HM Revenue & Customs estimates that £59.2 billion in tax went unpaid in 2024/25, equivalent to 6.4% of the total tax theoretically due.
Around 6% of that tax gap is attributed to the "hidden economy", which HMRC defines as economic activity that is entirely undeclared to the tax authorities. That equates to approximately £3.6 billion
The common assumption is that cash-in-hand businesses are making a straightforward calculation: stay off the books, pay less tax. Policy has largely followed that logic, leaning on detection, penalties and fines to push businesses into the formal economy.
But a new study led by Dr Danny Buckley of Loughborough Business School finds that most set out to become fully legitimate, only to find they cannot.
> READ DR BUCKELY'S ARTICLE IN THE CONVERSATION
The Loughborough-led study provides new insight into why this sizeable informal economy persists, finding that people who initially work cash-in-hand as a temporary measure can become trapped in informal ways of doing business, even when they want to become fully legitimate.
Researchers interviewed business owners in the East Midlands, working in areas including construction, plumbing, hairdressing, car repairs, landscaping and electrical work.
For many, informal work was initially a way to test whether a business could succeed without immediately taking on the costs and risks associated with formally running a company.
Most of those interviewed described informality as a provisional and strategic starting point, one that let them test ideas, build up money and establish customer demand. All said that at some point they intended to become fully formal.
However, the research found that the advantages of cash-in-hand working could gradually become disadvantages.
Most were left trapped in informal business models they could not sustain, and none made a clean transition into full formality.
Leaving 64% becoming trapped by unsustainable informal business models.
“The common assumption is that cash-in-hand businesses are making a straightforward calculation: stay off the books, pay less tax. Policy has largely followed that logic, leaning on detection, penalties and fines to push businesses into the formal economy”. said Dr Buckley.
“One of the biggest problems we found was price,”.
“Businesses could initially offer cheaper services because they were not accounting for tax and other costs.
“Customers then became accustomed to those prices, making it difficult for businesses to increase them sufficiently when attempting to become fully formal.”
The researchers identified three major forces that could keep entrepreneurs trapped
- Pricing routines. Early low prices, set without accounting for tax, hardened into fixed customer expectations
- Local legitimacy. Trust and work came from being known in the community rather than from formal credentials, so going official risked breaking faith with the customers who had vouched for them
- Administrative capability gaps. With one exception, none of the participants had business education beyond their technical trade skills
Dr Buckley said that tackling informal work therefore requires more than enforcement or making it easier to register and pay tax.
He said: “Support should reach entrepreneurs before informal practices like this become embedded.
“They need help understanding pricing, cash flow and business administration from the earliest stages of setting up a business.
“This could help prevent entrepreneurs who initially see cash-in-hand work as a temporary stepping stone from becoming locked into a business model they later struggle to escape.”
Read the paper, From opportunity to entrapment: path dependency of informal enterprise, published in the International Journal of Entrepreneurial Behavior & Research.
ENDS