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UNCLAS SECTION 01 OF 03 MADRID 002418 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR TRACI PHILLIPS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON ELAB KIPR SP
SUBJECT: SPAIN'S UNDERGROUND ECONOMY 
 
REF: A. MADRID 736 
 
     ¶B. MADRID 604 
 
¶1. (SBU) SUMMARY: Several European researchers have published 
studies outlining the problem of Spain's underground economy. 
 The most recent study, published by Friedrich Schneider in 
March 2004, claims that Spain's underground economy is 
currently equivalent to 22.3% of official GDP.  Spain's 
continually high unemployment and illegal immigration have 
accompanied the incidence of significant informal economic 
activity.  Unreported labor and income are more prevalent in 
predominantly unskilled sectors such as agriculture, 
construction, and some services.  The European Commission 
(EC) criticized the GOS in 2002 for its lack of coordination 
in dealing with underground economic activity, observing that 
the GOS tends to react to easily observable offenses instead 
of proactively seeking preventative measures.  Spain seems to 
benefit from tolerating at least some underground economic 
activity and is unlikely to combat it in the near future. 
END SUMMARY 
 
THE SIZE OF THE PROBLEM 
----------------------- 
 
¶2. (U) Published in March 2004, Friedrich Schneider's study 
entitled "Shadow Economies around the World: What Do We 
Know?" surveys the economic landscape of 110 so-called shadow 
or underground economies.  The underground economy is defined 
as "those economic activities and the income derived from 
them that circumvent or otherwise evade government 
regulation, taxation or observation."  In 2003, Spain's 
informal sector summed to 22.3% of official GDP, making it 
the third largest of OECD countries only surpassed by that of 
Italy and Greece.  While common perception is that 
underground economic activity is undesirable, Schneider found 
that an increase of 1% in the underground economy of an 
industrialized country results in a 0.8% increase in the 
official GDP.  His analysis showed that an increasing burden 
of taxation and social security contributions combined with 
greater state regulatory activities are the driving forces 
behind the growth and size of the shadow economy. 
 
¶3. (U) A 2001 study on the Spanish underground economy 
conducted by the Institute of Fiscal Studies of the Spanish 
Department of Treasury in cooperation with the Universidad 
Complutense de Madrid estimated Spain's underground economy 
to be 20% of GDP.  The report analyzes the growth of Spain's 
shadow economy over a twenty-year period on a regional basis. 
 It shows that over the last two decades, Spain's underground 
economy expanded from 15% to 20% of GDP.  Tenerife, Ciudad 
Real, and La Rioja were provinces with the largest 
underground economies.  Other, earlier studies have 
calculated Spain's underground economy as ranging from 20% to 
as high as 40% of official GDP. 
 
¶4. (U) The EC has also looked at the underground economy in 
Spain as part of a larger study on the issue in the EU.  The 
EC found that Spain has the second largest informal sector of 
the then EU-15, surpassed only by Italy.  According to this 
study, the Spanish underground economy is estimated to equal 
23% of GNP (7% more than the European Community average) and 
accounted for 120 billion euros (USD 143 billion at 1 euro = 
USD 1.19) of undeclared earnings.  The EC's study urged Spain 
to convert illegal employment into legal employment.  The 
study's authors criticized GOS policy for being ill suited to 
respond to growth in the underground economy, tending to 
react to the problem rather than consider ways to prevent it. 
 Furthermore, the EC reported that there is little 
cooperation amongst GOS agencies and instead each agency has 
its own priorities when it comes to reducing the underground 
economy. 
 
REASONS FOR UNDERGROUND ECONOMY 
------------------------------- 
 
¶5. (U) These studies indicate that rising labor costs and 
high social security taxes are key factors behind underground 
economies in Europe.  In the case of Spain, a confluence of 
two additional trends helped stimulate high levels of 
informal economic activity.  First, Spain historically has 
maintained a high unemployment rate (24.2% at its peak in 
1994, and currently 11.3%).  Second, Spain is a refuge for 
economic migrants from Latin America and, more recently, 
Northern Africa.  While not all immigrants are destined for 
the underground economy, statistics of detected illegal 
workers in Spain reveal that participation of immigrants in 
the underground economy has increased substantially.  By 2001 
(the most current statistics available), immigrants 
represented more than a third of detected illegal workers. 
 
SECTORS 
------- 
 
¶6. (SBU) The sectors that generally have the largest number 
of workers in the shadow economy are those that require 
minimal educational and professional formation. This is 
evidenced in cities like Tenerife, a tourism hub that is in 
the midst of a construction boom, Ciudad Real province, 
active in textile production, and La Rioja, an agricultural 
and leather production center.  The studies show that the 
highest concentration of illegal workers in Spain is in the 
agriculture, construction, and service sectors.  Gayle 
Allard, an economist at the Institute of Business (Instituto 
de Empresa) in Spain, opined that undocumented labor is a 
hidden subsidy for all of these affected sectors. 
Underground economic activity is beneficial not only for the 
private sector, but also more profitable for the GOS than 
enforcing their own tax and immigration laws.  The increased 
amount of immigrant labor in construction is a recent 
phenomenon linked to Spain's housing boom (reftel B) and the 
expansion of tourism and hotel construction along the coasts 
of southern Spain.  Allard believes that it is beneficial for 
the time being to have a subsidized construction sector to 
help lift Spain out of the recent recession. 
 
IMPACT OF UNDERGROUND ECONOMY 
----------------------------- 
 
¶7. (U) An underground economy of approximately 21% of Spanish 
GDP is roughly equivalent to 130 billion euros (USD 155 
billion).  This translates into significant unrealized tax 
revenue for the Spanish government.  A large informal sector 
also creates an atmosphere conducive to other illegal 
activities such as selling drugs and the piracy of 
intellectual property goods (e.g. software, CD's, DVD's, 
videogames, brand name clothing), which are significant 
problem in Spain (reftel A).  Spain's Treasury Department has 
calculated that the selling of one kilogram (2.2 lbs.) of 
pirated CD's is five times more profitable than one kilogram 
of hashish. 
 
¶8. (SBU) The underground economy also distorts Spain's 
economic statistics.  For example, some studies suggest that 
as much as one-third of the unemployed are involved in the 
underground economy.  If correct, this would mean that 
Spain's high unemployment rate is at least partially 
artificial.  If the GOS can, as the EC report urges it to do, 
transfer underground occupations to the legitimate labor 
force, this inflated unemployment figure could fall 
substantially and social security coffers could grow. 
 
GOS ACTION AND REACTION 
----------------------- 
 
¶9. (U) The EC report characterizes Spain's policy toward the 
underground economy as reactive and uncoordinated.  The GOS 
claims to be combating the problem by investigating illegal 
employment and unclaimed income cases.  For example, in 
summer 2002, Spain's Department of Treasury dispatched 200 
government officials along the coasts of Spain in an attempt 
to detect illegal employment and tax evasion.  If individuals 
or businesses were suspected of tax fraud, the officials 
would initiate an investigation of their tax claims.  Another 
inspection conducted by the Spanish Department of Labor had 
more tangible results, by recuperating 435.5 million euros 
(USD 520.5 million) in unpaid social security contributions. 
From January to June of 2002, the Department of Labor found 
33,215 underground workers, of which 4,137 were foreigners 
without work permits.  As a result of the inspections, GOS 
fined businesses 7.3 million euros (USD 8.7 million) and 
illegal immigrants 25 million euros (USD 29.9 million) for 
illegal employment. 
 
¶10. (SBU) While current action has allowed GOS to recover 
some lost tax revenue and punish employers for illegal labor 
practices, the current policy is not effective in shrinking 
the underground economy.  Instead of acting in advance to 
deter unreported employment or employment of illegal 
immigrants, its policies focus on reaction by giving 
disproportionate fines to employees instead of employers in 
the shadow economy.  While any action represents a 
commendable step, the EC suggests that preventative action 
through coordinated policies would prove to be more 
successful at reducing the submerged economy.  As the EC 
report found, the policies of the various government agencies 
are not coordinated.  That lack of harmonized policies leaves 
the government with misaligned goals, resulting in a 
governmental principal-agent dilemma.  Pilar L'Hotellerie, 
head of analysis of the Spanish economy for the Bank of 
Spain, said that although the new socialist government is 
paying slightly more attention to tax evasion and fraud than 
the former Popular Party (PP) government, she does not expect 
to see any form of legislation intended to deter underground 
economic activity in the foreseeable future. 
 
11.(SBU) COMMENT:  The GOS usually turns a blind eye to 
underground economic activity in traditionally important 
sectors such as agriculture and construction.  Untaxed 
factors of production act as a hidden subsidy, increasing the 
country's general economic welfare in sectors where official 
subsidies are impossible to enact because of GOS-EU trade 
obligations.  In many of these markets Spain is in direct 
competition with low labor-cost producers, and without these 
hidden subsidies domestic firms would exit.  There is no 
question that the underground economy has contributed to 
Spain's remarkable economic growth since joining the EU. 
Absent budgetary pressures or stronger EC urging to curb such 
activity, we see no change in the role or size of Spain's 
underground economy in the near future.  END COMMENT 
ARGYROS