(FORTUNE Magazine) – Gary McLaughlin, an electrical contractor in San Francisco, recently got a call from a real estate agent who needed a house rewired before its new owners moved in. He checked out the house and faxed in his bid. McLaughlin, 31, employs two electricians and a bookkeeper and says his bid was about 25% less than what larger contractors would charge. But it wasn't low enough.

Later that day the agent called back and asked McLaughlin if perhaps he'd made a typo on his estimate. "I have two other bids here," she said, "that are half what you're asking." The difference, McLaughlin told her, is that he has a license and pays workers' comp insurance and payroll taxes on his employees, who are in the country legally.

"Well, that isn't my problem," the agent said. McLaughlin lost the job.

"I get underbid by contractors who bring in off-the-books guys and family members," McLaughlin says. Why? His competitors operate in the strategically privileged business environment known as the underground economy. Made up of day laborers, illegal immigrants, even a business owner's relatives, this stealth workforce in the U.S. is closing in on the $1-trillion-a-year mark, according to one expert's estimate. Unburdened by pesky taxes and government rules, the underground economy is growing faster than the one populated by legitimate business owners and workers.

On this warped playing field, entrepreneurs such as McLaughlin find it ever harder to compete. Policy analysts are starting to pay attention to the problem, and the result could be an onslaught of regulatory activity--focused squarely on the small-business sector--that is likely to make life harder for all business owners.

The underground economy includes illegal businesses such as the narcotics and sex trades. But off-the-books immigrant labor is by far the biggest component. According to a recent Bear Stearns report, the nation's illegal-immigrant population, estimated by the Census Bureau at about nine million, is actually closer to 20 million. Bear Stearns ignored data from the census and instead examined indicators such as the explosion in housing starts and the demand for public services in high-immigration states such as Arizona, California, and Texas. One eye-opening statistic: Mexican nationals working in the U.S. sent home $13 billion last year, the second-biggest source of funds for Mexico after petroleum exports.

What's more, illegal immigration is on the rise, and the gatekeepers suddenly have bigger concerns. In 1997 the Immigration and Naturalization Service made nearly 18,000 arrests of employers who hired illegal foreign workers. In 2002 the newly named U.S. Citizenship and Immigration Service was folded into the Department of Homeland Security, which is much more concerned with thwarting terrorists than job seekers, and made fewer than 1,000 such arrests.

The IRS estimates that $400 billion a year in federal tax obligations goes unpaid thanks to off-the-books business practices--a number that nearly matches the 2005 federal budget deficit. The House Ways and Means Committee has scheduled hearings this congressional term on ways to attack the underground economy. The Bush administration has asked Congress for a $500 million budget boost for the IRS's enforcement division for 2006.

"The backlash is coming," says Mike Shaw, assistant state director of the National Federation of Independent Business's branch in California, home to an estimated third of the nation's illegal immigrants. In his new budget, Governor Arnold Schwarzenegger announced the formation of a 61-person task force to crack down on the state's myriad underground operations.

"What they [the INS] don't do becomes our responsibility," says Rick Rice, undersecretary of California's Labor and Workforce Development Agency, who will help assemble the task force. It will focus on companies of 100 employees or fewer, chasing down leads on unreported cash-only commerce and sifting through databases for tipoffs such as workers' compensation claims against previously unknown employers.

Rice scoffs at the notion that the crackdown could make life harder for legitimate businesses. But Shaw notes that any increase or change in regulation affects small businesses disproportionately, and would especially threaten industries such as agriculture, apparel, construction, and hospitality, which depend on immigrant labor. The result could be further losses of business to overseas competition, coupled with escalating costs at home. As the Bear Stearns report points out, an economy that appears to be enjoying a productivity miracle may instead be relying on a shadow labor force that produces a visible output while its workers remain invisible.

President Bush rankled anti-immigration forces last year by proposing a program that would extend legal temporary-worker status to currently illegal-immigrant workers for as long as six years. Part of Bush's stance is shrewd politicking--thanks largely to his immigration platform, he got a big lift from Hispanic voters in 2004. But it's also pragmatism, especially if Bear Stearns's 20 million figure is realistic. The AFL-CIO, which for years saw itself threatened by the influx of cheap immigrant labor, views the stealth labor force these days as a target for organizing. With Ted Kennedy as its advocate in the Senate, Big Labor goes a step further than the administration's policy, stumping for long-term illegal-immigrant workers to receive legal-resident status.

At the local level, scores of cities in California and other high-immigration states have launched day-laborer programs that match undocumented workers with employers for short-term projects such as house painting, yardwork, and construction. Tax rules on limited-term employment are murky enough for the municipalities to give the programs their stamp of approval, and the programs help workers obtain tax identification numbers.

Although he gets underbid by competitors using underground workers, McLaughlin, the San Francisco contractor, says he has found a viable niche: Homeowners who want proof that the contractors they hire are licensed and covered by workers' comp policies but don't want to pay the prices that larger contracting firms charge. Until the government settles on a way to assimilate the stealth labor, McLaughlin says, he'll refrain from turning to the day workers who line the sidewalks of San Francisco's César Chávez Street, gesturing to passing trucks in hope of landing a job for a few hours. But once he can hire them legally, he just might. "The work ethic of those guys is unbelievable," says McLaughlin, who regularly logs 12-hour days. "They put me to shame." ■

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