Government 2.0 and the End of the Shadow Economy

One of the most hotly debated economic issues at present is the seemingly low growth of productivity, despite the accelerated technological progress that is taking place before our eyes.

Some attribute it to a measurement error, as productivity statistics fail to fully capture the impact of new technologies. This happens both because production is underestimated by not accounting for products and services provided at zero cost (free apps, Wikipedia, etc), and by the complexity of measuring improvements in the increasingly important service sector (See Deflation: an inconvenient truth?).

An alternative explanation, championed by the economist R.J. Gordon, proposes that the gains from current innovations pale in comparison with the ones achieved over the last century thanks to the introduction amongst others, of the electricity, the internal combustion engine, sanitation, and petrochemicals.

However, one can venture a complementary thesis bridging both postulates, reckoning the growing size of the public sector and the public nature of last century’s innovations. It is pertinent to note that the national grid, the water and sewer systems or the first telecommunication companies were provided directly by state-owned enterprises or regulated as a public utility.

The difference is that the public services that have proliferated since the creation of the welfare state at the beginning of the last century (see graph below), have burdened productivity. The reasons for this are multiple; First, growth in the public sector is partly a consequence of regulating and controlling a growing societal complexity; something necessary to mitigate risks but with little impact on economic growth.

However, it is also unquestionable that a large part of the productivity gap between the public and private sector can be attributed to the fact that many of the major trends in labor (such as off-shoring or incentive-based compensation) have barely touched public servants, and also for the reason that the public sector has lagged behind in the adoption of new technologies.

Looking at the government as if it were a private company reveals many areas for improvement. The most obvious is the potential for reducing costs. Digitalization has been progressively introduced in the administration, but by many accounts its full potential has not been tapped. Taking into consideration that public employment in OECD countries represents about 20% of the total, converging in productivity with the private sector would be a boost for the economy.

The room for improvement is also huge in the area of revenue management. The adoption of artificial intelligence techniques, taking advantage of the digital trail of taxpayers, has the potential to put an end to the underground economy (more so if we would switch to digital currencies). For a country like Spain, with an estimated shadow economy equivalent to 25% of total output and with tax revenues representing 37% of GDP, this would mean an increase in revenue in excess of 9% of GDP! However, despite the stereotypes, this is an issue that affects to all developed countries, and not only those that score low in social capital. The size of the underground economy seems actually to be influenced by the tax pressure at country level, which would explain why the Nordic countries, regarded as highly civic, also have a very sizeable black economy.

Technology also offers the potential to transform the way we look at taxes. If we could know the consumption per taxpayer of the different public services, we could design custom taxes based on their utilization, instead of using indicators such as income or profits. Usage databases could be employed to derive probabilistic models for future consumption of public goods, and hence individualize taxes in the same way as insurers discriminate premiums amongst policyholders. For example, satellite tracking devices could easily reveal the kilometers of roads transited per driver and year, which would allow for the differentiation of road taxes.

This is the concept behind the “Benefit Theory of Taxation”, an old idea in economics, famously rebutted at the time by Paul Samuelson under the assumption that it is impossible to know the preferences of taxpayers, due to the incentive to «free-ride». That impediment would disappear if, thanks to technology, individual preferences could be inferred by tracking their consumption. Productivity would also receive another boost because of the time we would save filling tax returns and, more importantly, in complaining about taxes.


Fernando de Frutos, MWM Chief Investment Officer


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