INFORMAL ECONOMY AND TAX EVASION IN PAKISTAN

TECHNICAL REPORT
Prepared By:

Muhammad Summar Khalid Farooq

2017-AG-1979
MSC Economics

University of Agriculture, Faisalabad

 Contents

I. Abstract

II. Introduction

III. Estimation methods of Informal Economy

i. Methods
1. Direct - Methods
2. Indirect - Methods
ii. Previous Estimates of Underground economy for
Pakistan

IV. Methodology for estimating Informal economy

- Data
- Results & Findings
V. Conclusion

VI. References
 Abstract
There has been wide broadening conversation about the underground/shadow
economy/casual economy in achieving the proceeded with financial turn of
events and improvement. Hence approach makers and academicians have
endeavored attempts to check size of hid economy/casual economy and to
examine its causes, issues, sway on macroeconomic components . Regardless,
there is an agreement among system makers that better macroeconomic game
plan itemizing and its real execution are at risk to suitable organization of the
related issues of the underground economy. In Pakistan casual economy all
around contributes about 30% to half to the general GDP. In this report I have
assessed the size of casual economy of Pakistan using charge review based
strategy and evaluated the size of casual economy to be around 34%
Introduction
The term casual/shadow/disguised/dull/underground economy is yet to be
portrayed unequivocally. An ordinary definition used may be " unmeasured or
untaxed budgetary activities". In any case, it doesn't have any kind of effect the
way wherein it is portrayed casual economy is deficiently reflected in the
absolute compensation and consequence of a nation. In this report the term
casual economy/underground economy is used to show those activities which
are masked from obligation specialists attempting to maintain a strategic
distance from quick and underhanded costs. In strategies those trades which
are not recorded in power estimations. Therefore, it rejects unlawful trades,
for instance, drugs pay and pay from wagering in light of the fact that such
activities are primarily unrecorded in power experiences.

This division holds unprecedented hugeness in the headway of any country. As

showed by reports of the International Labor Organization the casual economy
in Pakistan is gigantic where masters have compelled access to work
government assistance administrations. The work power survey drove by the
International Labor affiliation communicates that the work outside proper
division during the budgetary year 2018 is about 68% of full scale work in non-
cultivating fragment. The key piece of work in the casual economy are retail
trade creating, organize/social and individual and individual organizations,
improvement and transport. There is a strong need to the compensation
earned by these casual fragments in the proper wheel of the economy.

Regularly, discretionary data wellsprings of money related activities and

announced trades are being used in national record course of action. The
frailty to trap the covered trades and nonattendance of accurate definition
make the estimation of casual economy problematic. It is very basic to have
thought of casual economy since its world is hardly reflected by the official
figures of monetary pointers i.e advancement, usage , hypothesis and
joblessness. These subtleties are used to figure polices relating social
government assistance tasks and improvement adventures. In case these
figures aren't right it would incite inappropriate technique responses and
inefficient utilization of benefits.

METHODS OF ESTIMATING UNDERGROUND ECONOMY

Direct Methods:

Survey Method:

Deliberate review technique is that strategy where respondents are

approached to uncover their salary, consumption or work status. Intentional
study technique has been scrutinized as a result of the way that the majority of
the cases respondents won't uncover their uncover their salary honestly.

Tax Audit:

In this technique unequivocal assessment of a self-assertively picked trial of

resident's yearly returns and wealth enunciations are driven. This system has
also been used in USA under management of Commissioner of the IRS (Internal
Revneue Service). This method chooses the size of casual economy by
evaluating the extra between compensation announced for appraisal purposes
and that conscious in the wake of examining the yearly returns of individuals.

Indirect Methods:
These methods endeavor to discover the follows, which the underground
economy leaves. The most used circumlocutory system to review the size of
the underground economy is monetary philosophy. Different meandering
systems consolidates work - promote approach, fiscal - approach, etc.
Backhanded strategies are examined quickly as under:-

Monetary approaches.

So as to evaluate the casual economy these methodologies depend on the

suggestion that reason to stock money is either support diverse sort of illegal
exercises just as it is additionally methods for loading somebody increases
gained through uncalled for implies. In casual economy individuals for the
most part embrace exchanges in real money just to stay away from the odds of
discovery.

To survey the underground economy financial systems rely upon the

explanation that the protected reason to keep money is either to down various
kinds of unlawful activities, or as a techniques for taking care of the profits of
one's abhorrent gotten gains. This gathers the trades working at a benefit
economy are financed generally with cash to diminish the chances of
revelation. Different adjustments of the financial strategies being used for the
estimation of the casual economy are as under:

(i) The money (cash) accessible for use to request stores.

(ii) (The Quantity Theory of Money).

(iii) The certified receipts which are of huge group.

The Guttmann’s First Approach:
Alongwith previously mentioned suspicions, Guttmann (1977) additionally
accepted the what we decided as proportion of cash to request stores, it didn't
change if the developing dark economy is missing. He furthermore taken the
assumption that during the hour of 1937 – 40 there has been no easygoing
economy and thusly extent of cash which is accessible for use extent to
demand stores remained consistent during the said period. Generally, the
acknowledgment was converse about this period. The maker used intrigue
store as denominator. What this tells is that development in extent urges
people to pull once again from premium stores and hold more money. In any
case, the opposite way around is moreover suitable.

Tanzi’s First Approach:

Tanzi (1980) showed significant perception of estimation of casual economy in
an earlier information on Cagan (1958). Cagan showed certain components
which have an effect over the money extent i.e advance expenses, yearly
obligation rates, certified per capita pay and he watched these elements to be
generally critical in explaining the cash extent.

Tanzi , after the revelations of Cagam, in (1980) associated the cash extent with
paces of costs and from that point on used it to check dull economy of United
States. As opposed to simply using the intrigue store as divider Tanzi used M2
as divider. In any case, the legitimate elements used joins, charge evaluation
rate, remuneration offer and pay rates/favorable circumstances, real per
capita pay, and financing cost on time stores. Tanzi, says that business charge
and different roundabout obligations are difficult to keep away from , along
these lines, he simply used individual appraisal rates which are quick costs and
avoided successfully.

The issue of using simply intrigue stores overpowered by CC/M2 as divider.

However, the three examination of doubts of cash related technique that cash
trades are simply happened in dull economy and that there has been zero dim
economy before starting period taken, and that the speed of income in casual
and formal economy is undefined are up 'til now genuine.

The second Approach - Transaction Method of Monetary Approach:

The creator expected that unregistered and sporadic buys are additionally
done through bank stores rather utilizing of cash. However, the remaining two
assumptions despite everything hold there. He has taken the association
between irrefutably the monetary estimation of trades and with pay evaluated
of the economy. Trades speak to all the widely appealing product and reused
items as well, while the compensation estimation joins freedom of definitive
organizations and items that are made in one year. That infers that
qualification between the certified GDP and hard and fast estimation of trades
would be the easygoing economy.

Three suspicions on which this methodology is based are : (I) That casual
economy during the time of 1939 was zero ii) on the off chance that there is an
expansion in apportion, at that point it can altogether be ascribed towards
increment in the size of casual economy. Iii) the figuring performed for
exchanges esteem is that , normal deals is increased with request store stocks
and it is included with the cash stock being duplicated with normal money
turnover.

Gauge of Feige were higher when contrasted with that of gauge of Tanzi and
Guttmann

There is a restriction in utilizing this technique, that the qualities which were
considered in this methodology in regard of exchanges being under taken in an
economy may not be convenient accessible in explicit timeframe. These
qualities are significant for estimation of cash turnover figures. Feige played
out this by utilizing figures that were determined by Laurent ( 1979 ) which
were determined so that a unit of cash ( times) utilized before it is being quit
coursing and partitioned by money normal lifetime.

The Third - Approach ( Phenomenon of Big Bill)

As showed by this view, the essentialness of huge division fiscal declarations
advancement in the stream as an element of all out of money in the course
extends the casual monetary activities. This strategy doesn't give the size of
the casual economy, which may figure using various strategies. This approach
determines if casual economy exists or not. This view point relies upon the
recognition that the gigantic division notes have extended even more rapidly
that money notes, and thus, extent of cash course as whole extended.

Assumptions and Criticism of the Monetary Approach

(a) Principle presumptions on which these methodologies are based and

their analysis are as under:-
(b)
 (c) (a) It is accepted that the main mechanism of exchanges in casual
economy depends on money. It has completely disregarded the effect of
deal exchange just as exchanges including pay off , generally if the pay
off is in the structure other than money notes.
(d)
(e) Smith (1986), scrutinized the exactness of such suspicions.
(f)
(g) (b) These approaches dependent on the supposition that there is no
casual movement win before time of benchmark period. Along these
lines, it implies that period which is set as benchmark period ought to be
(h)
(i) (c) assume that there is no underground financial development
before the start (benchmark) period. Along these lines, picking the
benchmark time period is principal in the estimation of the underground
economy, and the benchmark time span should be significant and must
accord situation similarly as history of the country. It is furthermore
acknowledged in this approach speed of cash in easygoing and formal
economy is undefined. This is solidly negated in light of the fact that
most of the budgetary trades rely upon cash if there ought to emerge an
event of easygoing and formal economy.

Income and Expenditure Approach

Dilnot and Morris recommended consumption and pay approach, expressed

that when use brought about surpasses pay during the one time frame, the
buyers will in general include in casual monetary movement.
This methodology is material both at the degree of family unit and at the
degree of National economy.

Date of family use was utilized at the degree of family unit of 7200 families,
and there pay and consumption was thought about. This methodology is
dependent upon analysis on the ground that ordinarily use is more in the midst
of low degree of business, ailment, and this may not win during the Boom time
frame. Similarly, individuals who are resigned fund their costs through
investment funds and along these lines their salary surpasses consumption.

In addition, the way that consumption surpasses the degree of pay of one
individual doesn't generally give proof of disguise of pay. All together for this
way to deal with succeed, implies are required to be recognized so purchasers
having authentic salary might be avoided from this domain.

Purposeful audit was driven which known as FES. Pyle (1989) made
investigation on the use of FES that those individuals who are locked in with
unlawful activities may not take a premium. Furthermore, all around the pace
of response is moreover 70%, and if remaining rate are related with enormous
casual trades than veritable estimation of economy may not choose using this
procedure. Generally, people who are autonomously utilized busy with casual
activities and make light of their results. People tend to under report their pay.

In any case, this philosophy progressively productive in assessing shirking of

little scope pay families. [Dilnot and Morris (1981)].
Criticism:
It is everything viewed as recognized that this method is apparently not going
to make exact examinations of the degree of diminish economy improvement
considering the way that by and large individuals tend to over report their use
usages and under report their compensation rates. Other than this there could
be enumerator and the respondent botch. This is especially if there should
develop an occasion of Pakistan.

At the national estimation, the capacity between the compensation and

utilization degrees of GDP is gathered as the decrease economy or beginning
holding up unpredictability (IRD). This procedure isn't the most lofty approach
for assessing the size of the underground economy. Bleeding edges (1982)
used this system and assessed the size of underground economy for Sweden.
In like way, Park (1979) evaluated for USA and Petersen (1982) for West
Germany. Macafee (1980) had in like route attempted to survey level of reduce
economy by using this procedure for the years 1960 to 1984 and found
declining IRD from 1978, and it was negative in 1984, which is incredibly
stunning.

It was found that there are various purposes behind dissimilarity among pay
and use extents of GDP [Pyle (1989)]. Thusly, this measure is respectably a
helpless marker to check the level of dull economy activity.

Labour Market Approach

The explanation of the work advertise approach is the measure of laborers

who are dynamic working at an advantage economy similarly as the all out
number of hours worked. This is then changed over into a money related unit
by duplicating hours worked by the commonplace profitability of the laborers
in the inconsistent market. Regardless, Pyle (1989) fights that it is past the area
of innovative psyche to precisely check the measure of hours worked by the
work in the underground economy and the regular adequacy. Moreover, it is
everything viewed as recognized that this system is beneficial for those nations
having negligible dull economy and is notable among the Italian market
inspectors to assess the size of the diminish economy.

Significant issue of utilizing this method is the non receptiveness of

information on number of specialists associated with the diminish economy
and the measure of hours worked by the work working at an advantage
economy.

Electricity Consumption Approach:

Drawing from the outcomes of an examination by Dobzi and Pohl (1995),
control usage is displayed by Kafman and Colberda (1996). Kafman and
Colberda ensure that electric force usage is the principle best physical
indication of monetary development in a country. All around money related
development and influence use has been exploratory in the whole world that it
is normally progressively like one to locks with the flexibility of influence/GDP.
By abusing this relationship, middle person estimation for a total economy; an
unmeasured measure of GDP can be practiced by deducting from as a rule
GDP.

Estimates of underground economy for Pakistan in previous studies:

Examinations of the underground economy have been subject of genuine
excitement for the composition. In Pakistan all of the makers have grasped the
financial approach and sought after Tanzi's methodology to evaluate the size of
the underground economy.

Shabsigh (1995) evaluated underground economy for the period 1975 to 1991
by turning out minor enhancements in the Tanzi's system. He used extent of
cash accessible for use to mean solicitation deposits4 as the dependent
variable, while per capita certifiable compensation, veritable financing cost,
per capita monetary organizations, typical charges on imports, ordinary costs
on admissions and typical obligations on private activities were picked as an
illustrative components. ARIMA specific was used to oust the autocorrelation
as opposed to loosened subordinate variable. He furthermore assessed the
long and short run assortments between qualification of the formal and the
underground economy and the organization spending insufficiency by using
the cointegration approach. Speed of money was believed to be the identical
in genuine and unlawful market and was controlled by parceling GNP with
legitimate money.

His evaluations (declared in Table1) show that the size of the underground
economy was 20.74 percent of GDP in 1975 and 20.46 percent of GDP in 1990,
proposing a stale underground economy. As such pace of improvement of the
underground economy is basically counterparts the pace of augmentation in
formal economy.

Ahmed and Ahmed (1995) have furthermore used Tanzi's strategy to check the
level of the underground economy for the period 1960 to 1990. They have
assessed two models with same illustrative components, i.e., advance expense
on time stores, total obligation salary to GDP extent, and trick variable for the
period 1960–71 in order to get the effects of cash assets of the past East and
West Pakistan anyway exceptional ward factors. In the fundamental model the
extent of cash accessible for use to M2 is taken as dependent variable while in
the second model variable of transport security is consolidated with money
accessible for use in ward variable. All of the elements are taken in log
structure and 1960 has been taken as benchmark period. Speed of money is
controlled by parceling GNP with real money. The results procured from the
two models are undefined.

Their evaluations show a declining underground economy since the sixties, it

declined from 51.96 percent to 35.09 percent in 1990. These outcomes are
defective when stood apart from different assessments. Moreover, before
1972 information on cash flexibly (M2) was not independently accessible for
East and West Pakistan, while in the post 1972 period it was bifurcated on the
suspicions of bit of slack vehicle on 70:30 explanation. The outcomes might be
affected by thought of pre-1972 information on cash gracefully (M2).

Iqbal, Qureshi, and Mahmood (1998) have moreover assessed the

underground economy by using Tanzi's methodology. Extent of money
accessible for use to M2 has been taken as the destitute variable, and the
educational elements fuse, nearby appraisals as level of GDP, worldwide trade
forces as level of GDP, certifiable advance cost, real per capita pay
improvement, banking organizations, and hoax variable for the period 1988 to
1996, to get the impact of helper adjustment program. Loosened subordinate
variable is furthermore used as an illustrative variable to speak to the inaction
in the cash feature. Like different assessments speed of unlawful cash is taken
to be equivalent to the speed of certifiable cash and the other two questions
are moreover taken to hold. They have moreover assessed the sectoral
debilitating of the underground economy. Their assessments show an
advancement in the size of underground economy from 20.2 percent of GDP in
1973 to 33.2 percent of GDP in 1990 and 51.3 percent of GDP in 1996 (Table 1).

Aslam (1998) similarly used Tanzi's methodology to assess the size of the

underground economy. Extent of cash accessible for use and outside money
records to M2 is taken as the penniless variable, while, outright appraisal
livelihoods as level of GDP advance expense on time stores and a false factor
for the period 1991–1998 (in order to get the impact of distant money records
introduced in 1991 onwards) have been taken as the instructive components.
All of the elements are taken in the log structure. He describes speed of money
as the extent of GNP to trade accessible for use out expansion to outside cash
accounts yet acknowledge same speed for both legitimate and unlawful
money. The two distinct assumptions are moreover taken to hold.

Aslam's appraisals show that the underground economy increases from 29

percent in 1960 to 43.9 percent in 1990. It was stale some place in the scope of
1990 and 1996 at 43.8 percent and a short time later declined to 35.5 percent
in 1998 (Table 1).

It is done up from the above talk that the common evaluations of the
underground economy are not genuinely strong. All the four examinations
using a comparative technique turned out with different results, which show
nonappearance of force of the evaluations. The results may differ to some
degree in view of qualification in the time period covered or changes in
assurance of the variables. Regardless, the changes in these appraisals suggest
that there might be an issue in the usage of the methodology that ought to be
reviewed to get unsurprising assessments.

The review of the test verification shows that: picking an utilitarian structure is
a vital worry since using condition in twofold log structure, semi logform or
clear direct structure basically changes the results; picking a significant
benchmark is in like manner a critical deterrent, which should be settled
toward the beginning; changing the period of time changes the results
profoundly , as reported before in case of Tanzi (1980, 1981); fuse and
dismissal of elements from the model results in gigantic difference in the
assessments along these lines, thought of noteworthy variables is very
important.5 In the accompanying territory we will progress new measures of
the underground economy and expense evasion by emptying the various
peculiarities and shortcomings of the examinations investigated above anyway
much as could sensibly be normal.
Result of Studies of Ahmed and Ahmed:-
 70

60

50

40

30 Tax Evasion
Underground Economy

20

10

0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
19 19 1 9 1 9 19 1 9 19 19 1 9 19 19 1 9 19 1 9 1 9 19 1 9 19 19 1 9

Underground economy: Average percentage: 41.5 %

Tax Evasion Average Percentage: 4.85%

Iqbal, Qureshi and Mahmood (1998)

 70

60

50

40

30 Tax Evasion
Underground Economy

20

10

0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
19 19 1 9 1 9 19 1 9 19 19 1 9 19 19 1 9 19 1 9 1 9 19 1 9 19 19 1 9

Underground economy: Average percentage: 35.4 %

Tax Evasion Average Percentage: 4.42%

Aslam (1998)
70

60

50

40

30 Tax Evasion
Underground Economy

20

10

0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
19 19 1 9 1 9 19 1 9 19 19 1 9 19 19 1 9 19 1 9 1 9 19 1 9 19 19 1 9

Underground economy: Average percentage: 38.24 %

Tax Evasion: Average Percentage: 4.02%
Rehana Siddiqui and Naushin Mehmood again replicated these studies in order
to revisit the estimates for underground economy of Pakistan and period of
estimates was extended upto year 2002.

Result of the studies is as under: -

70

60

50

40

30 Tax Evasion
Underground Economy

20

10

0
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02
19 19 1 9 1 9 19 1 9 19 19 1 9 19 19 1 9 19 2 0 2 0

Another examination has been performed by the Ahmad Gulzar , Novaira

Junaid and Adnan Haider (PIDE, Islamabad), PNTR, Ministry of
Communications, (BNU), Lahore, Pakistan SBP, Karachi, Pakistan)

Results of studies are as under:

Electricity Consumption:
 70

60

50

40

30 Tax Evasion

20

10

0
73 975 9 77 9 79 981 983 9 85 987 989 9 91 9 93 995 997 9 99 001 003 0 05 0 07 009
19 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2

MIMIC Model:

35

30

25

20

15 Tax Evasion

10

0
73 975 9 77 9 79 981 983 9 85 987 989 9 91 9 93 995 997 9 99 001 003 0 05 0 07 009
19 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2

Monetary Based:
 45
40
35
30
25
20
Tax Evasion
15
10
5
0
73 975 9 77 9 79 981 983 9 85 987 989 9 91 9 93 995 997 9 99 001 003 0 05 0 07 009
19 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2

Labour Force:
35

30

25

20

15
Tax Evasion
10

0
7 3 9 75 97 7 97 9 9 81 98 3 98 5 9 87 98 9 99 1 9 93 99 5 99 7 9 99 00 1 0 03 00 5 00 7 0 09
19 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2

Size of the informal economy differs in all of the above approaches.

METHODOLOGY:
Tax Audits (Direct Method):

The cost reviewing methodology chooses the size of the casual economy by
evaluating the waiting between compensation reported for appraisal purposes
and that intentional by institutional checks.

As it has been seen that different methodologies are being utilized beforehand
for assessing casual economy of Pakistan in recent years. Rather than utilizing
these backhanded techniques I have utilized direct strategy which is Tax Audit
based estimation of casual economy.

The procedure continues in such manner that I have gotten information of

people whose cases were arbitrarily chosen for review for charge year 2014
and thought about pay evaluated by the assessment specialists with the salary
previously pronounced by the citizens in their arrival of pay. The motivation
behind why I have taken the information identifying with charge year 2014 is
that it is generally near current monetary year and another principle reason is
that review for the duty year 2014 has been finished in the event of the
considerable number of citizens. The FBR has the strategy of choosing the
cases for review each year. Review for the expense years 2015, 2016, and 2017
and under procedure. I have just considered the information of the duty year
2014 in light of the fact that in numerous examinations have just been finished
by various creators in regard past financial years as referenced previously.

Because of specific confinements I have had the option to assemble

information of citizens enlisted inside the regional purview of Regional Tax
Office, Faisalabad. In any case, I have attempted to extrapolate the information
for everywhere throughout the Pakistan so as to quantify the size of the entire
economy of Pakistan.

Results and Findings:

Most of the Data used has been obtained from FBR website as well as from the
office of Regional Tax Office, Faisalabad.

Total number of taxpayers registered with FBR = 1,999,361

Total No of Taxpayers selected for audit for tax year 2014 = 67385

% of taxpayers selected for audit is 3.37 %

Due to certain limitations I have used the data of taxpayers registered within
the territory of Regional Tax Office, Faisalabad. However, I have extended my
results to all over Pakistan for estimating the size of underground / informal
economy of Pakistan. Regional Tax Office, Faisalabad is third largest field
formation of FBR.
Data has been obtained from FBR, and Economic Survey of Pakistan 2018-19.

Total tax paid by the taxpayers (Sample of 3548) along with return
of income filed for tax year 2014 : Rs 14,043,335
Whereas, tax determined after audit of Income Tax returns
resulted in assessment of tax liability amounting to Rs. 18,677,636 which
resulted in gap of approximately 34%.

After obtaining data from concerned authorities, it has been found that
taxpayers who were subjected to audit have evaded around 34% of due tax
amount. Therefore, this represents the gap of formal transactions versus
informal transactions. The taxpayers did not pay the actual tax owed by them
to the National Exchequer.
In view of the above, we can say that size of informal economy has been
estimated as 34%.

Assumptions used:
1) Transactions embraced by lawbreakers have been viewed as irrelevant
to impact in general all out exchanges of economy.

2) The example is thought to be illustrative of significant populace who are

either enlisted with charge specialists and if not enrolled they mean to dodge
installment of assessments.

3) These review can simply give point examinations of duty shirking and
time arrangement data can't be gained

4) Industrial segment represent significant expense commitments in

complete assessment assortments, consequently there share in tax avoidance
has been considered when contrasted with administration part and farming
segment.

CONCLUSION:
There is neither an accurate meaning of the underground/casual economy nor
any strategy exists which could definitely evaluate the size of the economy, it is
basic to consider the basic of size of casual economy in view of the truth it
exists in every economy and it uncommonly influence the macroeconomic
markers. That is the explanation, various methods were delivered for
estimation of size of economy.

In this report I have utilized the technique for charge review based estimation
of casual economy. It is accepted that expense rates are main consideration
which convince the individuals to conceal their exchanges from the
Government. The expense review approach shows that casual economy has
been around 34% during the monetary year 2014.

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