Pakistan’s Informal Economy

M. Munir Qureshi
Pakistan has an abnormally large ‘Informal sector’ – also known as ‘Black Economy,’ ‘Shadow Economy,’ ‘Gray Economy,’ and ‘Parallel Economy’- . Estimates for this sector Range between 35 – 100% of GDP. Conservatively, today its’ size may safely be estimated at 70% of GDP ie US $ 119 Bill (Fixed Factor Costs) and US $ 350 Bill (PPP). An obvious consequence of this state of affairs is significant loss of tax revenue. By definition, the Informal Sector of the Economy is an undocumented sector and earnings of the Player’s in this segment of the economy are not formally ‘Reported’ and no Tax Returns are filed. However it would not be fair to infer that the taxable capacity of this sector is at par with that of the regular, Formal Sector. Such a contention would clearly be simplistic. This is because the major ‘activity’ in the informal sector is small scale, cottage industry based manufacturing, with limited value addition. Mostly family enterprises, subsistence level earnings are usually the norm. To be sure there are some medium scale enterprises too yielding reasonable but not significant income. However

these would not be more than 10 – 15 % of the total manufacturing units operating in the informal sector.

Significantly, out of Pakistans’ total labor force of about 47 million, the bulk of the country’s non agricultural labor force, some 18 million [the agricultural sector accounts for a labor force of 20 million, has no ‘parallel’ or ‘black economy’ as such] , is employed in the informal sector with about 9 million employed in the formal sector.

Looking to its’ composition, the cottage industry based manufacturing segment of the informal sector would have limited tax potential – but certainly not zero.

The fact that the informal sector provides gainful employment to a very large proportion of the working ( non agricultural) labor force – albeit yielding largely subsistence level earnings- is a positive feature as it enables a very large number of working people ( men, women and even children) to earn enough to keep body and soul together. It also gives them a modicum of dignity and improves their ‘self image.’

The loss of tax revenue to the exchequer is however undoubtedly a negative feature.

The growth in income in the informal sector does not find its’ way into the National Income Accounts as such Income is not formally Reported and no Returns are filed. For this reason the published national income of a country is actually understated to the extent of the income generated in the informal sector. Thus when we say that Pakistan’s GDP is $ 180 Bill in 2008 we are not taking into account the Income attributable to the large informal sector. If this income is, say, $ 126 Bill ( ie 70% of the regular, formal economy), then the real GDP of Pakistan in 2008 would be $ 306 Bill (Fixed Factor Cost basis). A large informal sector can be problematic in that it becomes difficult to factor in when planning economic development as very little is known by way of its’ structure , composition and range of activities.

As the informal sector has both positive and negative features, it is also often referred to as an ‘oxymoron.’

Ominously, the informal sector also has certain features that may not be immediately obvious but are nonetheless certainly there and these can be highly de -stabilizing for the regular, formal economy. These features include, hugely profitable, ‘business’ activities of a criminal nature, surreptitiously carried out by a relatively small segment of the total population of the informal sector. These players make a mockery of the rule of law and their ‘business’ activities include – but are not restricted to- smuggling of all kinds of contraband in general demand ( narcotics, counterfeit goods including cosmetics, auto parts, medicines, digital media including information technology software ,movie DVD’s, soft drinks, arms and ammunition and other miscellaneous merchandise). Besides smuggling of these items into the country from ‘exporters’ abroad, a number of these items are even manufactured within the country in small to medium scale, clandestine manufacturing establishments – some quite sophisticated using modern technology. The smuggling of currency into and out of the country by illegal ‘forex’ companies - the so called ‘havala’ networks, under investigation and facing crackdown after 9 / 11 but still functioning are also part of this criminal segment of the informal sector. ‘Corrupt practices’ of government functionaries working at all tiers also generate a great amount of black money in third world countries and Pakistan is no exception. So it is not only black economy ‘businessmen’ who make a great deal of money illegally in developing countries. While we generally tend to gloss over this aspect the fact is that they not only do much harm to the State exchequer by evading taxes on their ill gotten earnings but in a more subtle way, also undermine the integrity of such vital institutions causing considerable long term damage. It is not easy to quantify the illegal earnings attributed to corruption but anyone who been following media reports in recent years can see that the ‘problem’ is indeed on a much wider scale than we are inclined to believe and the billions of dollars worth of ‘assets’ stashed away in safe havens abroad by high profile ‘players’ are testimony to the scale of the problem. It is now no secret that these assets have been contrived in their entirety by corrupt practices and there is indeed direct as well as indirect evidence in the public domain in this context. Authoritative studies detailing the role of banks- including big name multi-nationals- in laundering black money

are also available and anyone who is adept at using a search engine with a web browser on the internet should have no problem in accessing and examining them at his leisure.

Strangely, government too can unwittingly put untaxed money in peoples’ pockets and thereby make a contribution to the informal sector. One example of how this can happen is when the electricity tariff is not at par with what the ‘market’ says it ought to be. Thus when government pays a ‘subsidy’ on the electricity generated thereby offsetting ‘cost’ of generation to that extent – as it has been doing in Pakistan for a long, long, time now- it is in effect increasing the consumers disposable income by equivalent amount and since the receipt of such income is never declared by the recipient, hence no income tax is paid thereon. It thus becomes an ‘informal income’ of the recipient. The income tax statute was not able to cope with this situation prior to the enactment of the Income Tax Ordinance of 2001 and thus everyone got away scot free. The new law is much better able to deal with the matter and it remains to be seen how the tax department deals with the situation.

While ALL informal sector activity is by definition ‘illegal’ because it violates laid down law, it does not follow that it is also ‘criminal’ in nature in the sense that when detected by the competent authorities is necessarily liable to be prosecuted and on conviction those involved required to be incarcerated in a penitentiary. However the segment of the informal sector that includes smuggling and manufacture and sale of counterfeit goods as well as moneys contrived through bribes, kickbacks and commissions illegally ( asin the case of public functionaries) entails serious criminality. This is also the segment that generates significant – at times, huge- extra legal earnings. The players in this segment though relatively few in number – compared to the total population of the informal sector- often have outlandish lifestyles with conspicuous consumption the norm and because they are rich, are also ‘well connected’ they also have serious ‘clout’ that enables them to keep operating in the informal sector with impunity. Why should it be so difficult to track down the informal sector players in Pakistan? The tax authorities in Pakistan have not been able to prosecute and send to prison even a single tax evader in the last (62) years. This, in a country where tax evasion is endemic! Why so?

The main reason is that it is not at all easy to nab any tax evader in Pakistan but the informal sector tax evader is a special breed. For one thing it would be rare for him to have no declared source of earnings at all. If he is a smuggler he would of course not declare his earnings from smuggling. Technically he can as the tax law, on pain of strict punishment, mandates that ALL INFORMATION declared by a taxpayer be kept secret. In practice however no criminal in Pakistan will ever take the chance of making a public declaration to that effect- especially not in a Tax Return. So he does the next best thing and declares all income but that realized from smuggling. He may have agricultural land and if the holding is large enough then he should be able to attribute good income from that source. He could also be running a perfectly legitimate business enterprise and declare good income from it and pay due tax. This would give him legal cover from prying eyes. He could be the legal owner of immoveable property and be earning rental income. Similar would be the position when the ‘player’ is a government functionary in receipt of black money for favors bestowed illegally. Unlike Al Capone, the tax evader today is no ghost to the tax authorities. He has a tax ‘profile’ that he has contrived with great care- often with expert legal help, readily available. Thus it cannot be said that has no legal income to support his lifestyle. In actual fact he is often able to camouflage his illegal income by setting up a façade of legal earnings in which the black money income of course finds no mention. It is up to the tax authorities to peel away this façade and expose the illegal earnings but that requires great skill, motivation, integrity and daring. Unfortunately, in Pakistan these are qualities sadly lacking in tax functionaries. Because of the clout that the informal sector players wield, highly motivated and skilled revenue personnel are required to be deployed to tackle this segment of the informal sector effectively and they need to be supported effectively by specialized intelligence gathering, surveillance, exchange of information and the setting up and effective utilization of data bases containing information pertaining to all kinds of assets and property and financial transactions that have a bearing on income. Above all, their integrity must be above board.

One is reminded of the great, indeed, heroic, effort made by the United States Treasury Deptt / Internal Revenue in the 1920’s in successfully bringing the notorious U.S Black Economy player, Al Capone, to book in a

daring and well planned operation. Indeed interest in the ‘informal sector’ of the economy starts with this landmark incident in US history. The great risks that revenue personnel must take are still there today as there are many such wannabe Al Capone’s operating in Pakistan who are just as ruthless, devious and ingenious as the real ‘scarface’ of yesteryears.

A large number of Pakistan’s existing taxpayers, especially those in the wholesale and retail sale of merchandise, have forged close links with the informal sector. Thus many of the top Departmental stores in posh commercial areas in Pakistan openly display high value goods like crockery and electrical gadgets that have been smuggled into the country. They also sell a great deal of counterfeit merchandise either smuggled into the country or manufactured in the many clandestine units operating in different parts of the country. Many exporters also purchase their goods from the informal sector including garments, sports goods and leather goods. A plethora of ‘Bara’ markets – euphemism for ‘smuggled goods market’- do a roaring business in every major city of the country. The original ‘Bara Market’ was, not too long ago, restricted ONLY to a suburb of Peshawar city.

Unwittingly perhaps, the large, private, banking sector in Pakistan including the, so called, “exchange companies” and “Hawala” networks, routinely launders a great deal of the black money generated in the country. Corrupt businessmen, politicians, bureaucrats, Defense personnel- all are involved. In Pakistan many of the ‘Hawala’ networks have been hijacked and compromised by drug traffickers, corrupt officials, money launderers, organized crime and terrorists. Pakistani Hawala networks alone move anywhere between 5 – 10 billion dollars annually. In 1999 Institutional Investor Magazine identified 1100 money brokers in Pakistan and transactions that ran as high as 10 million US dollars apiece. Most Hawala networks are controlled by Pakistani and Indian expatriates and immigrants in the gulf. Indeed one explanation for the plethora of private banks in Pakistan, including some ‘big name’ multi-nationals, is that Pakistan is perceived as ‘fertile territory’ with plenty of black money there for the taking by private

banks that are well resourced and daring. True, under the ‘know your customer’ policy the State Bank of Pakistan mandates that due diligence be shown by all Banks when dealing with customers and especially when new customers are allowed to open accounts to ensure that moneys of dubious origin do not find their way into the Bank. This requirement has been in force for the last few years now and apparently it has had a salutary effect insofar as black money cannot now be brought in as brazenly as before. But there is reason to believe that human ingenuity being what it is and the pressure to being in additional funds being there it is too much to expect that the ‘KYC’ policy has put an absolute end to bring in ALL ‘tainted money.’ ‘KYC’ oversight too is perhaps not as rigorous as it ought to be so all said and done loopholes are there and will be found and are being found all the time to find a way around the ‘KYC’ requirement. Effective oversight is especially difficult in the case of the so called ‘exchange companies’ – even those ‘authorized’ to transact business in the movement of foreign exchange. Contrary to popular opinion, informal sector players do not stash their illegal earnings at home – at least not ALL of their earnings. Most players, except may be those placed at the bottom rung of the subsistence level earnings ladder, open a bank account and deposit a good part of their takings there. The account(s) may or may not be in their actual name. In any case tax authorities are barred by law from routine access to any bank account. And the banks are bound by confidentiality provisions in banking laws from disclosing any information regarding their clients. Tax authorities may requisition information in specific cases only. They have to furnish the exact name and precise account number of a bank’s client. More often than not there are gaps in the information that may be available to tax authorities. Either the name may not match and / or the account number may not tally. This mismatch may be further complicated if the bank account holder in question involves a fictitious identity. Many clients have more than one account and it is certainly not impossible to set up an account in a fictitious name especially if the client is a moneyed person and is in a position to give the bank a hefty deposit. He would be then perceived as a good customer and various ‘services’ gladly provided. After all, commercial banks are commercial ‘business’ enterprises and clients with ‘resources’ are vital to a bank’s profitability and growth. The (80) million or so bank account holders in Pakistan - when the number of registered taxpayers arehardly (3) million!)- are testimony to the great inroads made by informal sector players in the banking sector. While it is a fact that many account holders have more than one bank account , still

the gap between the number of bank account holders and registered taxpayers is too obvious to ignore. A large proportion of the black money generated in Pakistan has been sunk in real estate and property development. Huge profits by way of capital gains have been made by speculators and they have not had to worry about any effective system of capital gains taxation at the federal level. The taxation of immoveable property is a provincial subject in Pakistan and undervaluation of property is routine for registration purposes. Largely as a result of the intense interest in this segment of the economy, prices have been bid up to astronomical levels in the recent past having come down only after the worldwide financial crisis of 2007. There has also been significant flight of resources (contrived largely through black money) to Dubai from Pakistan for investment in property triggered by a housing bubble there. That bubble has now burst ( as all bubbles eventual must). Finally, billions of dollars of Pakistani black money has been kept in safe haven banks abroad. It has been estimated that the total hoard of Pakistani origin dollars in save haven banks in foreign jurisdictions is probably enough to liquidate the country’s foreign debt of $50 billion plus!

Strange though it might appear, prior to the enactment of the Income Tax ordinance of 2001 – when the Income Tax Ordinance of 1979 was in force and before that, the Income Tax Act of 1922 (as adapted in 1947) in which a similar position obtained - there was no provision in the tax statute requiring a taxpayer to maintain accounts – of any sort. When formally called upon by the tax assessing authority to explain the declared version as per the Return of Income filed by him In fact he was well within his rights to say that he was not maintaining any sort of record pertaining to the business transacted by him and the tax assessing authority was then obliged to make an assessment of the taxpayers income on the basis of whatever information was available at the time regarding the taxpayers business affairs. More often than not such information was minimal if not a complete blank. At best he would direct the circle inspector to conduct a ‘spot enquiry’ and submit a report which again was almost always sketchy. Thus hampered the assessing officer was obliged to make an ‘educated guess’ and ‘determine’ income accordingly. Naturally this more often than not greatly facilitated the taxpayer. More seriously though, this lacuna in the statute encouraged undocumented transactions. And undocumented transactions are the lifeblood of the informal sector. Coupled with the fact that tax laws were enacted – like the notorious

Foreign Exchange Bearer Certificate Scheme of the 1990’s (FEBC’s) and the repeated so called, Tax Amnesty Schemes- that actually encouraged holding moneys contrived by less than legitimate means, the absence of any statutory obligation to maintain records/accounts of any kind by a taxpayer gave a huge impetus to tax evasion. Little wonder then that the informal sector has grown by ‘leaps and bounds’ in Pakistan.

The Income Tax Ordinance of 2001 (effective with effect from July 2002) has for the first time made it mandatory for a taxpayer to maintain accounts as prescribed under the statute/Rules. Non compliance attracts stiff penalties under the statute. Deterrence to non compliance is thus built into the statute. This is most certainly a big step in the right direction- albeit a step late in coming. However it remains to be seen how far it will facilitate revenue mobilization. .

While loss of tax revenue is an obvious negative feature of the informal sector, a less obvious feature, but one that has enormous significance for the future health of the economy, is the erosion in the overall competitiveness of the economy.

A country, like Pakistan, with an abnormally large informal sector, will have a very large number of manufacturing enterprises of all kinds that cannot by their very nature properly exploit internal and external economies of scale. Modern manufacturing technology is not put to use and instead refurbished and improvised technology is employed. Very often technology discarded as ‘junk’ abroad is imported as ‘scrap’ and then re-engineered and put to use, often perforce. There is no access to any kind of research and development and of course there is no concept of modern management practices. The end product manufactured in these ‘improvised manufacturing enterprises’ is bound to have deficiencies in quality and unit price will also usually be on the higher side.

As stated earlier, many exporters in Pakistan purchase finished products as well as semi finished items from the informal sector. This is especially true in the case of garments, woolen carpets, sports goods, and leather goods. In the past Pakistani exporters were uniquely placed to export such items for a while when there was not much competition and made

good profits but now with countries like China, India, Thailand and Bangladesh offering stiff competition taking advantage of relatively more elaborate manufacturing infra structure – especially in the case of China and India- Pakistani exporters are finding it difficult to compete and the informal sector is becoming a clear liability.

In order to have an idea of the growth of the informal sector over time, the increase in consumption of electricity vis a vis GDP growth is a reliable ready reckoner. Interestingly, worldwide, the consumption of electricity is seen to move in ‘lockstep’ as it were, with growth in GDP and to have ‘unitary elasticity’ relative to GDP. Thus a 5% growth in GDP is normally expected to lead to a (more or less) 5% increase in overall electricity consumption. So consistent and direct is this observed relationship that it has become a standard to estimate electricity generation capacity requirements over time, given the projected growth in GDP. An added spin off of this relationship is to use it to observe the growth in the size of the informal sector particularly in developing countries. Thus when electricity consumption is seen to outstrip growth in GDP, the increase is attributed to increased informal sector activity. The extra demand for electricity ( ie over and above the expected ‘lock step’ growth in electricity consumption relative to GDP) emanates from the increase in electricity consumption from an ‘enlarged’ informal sector yielding higher income for the players.

Quantifying the growth in electricity consumption in different time frames and relating the same to the growth in GDP will help appraise the size of the informal sector by extrapolating ‘base year’ size of the informal sector by the rate of differential increase in electricity consumption over GDP.

According to published WORLD BANK DATA per capita electricity consumption in Pakistan has increased from 6 Kwh in 1947 to 63 kwh in 1970 and 520 kwh in 2004. Thus between 1970 and 2004 ( the time frame relevant for appraisal of the informal sector in Pakistan), there has been a 725% increase in electricity consumption per capita. In the same time frame,, per capita income has increased from US $ 170 to $ 640, that is by 276%. The differential increase of 449% is attributable to the increased demand for electricity emanating from the informal sector.

The shortfall in electricity generation vis a vis demand in Pakistan since 2008 is creating serious problems for formal and informal sector industry. In the case of the informal sector some 25000 power loom operators employing more than 500,000 workers face the threat of under capacity operation or even closure in some cases because of frequent and prolonged interruption in the supply of electricity (load shedding). Most of the power loom operators are placed in the informal sector and they manufacture something like 50% of the total fabric manufactured in Pakistan, a large proportion of which is consumed in the garment manufacturing segment of the economy. This segment has a pronounced export orientation and the interruptions in the supply of electricity will surely lead to a fall in export earnings. Unlike composite textile mills that have their own electricity generation capability, the informal sector power loom operators rely almost entirely on electricity available on the national grid. While some of these units might actually be “stealing electricity” from the grid – by using illegal ‘hooks’ for instance (called ‘kunda’ in the vernacular)many more tamper with the electricity meters in connivance with electricity meter inspectors who gladly ‘supply’ their ‘expert’ meter tampering services for a ‘fee’ (bribe).This has spawned a new class of rich meter readers and has made meter reading a much sought after ‘profession’ for those placed in the under privileged segments of society in Pakistan. The scale of this activity can be gauged from the fact that some 25 – 30% of the electricity generated is “lost” in that no revenue is generated as no ‘Bills’ – for electricity consumed- have been issued. This is a huge loss indeed for WAPDA and PEPCO (Water and Power Development Authority and Pakistan Electric Power Company, respectively – the two organizations responsible for generation, transmission and distribution of hydel and thermal based electric power in Pakistan).

Power loom operators are not the only ones guilty of ‘stealing electricity.’ In fact this is almost something of a national pastime and virtually anyone who can do so will not miss out on an opportunity to get some electricity at least for free. The extremely high, electricity tariff has a lot to do with this. On a Unit basis (Kwh), looking to per capita income, the electricity rate structure is probably the highest in the world. In fact it is prohibitive. It is 60% higher than in India and 40% higher than in Bangladesh. And practically no one can get an electricity connection at the ‘official price.’ An informal payment has got to be made in almost every case over and above the official cost to the consumer.

So it is the prohibitively high electricity rate structure that is at the root of the endemic stealth of electricity. The impact of the high tariff has been cushioned for a long time by a significant subsidy given by government to offset the burden on the consumer. That however would no longer be feasible as international institutions giving economic assistance to Pakistan insist that all subsidies be removed as they are a distortion in the system and the consumer bear the actual burden of the facility at ‘market price.’ The government is doing what it can to delay complete removal of the electricity subsidy as it knows only too well that a public backlash is inevitable. But for how long can matters be held in abeyance?

The present mix of thermal and hydel generated electricity (65:35) makes it inevitable that the rate structure be pitched high as thermal electricity is particularly expensive because of the rising price of oil. What complicates matters is that in Pakistan the so called (multi -national) Independent Power Producers (IPP’s) have, since the nineteen nineties when agreements with them were first formalized, been able to negotiate tariffs for supplying electricity that are seen by many to be prohibitively high. At full capacity these seventeen IPP’s are able to put something like 3500 – 4000 MW of thermal origin electricity on the national grid which given the total installed capacity (thermal and hydel) of 19000 MW is of considerable significance. However most of these units are not operational due to accumulation of huge arrears of payment from government. As a result the IPP’s are not able to pay the Pakistan State Oil Co (PSO) for deliveries of furnace oil used in their generators. The magnitude of the problem can well be gauged from the fact that one such large IPP, HUBCO, is owed Rs 50 Bill from government as of 1st June 2009 and HUBCO in turn owes PSO Rs 39 Bill for past deliveries of furnace oil. This ‘circular debt’ problem has defied solution to date but government has made a commitment to clear the outstanding payment to HUBCO by august 2009.

What is ironic however is that Pakistan is sitting on 180 billion tons of coal of reasonably good quality in Thar, Sindh province and has made no attempt to exploit this valuable resource in electricity generation. This coalfield is probably among the largest in the world and its’ existence has been known since 1958. Presently 65% of the total electricity generated in Pakistan is from thermal units that mostly use furnace oil which of

course is priced high given the escalation in oil prices. Had a bold decision been taken at the right time to tap the Thar coalfield and to use coal in the thermal units for electricity generation, we would not be confronted with the severe crisis with which we are presently burdened. Matters can still be remedied provided the decision is taken to exploit Thar coal and to convert the existing thermal units to use coal instead of furnace oil and natural gas. Unless this is done, there is no way that Pakistan can deal effectively with the prohibitively high electricity tariff which is the root cause of widespread electricity theft and is holding up industrial development – both in the formal as well as the informal sectors.

In the past, Pakistan’s high tax rate structure was seen as an important causal factor in the growth of the informal sector. Indeed, with the highest marginal rate of tax for Individual Income pitched at a prohibitive 98% (in the latest fifties) there was little incentive to declare true income and pay a rate of tax that was rightly perceived to be confiscatory. Similarly, in the case of corporate income, tax rates were not only high but pitched at three different tiers for public limited, private limited and banking companies, respectively. Banking companies were subject to the highest tax tier and public limited companies to the lowest. However thankfully all that has changed over time and, income tax collection has increased sharply (surpassing a trillion Rupees in fiscal 2007-08) as tax rates have fallen bearing out Professor Laffer’s ( nay, Ibn e Khaldun’s ! ) proposition that (a) revenues are increased upto a point with each increase in tax rate and once that point has been crossed [ roughly the midpoint on the Laffer Curve) tax rate increase leads to a fall in revenue and (b) for each quantum of tax collection there is a high rate of tax as well as a low rate of tax and it makes eminent sense to opt for the lower rate of tax to achieve that quantum of tax collection because the lower rate of tax is associated with economic benefits that may not be immediately perceived but that are very much there and these benefits encourage risk taking and lead on to innovation and increased productivity and ultimately to an escalation in income and hence a higher economic threshold.

Presently, Pakistans’ corporate and Individual income tax rates are at their lowest ever ( 35% and 25% respectively) and the discriminatory rate structure for different types of corporate earnings has also been done away with. Pakistan government policies have also had a lot to do with the growth of the informal sector. Take for example the practice of allowing a so called ‘Amnesty’ on black moneys held by people allowing them to get it ‘laundered’ (whitened) by paying nominal income tax. A number of such schemes have been announced by government over the years and people have almost become ‘conditioned’ as it were to wait for the next amnesty

scheme and get their black money hoard whitened! Such expectation creates a mindset that is highly detrimental to the development of ‘tax consciousness’ which is central to effective ‘voluntary compliance’ with tax laws. Besides periodic tax amnesty schemes, special financial instruments like the ‘foreign exchange bearer certificates’ and the ‘foreign currency bearer certificates’ have been floated with a ‘no questions asked’ policy that actually made it possible for people holding black money to earn good interest on their Black money holdings giving Pakistan the dubious distinction of being the only country in the world where there was a government sanctioned premium on holding black money! While the plethora of ‘money whitener schemes’ are gradually being phased out, a great deal of damage has been done already and governments stated resolve not to repeat such costly ‘mistakes’ in future needs to be tested before it can be said that lessons have actually been learned. Weaknesses in tax administration are also an important reason why it has been so ‘safe’ for a very large proportion of the working (non agricultural) population to operate in the informal sector with virtual impunity over a protracted time frame. Perception is said to be 9/10ths of reality. If the ordinary man in the street is of the opinion that State Institutions set up for revenue mobilization and economic vigilance are inept, corrupt, apathetic and lethargic in the discharge of their duties, he will most certainly take advantage of the situation. This of course means that he will evade taxes. But then institutional malfeasance is not confined to tax matters only. Thus if the police force under performs, crime will rise as criminals take advantage.

Tax personnel either lack the necessary expertise to understand the informal sector phenomena and track down players especially those engaged in the criminal segment of the informal sector where the bulk of the supernormal profits are generated or have been seen to be susceptible to monetary inducement (bribes) to permit such activity and let the players get away with non reporting of income and resultant tax evasion. Some important first steps have indeed been taken to motivate tax personnel to resist the temptation to accept bribes such as doubling of the basic emoluments of officers and support staff. However much more needs to be done.

Pakistan desperately needs to deal effectively with the worst features of the informal sector. The miserably poor tax to GDP ratio – currently

pitched at an abysmal 9% or so- and the extremely narrow tax base – hardly 3 million taxpayers regularly filing Returns- are cause for grave concern. Pakistan desperately needs to be able to generate revenues to meet the pressing needs of economic development, Defense and debt liquidation. A concerted effort will therefore be required to achieve this objective and tackling the challenge of the informal sector is a key element in this effort.

The only truly effective long term solution to the menace of the black economy with a preponderant criminal segment to it is thoroughgoing documentation of the economy and the setting up of ‘data bases’ coupled with the use of specialized computer based ‘software’ to collate and analyze the data on a real time basis. Mere collection of data is not enough. It is only when there is a demonstrated capability to sift the data and get to the tax evader that there will be a deterrent effect on the public. In our time and age the technology that can make all this possible is there in the global market place. It may not be cheap but the cost is not prohibitive and given the enormous benefits to the economy an investment in such technology is most definitely feasible. Required more than anything else however, is a sternly committed executive will and an unwavering determination to recognize and deal with the problem. Important beginnings have been made in Pakistan but more, much, much more, needs to be done. In India, during the Indira Gandhi emergency rule imposed in 1975, the Hawala networks were specifically targeted and ruthlessly dealt with and ultimately eradicated. Similarly in Bangladesh, Philippines and Sri Lanka the governments have put an end to their operations. There is absolutely no reason why the same cannot be replicated in Pakistan.


Quantifying the Pakistan Informal Sector.

UnderGround Economy in Pakistan- vital statistics
Year UGE SIZE UGE – Tax Evasion
UGE-% of GDP

1978 1983 1988 1993 1998 1999 2000 2001 2002

41.832 104.759 192.752 470.124 1449.891 1146.839 1094.052 1298.233 1388.064

Bill Rs

4.644 13.361 26.672 62.913 193.397 152.499 141.077 169.025 175.472

Bill Rs

23.51 28.75 28.54 35.27 54.52 39.03 34.76 38 37.25


The results of one researcher’s efforts to quantify the Informal Sector in Pakistan are tabulated above. The Informal Sector as a matter of economic significance is seen to have arisen in the 1970’s and to have peaked in the closing years of the 20th century. This is understandable given the state of fiscal policy in that time frame. However there is no unanimity here and the size of the informal sector has been appraised differently by different economists and researchers. Because of data constraints analysis of the size of the informal sector is difficult. However the fact that demand for electricity has registered a sharp surge in recent years is a factor of considerable significance as, given the ‘normal’ lock-step relationship between electricity consumption and gdp growth over time, the present asymmetry is being related to a considerable increase in the size of the underground economy. The high growth in the financial services sector as well as money supply vis a vis demand and time deposits in banks (M2) also lends support to the view that the UGE has grown much faster than what the researcher’s might cautiously calculate. In 2009, informed opinion on the matter is inclined to hold that the informal economy is at least as large as the regular economy. Some even hold that it could be larger than the regular economy.
Source : M. Ali Kemal, Underground Economy & Tax Evasion in Pakistan -A Critical Evaluation.

The Informal sector is present in ALL countries, no matter what their scale of development. However, in general, the more developed an economy, the smaller the size of the informal sector – and vice versa. Also – again, in general- the greater the size of the informal sector, the more inequitable is the distribution of income ie the ‘higher’ is the gini coefficient.

In general, the greater the size of the Informal sector, the lower is the tax to gdp ratio.

Factors giving rise to the informal sector
1.Inequitable distribution of Income. 2. Inequitable Tax System. 3.Prohibitive taxation. High tax rate structure. 4.Sociological factors. Colonial legacy. 5. Perceived disconnect between payment of tax & matching benefit to the payer. 6.Institutional decay.


In general, significant inequalities in the distribution of Income are associated with relatively large Informal Sectors.

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