Interview: June 2003

Translated by Yuki Allyson Honjo

What was the initial brainwave that made you start a study on Japan's underground economy?
In 1999, when I was temporarily transferred to the Japan Center for Economic Research, I came across a few foreign papers on the study of underground economies and it captured my interest. In Japan, there really has not been much past research on the underground economy, and I decided it was worth studying. In 2000, I was sent to the Institute of Southeast Asian Studies in Singapore. Although Singapore has a strong "wholesome" image, the existence of an underground economy with prostitution and gambling was known. Once I realized that an underground economy exists in each and every country on the scale that cannot be ignored, and this made me decide to further my research. 

Could you tell the readers what your main conclusions of your book White Paper on Japan's Underground Economy? What are the main components of Japan's under ground economy? What are its drivers?
In 2000, tax evasion took up 73.3% of the Japanese underground economy. The remaining 30% is other forms of illegal activity, of which illicit income from organized crime is 10.7%, and the sex industry occupies 8.5%.

Since the 1990s, the overall underground economy has been on the decline because of the downward trend in tax evasion, which takes up the majority of the underground economy. However, income from organized crime and the sex industry are on an upward trend, but because they occupy a comparatively smaller proportion, they don't affect the overall underground economy.

You state that the size of Japan's underground economy is about 23.3 trillion yen in 1999-that's a very big number. First: plus or minus how much? Second: could you define what you mean by underground economy?
Because its very difficult to measure the underground economy, it's essential to estimate a certain margin. In this book, I define the "underground economy" as economic activity that is not released in official public statistics such as GDP and is a deviation from various government and tax regulations. Concretely, things like tax evasion and other forms of criminal activity are included in the underground economy.

On the other hand, 23.3 trillion is about 4.5 percent of the nominal gross domestic product. This is considerably smaller on a relative basis compared to other countries. While these numbers are always hard to pin down, figures have varied from (as of 1990) 23.4 percent for Italy, 13.1 percent for Germany, 9.4 percent for France, and 7.5 percent for the United States. Do you feel that 4.5% of nominal GDP is damaging to Japan? Why do you think Japan's underground economy is relatively small? In your opinion, is it a problem?
The size of the underground economy is 4.5% of nominal GDP, which is smaller in scale relative to international comparisons. However, because the present Japanese growth rate is staying at more or less 1%, whether or not the underground economy (4.5%) is counted in GDP makes a big difference in assessing the economic climate.

As for reasons why the Japanese underground economy occupies as relatively small place in the economy 1) Japanese tax rates and unemployment rates are relatively low 2) Compared to the US and Europe, the system dealing with the underground economy is much stricter. The scale of the Japanese underground economy is not yet that large. It's not likely to become a troublesome problem if you increase tax agency staff to control tax evasion and if you make plans to stop the spread of the underground economy now.

Why do you think there are so few books on the subject?
The biggest reason is, as expected, there are plenty of statistics that can't be trusted. When I started my research on the underground economy, I had a lot of trouble constructing my data set. The other reasons are that, in the case of Japan, it's often the case that those in power accept bribes and are involved in the underground economy. Also, you could say that it is considered taboo to focus on the underground economy.

In contrast, US and Italian underground economy is oft-debated ground. For example, Professor Edgar Feige of the University of Wisconsin estimated the US underground economy to be between $500 billion and $1 trillion in 1993. Did you refer to other countries and their methods of accounting for the underground economy?
In terms of top-down estimation methods, I often referred to the analysis of foreign researchers .

One way of calculating the under ground economy in aggregate is to take a top-down approach: the size of the underground economy can be determined from currency data by looking at the real increase in currency per capita over some base period. (The assumption is that non-underground consumers would not increase their day-to-day need for cash in inflation-adjusted terms). A significant increase in cash per capita is taken as sign of cash used in the underground economy. Could you tell in detail about your calculations and the ways in which you solved methodological issues?
The following are the details of the top down estimation method. First, I assume that underground economy transactions are all cash in order to avoid detection. Then I estimate the total over all economy's cash demand, and then the "above ground" (legitimate) economy cash demand. The difference is the estimated cash demand of the underground economy. That is, I first estimated the function of the cash demand by using explanatory variables to explain the variable numbers that did not equal the influence of the cash demand. Then I use the (imposed) tax rate in the estimation formula. Thus, the heavier the tax rate, the more tax evasion, and the more cash slips way from the tax authorities into the underground economy.

The guidance from this cash demand function becomes an estimate of the total economy cash demand, which we will call (1). Next, if we assume that the tax rate is zero, then the assumption is that the underground economy doesn't exist. Only the "legitimate" economy is creating the demand for cash, which we will call (2). Therefore, the difference between function (1) and (2) is the basis for the estimate of the amount of the cash used by the underground economy, or "underground money."

But, this estimation method makes the strong assumption that all underground economy transactions use cash. Moreover, if underground transactions use something other than cash, then the estimate doesn't work as well.

How did you assign a value to each of underground sectors-i.e. tax evasion, prostitution, illegal gambling, narcotics etc. within this total? How for example did you generate the statistics that foreign female prostitutes are a 26.4 billion yen economy?
In making estimates of the size of the underground economy, I use the combination of a top-down (monetary) and a bottom-up approach. In the case of the top down method, you can estimate the overall size of the underground economy but you can't tell what's going on inside as it remains a black box.

In order to make up for this, you have to use that method together with the bottom-up method. With the bottom-up approach, you estimate and add the following together so you can get the overall scales of the underground economy: 1) total tax evasion 2) total organized crime income 3) income from the sex industry, 4) car theft 5) illegal gambling 6) illegal video rental shop profit 7) counterfeit brand name goods 8) firearms black market 9) illegal money lending 10) gratuities given to doctors 11) income from illegal drug sales 12) income from rigging Pachinko machines.

As it varies on a case by case, I don't have room to go in further elaborate on the underground economy estimation methods, so lets leave it at that. This bottom up approach is the most original method employed in my research.

How did you collect your data-after all there are no government statistics on many of these sectors. What do you feel were the main difficulties and problems in the data?
In the case of the top down (monetary approach), I used publicly released statistics on the money supply and GDP. On the other hand with the bottom (direct approach), as there are no public statistics, I made estimates by using a large number of extensive questionnaires, conducting interviews, the internet, pornographic magazines and books. In particular, I had trouble with estimating the per establishment sales of the sex industry. I estimated the number of customers by day by creating a sample of 30 establishments and then ascertained by phone their waiting time and the number of rooms.

Was the veracity of the data ever an issue? For example for a given illegal activity, over the phone for a given service, on might be quoted one price. In reality, the activity may have a much higher price, or may have hidden charges that elevate the price.
My sample is limited to establishments that advertise on the Internet. That kind of the dual price system never occurs in establishments that publicize on the Internet. However, I think there are some problems in that regional price differences are not reflected in the estimates, as the data are collected mainly from Tokyo.

Also, how did you account for business with both an underground and legal component-such as a pachinko parlor running illegal gambling or a club with prostitution on the side. Any amusing/hairy incidents in collecting data?
Regarding the companies and individuals who have lawful economic activity, I only count the portion of the tax they have evaded. Thus, there is no double counting. In order to collect data, in the case of the sex industry, I pretended to be a customer and went into the establishments to interview the women. As for organized crime, in order to avoid danger to myself, I collected the information indirectly through a journalist familiar with the field.

What is the fate of Japan's underground economy? Will it grow or decline in the next ten years? How does the current economic down turn impact the underground economy? Are there any counter-cyclical or acyclical industries in the underground economy? Any growth industries within the underground economy? What's in decline?
The Japanese underground economy is in on a downward trend, but there is a high probability that, in the long term, it will expand due to the influence of service sector growth and tax rate increases driven by an aging society. The underground economy benefits from the development of the service industry because transactions are in cash and tax exemptions can be gained by underreporting. In the case of tax evasion, the increased tax burden and social security will induce more tax evasion by corporate as well as household entities. Furthermore, information technology helps the economy move faster. As much economic activity is done through the internet, transactions become unclear, which feeds strong growth in the underground economy.

The decline in tax evasion is tied into the current economic malaise. A characteristic of the Japanese tax system is that it mainly relies on income tax, and the tax burden becomes heavier when economy strengthens as it is imposed on a graduated scale. In the opposite case, when the economy weakens, the tax burden becomes lighter.

Therefore, the assumption is that when the economy is sluggish, tax evasion decreases because everyone's tax burden is lighter. On the other hand, for example, income from the sex industry, which is tied into a basic (unchanging) human need, is on the rise, as stated above, because it is not influenced by the economic cycle.

While hard drugs, violence for hire, tax evasion and underage pornography are definitely negative, how much of a problem is the underground economy? To play devil's advocate, are there any positive aspects to the underground economy-after all, the non-violent sectors are supplying a demand and employing people. . .
As you pointed out, expansion of the underground economy provides some benefits to society and the overall economy. To begin with, the first benefit is that the underground economy can revitalize the legitimate economy. That's because income and wealth generated from criminal activity feeds back into the legitimate economy.

For example, let's assume a given organized crime member earns a huge profit from drug dealing. That income was earned entirely though underground economic activity. However, most of the money he made in the underground will be spent in the legitimate economy though consumption and investment activity. This money connects with the legitimate economy as it stimulates demand. Of course, if the gangster uses the ill gotten gains in Soapland [bathhouse/prostitution], the money changes hands from the one underground outlet to another and does not stimulate the above ground economy. But the girl who works at the Soapland uses the money to buy a Gucci or some other brand name bag, it circles back into to stimulate the legitimate economy.

In Japan, there are middle and high school girls who "date" older men for money (enjokosai). The money that they get is almost all used to buy brand name goods and for fun. I think it is sad that Japan's sluggish consumption is being essentially propped up by girls who take part in enjokosai.

The second benefit is, that in an expanding underground economy, people who lost their jobs are given an opportunity to work. For example, due to the long running economic malaise, young female college students may find that their job search is moving at glacial speed, some of these women many take the leap into sex industries and become Soapland and S&M workers for some quick cash.

Third, there is a possibility that the growth of the underground economy in the long term may contribute to improving the efficiency of the economic system. One major reason behind the growth of underground economic activity is that the legitimate economy creates markedly unreasonable regulations, and as a result, they affect the ideal efficient economic activity. In the case in which the government goes too far, so long as there is a productive economy, it's probably the case that the underground economy is a short cut to efficiency in that it will be the trigger to improve the economic system.

Fourth, and his only applies for developing countries, but in the case in which the underground economy occupies a large portion of the overall economy, the per capita GDP that does not include underground economy is calculated to be extremely low, they can receive preferential treatments in aid and trade from international agencies like the UN, the IMF, and ILO. In terms of international aid agencies deciding whether or not to give aid, the judgment standard is the size of the per capita. Even if economic standard aid includes real GDP per capita that includes the underground economy, and if you revise down the real per capita GDP to exclude the underground economy, it could reach the aid standard.

However, and this is my personal judgment, I think that the existence of a underground economy is not desirable for society. In the present circumstances, if you compare the costs from the loss of government income from underground activity that occurs from tax evasion and the benefits of the underground from the profits gained from underground activity and the multiplier effect of stimulating the legitimate economy, I think costs outstrips the benefits.

What policy decisions, if any, have to be made about the underground economy? What aspects of the underground economy could sensibly recovered and incorporated into the real economy? What industries could be taxed and how much of an impact would there be to Japan's tax revenue strapped economy? Would it make a difference?
In order for the underground economy to shrink, I think that you have to strengthen the efforts into controlling tax evasion, which occupies most of the underground economy. In the case of Japan getting rid of tax evasion, I think that it is necessary for tax investigations to be more thorough by increasing the number of tax agency employees, which compared to other advanced countries, is lacking. While it's important to preserve privacy, ultimately I think that it's desirable if the tax system can get a hold of all that income by introducing tax-payer identification numbers.

Again, there is a chance that some underground criminal activity may be made legal. If you legalize things like casinos and prostitution houses, it's desirable in the sense of increasing tax revenue. For example, if you legalize casinos, the underground money that flowed through the casinos would shift into the legitimate economy. Let's make a rough calculation of how much we could expect if we did that. Using "The Economic effect of Casinos" which was released by Tokyo Metropolitan Government in October 2002 and accepting its assumptions of the matter in question, we calculated the impact on tax income.

Tokyo Metropolitan Government assumes that a 20% tax on the casino's gross profit and a gaming tax, and 5% consumption tax on total sales, and a 30% corporate tax on net profit.If we assume that the money from the casino market flows into legitimate economy, we could expect a gain from income and gaming taxes would be on a nationwide basis about 42 billion yen, consumption tax would be 10.5 billion and corporate taxes of 1.9 bn, for a sum total of 54.4 bn yen gain in tax revenue.

As an economist, you must have some opinions on Japan's economic malaise. What do you feel is Japan's main problem? What's your solution? Raise interest rates? Increase inflation? If you could assign blame, whose fault is it?
At present, I think that deflation is the foremost reason preventing the recovery of the Japanese economy. Japanese deflation is fundamentally a chronic lack of demand, I think it is important to adopt a Keynesian financial and monetary policy in order to directly to fill the GDP gap (the difference between the potential GDP and the present GDP).

While the joint minister for economy and financial services Heizo Tanaka is pushing a plan that calls for structural reform which is necessary to create strong long term growth but in short term, the plan increases unemployment and increases pressures on deflation. In practice, I think that he should push structural reform after getting rid of deflation.

What in your mind are the best books (in any language) on the Japanese economy today? What do you feel are the worst?
I think that on the deflation issue, Shisan Defure de Yomitoku Nihon Keizai (Understanding the Japanese Economy's Asset Deflation, Dai-ichi Life Research Institute) is the best textbook on the subject. Moreover, on the subject of non-performing loans, Sasaki's Kamata Senki (Kamata War Dairies, Nikkei Business Press) is not only written in detail and has a real grasp on the situation, it is really a book that ought to be read.

As for the worst textbook, I think Heizo Takenaka's Ashita no Keizaigaku (Economics of Tomorrow, Gentosha Publishing) has many theoretical problems.

What are reading right now? What do you like to read in general?
I am reading Manabu Miyazaki, Toppasha (Barricade Runner, Gentosha Publishing). On the whole, I like reading about Bubble-Era Japanese economics, in particular, I enjoy reading anything that analyzes the "underground" aspect of that era.

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