Estimates of the Black Economy Based on Consumer Demand Approaches

We propose a consumer demand system approach to estimating the size of the black economy where alternative hypotheses affecting the empirical results can be tested in a nested framework. This approach allows for the estimation of the under‐reporting of household income from various sources, dispensing with the need to use arbitrary criteria to classify households by their main source of income. It also avoids potential bias in black economy estimates arising from mistaking preference heterogeneity (substitution) as income effects. We illustrate these arguments by estimating the extent to which self‐employment income in the UK is under‐reported using parametric and nonparametric techniques.