Does informal economy impede economic growth?

Evidence from an
emerging economy
Introduction

The word informal economy is described through various ways in the existing literature,
such as black, shadow, hidden, irregular, unofficial, unobserved, underground and grey
economy (Gylys 2005). First of all, there is no difference between the informal economy
and the underground economy, because several countries called informal or underground
economy or some other names. However, the approach and objective of both (informal
and underground) are the same. The informal economy is renowned with diverse
appellations around the world. For instance, the Japanese recognize it as ‘Hidden
Incomes’, the French identify it as ‘Travail au noir’, Italy considers it as ‘The Lavorno
Nero’, the English call it ‘Fiddle’, the Swedish Russian term it as ‘Hidden Economy’,
while in Pakistan it has been analyzed as an ‘Hidden Economy’ or ‘Informal Economy’.
Such kind of economic activities, which are not reported in National Income Accounts,
come under the definition of the informal economy. It is also called the subordinate zone
of the overall economy, which can play a positive role for the growth of the overall
formal sector of any economy (Gulzar, Junaid, and Haider 2010).

The informal economy encompasses those activities that necessitate a cost but are
excluded from the benefits and rights of the formal deeds. They may transpire as informal
housing, informal transport, informal industrial sector, etc. However, these activities are
illegal but are not anti-social activities like the drug trade, smuggling, gambling and pork
(Ahmed and Ahmed 1995). The informal economy is expanding its growth with a rapid
pace in Pakistan from the last couple of decades. However, the position of the formal
sector is on the retreat stage. There are many factors, which play to the continuous growth
of the informal economy in Pakistan from the last several years. These factors include a
constant share of the formal manufacture sector in total employment and output, a
continuous increase of informal jobs in total employment level, the formal economy
became the victim of growth share of cash transactions in the overall economy and an
important one is a boost in tax gap estimation. Kemal (2007) concluded the underground
economy with these remarks that the formal and informal economies have a positive
relationship between them because when the formal economy upsurges, then
automatically proliferates the underground economy. For instance, when an organization
appoints some contract and permanent employees, then it is liable to pay taxes for hiring
permanent employees. However, the organization has no panic of taxes for the contract-
based employees. This is one the reasons that most small-level businesses preferred to
hire contract-based employees to evade taxes. To some extent, a collective role of some
partial elements also became the cause for declining the formal economy, for instance,
firm-level behavior has provided such genius clues to identify the trends in the economy,
 tax-registered firms in terms of sale and income tax has declined in the last couple of
years according to the tax experts. The anecdotal proof suggests that the underground
economy production has rapidly increased due to large-scale manufacturing firms that
have either partially or completely shifted their production units. But, the federal board of
revenue (FBR) has caught many significant pieces of evidence in these phenomena.
Kemal and Qasim (2012) reported that the size of the informal economy in 2008 lies
between 74% and 91% of the reported formal economy. It is noted that more than 73.3%
of the informal sector people have got their jobs outside of the agriculture sector in rural areas
than urban areas. Most of them are connected with the construction and transport sector, personal
and social or community services, the trade manufacturing sector and finally wholesale and retail
businesses according to the labour force survey 2008–2009. However, several researchers
conducted their studies to examine the size and role of underground economies with the limited
time period and adopted trivial methods. However, these adopted methods have serious issues,
which were emphasized by Tanzi (1983) and some of the researchers. This study addresses
following the area of the informal economy, such as expansion of the informal economy,
previously used trivial methods or approaches to identify the informal economy, time period or
data for a short time period used in the past studies. This study also uses latest data set from 1973
to 2017, as we did not find any comprehensive study on this topic in the perspective of Pakistan’s
informal economy; we expect that some reports have been published by the Pakistan Institute of
Development Economics (PIDE) and the State Bank of Pakistan (SBP) to highlight this issue.
Moreover, this study also identifies to what extent, the informal economy impacts the formal
economy of Pakistan. Furthermore, how does this informal economy influence the policy design
for policymakers?

Conclusion

The purpose of this study is to re-investigate the several effects of the informal economy
on the level of economic growth in Pakistan. It is observed that from the last couple of
decades, Pakistani economy continuously becomes the victim of the informal economy
due to several reasons such as political instability, war against terrorism, unremittingly
decline in exports revenue and law and order situations. But, several plans launched by
the different provincials and federal ministries are unable to overcome this whole
situation completely. Nowadays Pakistan is going through the economic tumult and
desperately increases in the size of the underground economy as compared to the formal
sector, which is disgusting. The PIDE and SBP have published several reports to
highlight this issue, but we did not find any comprehensive study on this topic, which has
properly addressed this issue and given suitable implication for policymakers. The results
indicate that the informal economy has a significant role in declining the formal sector of
Pakistan economy. Moreover, 56% of the informal economy is measured of total GDP.
This study adopted the ARDL approach as all the variables are stationary on the level and
the first difference with the trend and constant. The Wald F-test revealed that overall
model of this study is statistically significant as lower and upper bounds values are lesser
than the F-test value. This study used Engle-Granger causality and VDM tests to check
the causality robustness between dependent variable as GDP and rest of
independent/policy variables. But, bidirectional causality is measured at 10% level of
significance from LUE to GGD. Furthermore, stability and diagnostic tests show that
model is a best fit and it suffers neither autocorrelation and nor heteroskedasticity. This
study also suggests some policy recommendations for policymakers to reduce the size of the
informal economy from Pakistan. First, the government should implement taxes on the
agriculture sector, as approximately 70% Pakistan population belong to the agriculture sector.
But, Pakistan agriculture sector has not involved in any big direct tax. Second, the FBR takes
serious action against illegal transportation system and puts them under documented system with
a serial number as per provincial and federal level. This action will give a proper income in the
shape of revenue tax through a proper channel. Finally, provincial and federal governments join
hands to eradicate non-documented housing schemes. These housing schemes are working at a
small, medium and large level such as, rent the house, small businesses inside the house and big
housing schemes, which are neither reported nor documented in complete form. Moreover, the
ministry of land and cooperative society will make sure that all resident, industrial and agriculture
sector lands to escape from landlords and fake owners of lands. This activity gives a lot of
revenue in the sense of taxes.