How the Underground Economy Punishes Small Businesses

Last year, Oscar Pintado fell to his death down a 45-foot elevator shaft at a 450-unit residential construction project in Massachusetts. The 27-year-old laborer "worked" for National Carpentry Contractors, a large, well-known framing contractor.

But National Carpentry claims it has no employees, just 150 independent contractors. The company told federal investigators that Pintado actually worked for a company that did not exist, for an owner who could not be found. He was paid in cash, and his death left his family without benefits or compensation, according to Mark Erlich, executive secretary-treasurer of the New England Regional Council of Carpenters, a labor union.

Pintado was a nameless, faceless worker in the nation's underground economy. It's vast, perhaps $1 trillion to $3 trillion in size. And it costs the government an estimated $100 billion a year in lost taxes. It's a world fueled by cash under the table, no benefits, no job security, no taxes, and no questions asked. Since 1990 it's grown by 28 percent, according to one study, and small businesses are caught right in the middle of it.

"There are thousands and perhaps millions of Oscar Pintados working on construction sites in this country. Some are citizens, some are here illegally, but all of them are invisible victims of this nation's shadow economy," said Erlich.

The Senate small business committee recently tried to get a handle on the problem with a field hearing in Massachusetts. Those who testified were mostly from the construction industry, where the problem is rife. How the underground economy grew to its present size, and what it means for the real economy generally -- and small business owners specifically -- are complex questions with no simple answers. But the impact on legitimate small businesses that comply with federal and state laws is significant and needs to be addressed.

Scott Morrisey owns Red Line Walls Systems, a commercial drywall and metal-stud installer in Leominster, Mass. "Our company has prided itself on its ability to provide good jobs at good wages and a generous benefits package," he said. But that policy comes with a price. Morrisey estimates that providing those benefits, plus paying Social Security, Medicare, and workman's compensation and unemployment insurance adds 48 cents to every dollar of a contract bid.

In the construction industry, businesses like his work on roughly a 5 percent margin, and labor costs typically make up 45 percent to 50 percent of the project cost. Since contractors all pay about the same for materials, the pressure to cut corners on labor to get a competitive advantage is strong. "Our company supplies health, disability, and dental insurance alongside other benefits like [paid] holidays and vacations," he said. But the expenses are often a deal breaker when competing against underground businesses.

Even if the underground company pays workers the same hourly rate, which it often doesn't, it has the ability to bid as low as $50,000 on a contract that Red Line could bid no lower than $74,000 on, since Red Line must pay benefits and taxes. Morrisey says he tries to make up the difference by asking his employees to work harder to cut costs through higher productivity. Even then, he must rely on clients who are willing to pay a little more for quality work.

Simply refusing to pay benefits is only the tip of the iceberg, however. Jennifer Stark, an assistant attorney general and head of the fair labor division in the Massachusetts Attorney General's office, testified that abuses are often far worse. In her experience, she's dealt with companies that pay below the minimum wage, require workers to work significantly more than 40 hours a week, and don't pay overtime. Some employers give workers paychecks that bounce week after week. Employees, however, are reluctant to quit for fear of never collecting back wages.

Some unscrupulous employers take credit for deductions for health or pension plans but never pay the premiums. "In one particularly egregious case, an employer never paid any employee. Instead he hired a crew of undocumented workers, worked them for several weeks, let them go, and then kept cycling through new crews of undocumented workers every few weeks, never paying any of them," she testified.

"Interestingly," she added, "we hear from many legitimate small businesses that they are thrilled that Massachusetts' Attorney General Martha Coakley is vigorously enforcing the wage and hour laws. They concur with the AG's [Attorney General's] assumptions that enforcement of the law will level the playing field within the small business community and allow them to become more successful, [because] they will no longer be undercut by businesses that are not playing by the rules."

For the past year the Massachusetts Attorney General's office has made enforcement of wage and hour laws a priority. It has stepped up processing complaints and imposed fines with violations; criminally prosecuted egregious violators; increased the amount of fines; and established an open-door policy for businesses unions, workers, and advocacy groups to discuss issues and resolve disputes. It's also increased outreach and education efforts, including adding victim advocates.

Massachusetts' efforts show that better enforcement can help. What's more, most small businesses will welcome such efforts. But the problem is broader than one state and must be addressed nationally. The nation's deeply flawed immigration policy certainly has something to do with the growth of the underground economy. But that's only part of the problem. Unscrupulous business owners who take advantage of the system are another part. And the government itself also bears blame.

For the past 40 years the emphasis in Washington and state capitols around the country has been on deregulation. The disdain for red tape has largely been rooted in conservative Republican administrations from Ronald Reagan to George W. Bush. But both President Carter and President Clinton also embraced deregulation, and it has been both a blessing and a curse. The repeal of costly and unnecessary red tape has made businesses more competitive. But many regulations that play an important role in the economy are poorly enforced at the state and national level.

Better enforcement of wage and hour laws, for example, would be a good place to start. But unless more rational, workable policies on immigration are adopted and enforced, the underground economy will only get bigger.