funds from the EU budget. Therefore member states who have a high percentage of their GDP in illegal activities will have their assistance from the EU reduced. See graph from Wall Street Journal.

Countries like Columbia have traditionally had a very large informal economy – drug trafficking – and it is estimated that between 1980 and 2012 that shadow activity varied between 27% and 56% of GDP.