The Cash Under the Carpet

A sprawling shadow economy, fuelled by trust deficits and loopholes, continues to thrive beneath the surface of India’s formal growth story.

A parallel economy poses a serious threat to both economic growth and fiscal discipline. Commonly referred to as the ‘shadow’ or ‘black economy,’ it encompasses activities that deliberately evade government oversight and documentation. As defined by the Organisation for Economic Co-operation and Development (OECD), it includes all market-based legal production that is intentionally concealed from public authorities. Core drivers of the shadow economy include informal sector activity, unreported income, cash-based transactions without documentation, and illicit trade.

The shadow economy isn’t solely the result of hidden transactions. It also reflects deeper psychological undercurrents. Insights from behavioural economics reveal that individuals often base their decisions to participate in informal economic activity on psychological and social cues, not just financial rationale. A common trait is the preference for personal financial benefit over collective responsibility, especially when informal practices are normalized within close-knit groups, reinforcing such behaviour. Moral rationalization plays a role too. People may justify bypassing formal systems as a response to perceived injustices like excessive taxation, bureaucratic inefficiencies, or systemic corruption. Perhaps most critically, trust in public institutions is a decisive factor when governance is seen as ineffective or self-serving. Individuals feel less compelled to comply with the rules of the formal economy.

Measuring the shadow economy remains inherently difficult due to its unregulated nature. Voluntary surveys offer limited insights, as respondents often withhold sensitive information. Government audits and compliance checks can uncover specific instances of tax evasion but fail to capture the full extent of informal activity. While household and labour force surveys help identify informal employment, they typically overlook business-to-business transactions. Indirect indicators such as patterns in cash usage, electricity consumption etc provide rough estimates but are constrained by data gaps and accuracy.

Full tax exemption on agricultural income creates loopholes for money laundering, as the sector’s informal, seasonal and small-scale nature limits regulatory oversight. Urban real estate continues to serve as a key conduit for black money, with a significant portion of transactions still conducted in cash to evade regulatory scrutiny. A vast informal trade sector led by hawkers, vendors and small shops thrive on unbilled transactions. Hawala networks, fake invoicing and cash-heavy sectors like real estate and gold erode transparency. Add to that collusion in public works, opaque political funding and lax enforcement, and the shadow economy stays deeply entrenched.

India’s shadow economy has seen notable structural shifts over the past three decades, showing a consistent downward trend. According to estimates by Medina and Schneider (2018), it constituted an average of 23.91 percent of GDP between 1991 and 2015. The high prevalence of informal activity in the early 1990s was largely attributed to a tightly controlled economy dominated by excessive regulation and legacy of the license raj.

Post-liberalisation, India’s shadow economy began to shrink due to better regulation, simplified business processes, and expanding formal sector avenues. Reforms after 2010 such as digital infrastructure growth, targeted welfare schemes, and formalisation drives further accelerated this decline. An SBI report estimated that size of formal economy has reduced to 15–20 percent of GDP in 2020 from 52 percent in 2017–18. ACCA projected a drop from 17.22 percent of GDP in 2016 (Rs. 26.16 lakh crore) to 13.6 percent by 2025.

Due to the massive size of the shadow economy, the government loses around a staggering Rs. 5 trillion in tax revenue every year.

India has the third-largest shadow economy by value estimated at $931 billion behind China ($3.6 trillion) and the U.S. ($1.4 trillion). However, as a share of GDP, India fares relatively better. In 2015, it ranked 124th out of 158 countries, with its shadow economy at 17.89 percent of GDP well below the global average of 27.78 percent and the developing country average of 41 percent.

India has undertaken several policy initiatives to curb shadow economy, which have yielded mixed outcomes. The most notable was demonetization of Rs. 500 and Rs. 1,000 notes which constituted 87 percent of the currency in circulation valued at Rs.15.44 trillion, was intended to flush out black money. RBI confirmed that 99.3 percent of the invalidated currency returned to the banking system. This move caused widespread disruption and huge inconvenience but generated a wealth of data that helped tax authorities scrutinize unaccounted deposits and strengthen enforcement efforts.

The introduction of GST in 2017 marked a decisive step towards formalisation, with its unified tax regime and digital trail helping expose evasions through data analytics. Meanwhile, the Digital India campaign has turned the country into a global leader in digital payments. The rise of UPI, even among small traders, has nudged informal transactions into the open. Financial inclusion schemes like Jan Dhan and direct benefit transfers have widened access to formal credit. Yet, for all this progress, cash still rules in rural India.

India has tightened the legal noose around the shadow economy through measures like the Black Money Act, the amended Benami law, and mandatory PAN for large transactions. Its participation in global tax information exchanges and revised treaties with tax havens mark a broader crackdown on evasion. Recent regulatory simplifications and new income tax laws aim to draw small businesses into the formal fold.

Erasing the shadow economy entirely is wishful thinking as human habits, not just loopholes, keep it alive. But shrinking it to single digits of GDP is within reach. Lasting change will come not just from crackdowns, but from cooperation. After all, formalisation isn’t just good economics – it is nation-building.

(The author is a Chartered Accountant with a leading company in Mumbai. Views personal.)