Pakistan’s undocumented economy

Increasing public awareness about benefits of taxes can help reduce impact of informal economy on economic growth

Undocumented economy, also known as informal or shadow economy, poses enduring challenges for economies across the globe. Pakistan, marked by a significant informal sector, grapples with its own unique set of obstacles stemming from this parallel economic system. The undocumented economy entails economic activities that escape official records and taxation by government authorities. This encompasses transactions conducted in cash, unregistered business operations and off-the-books employment. According to a World Bank report, in 2022, the total size of the informal economy in Pakistan was around $457 billion. However, the estimates from SMEDA indicate that the informal economy has a market share of more than 40% of the GDP.

This sector encompasses various entities such as street vendors, domestic workers, small businesses and large portions of the real estate sector, frequently operating without formal registration. Within the informal sector, disparities in compensation and benefits manifest, perpetuating a scenario where wages are markedly lower and employment perks are scant compared to formal sector. This makes income inequality worse, particularly for a large portion of the population working in these informal jobs. Nearly 75% of the total labour force in Pakistan is engaged in informal sector employment (Labour Force Survey 2020/21). The informal nature of this sector not only violates the labour rights of the individuals but also adds to the bigger problem of income inequality in society and inadequate access to a universal social protection system.

The impact of the informal sector on the official economy can vary over time, leading to two different ideas. The informal sector is seen as a refuge for casual jobs and businesses because it can avoid dealing with bureaucracy and legalities. This might help the economy in the long run as the money earned in the informal sector is spent on goods produced by the formal sector. Especially in countries with a lot of poverty and weak social welfare systems, the informal sector might act as a kind of substitute for social security. However, in the short term, having an informal sector can be problematic for the government, especially when it comes to collecting taxes. It can slow down formal sector participation as they are the ones who are bearing the burden of non-taxpayers.

In Pakistan, the informal economy is mostly caused by corruption among tax authorities and businesses. According to a LUMS study, out of Rs100 of tax collected, only Rs38 goes to the government while Rs62 is divided among the taxpayer, tax collector and tax practitioner, leading to unrealised tax income. Similarly, excessive tax burden is another hurdle for shifting towards a formal economy.

Promoting a formal economy is not only beneficial for the government but also for the individual. Formalisation can strengthen the rule of law and expand government authority which can be beneficial for society. It can help create fairer societies by allocating fairly the rights and responsibilities among members. Moreover, being a part of a formal economy qualifies for government help during times of crisis. The Covid-19 pandemic is a recent example.

To tackle these issues, the government needs to fight corruption with mandatory annual declarations for politicians and bureaucrats, along with thorough audits. NAB can play a vital role in preventing corruption. Similarly, training tax officers and expanding the tax base are crucial, including efforts to register unreported sectors like transportation and online businesses. Amnesty schemes should be stopped to uphold the rule of law, and promoting online business can help make transactions traceable.

Increasing public awareness about the benefits of taxes can help reduce the impact of the informal economy on economic growth. Formalisation of the economy is a complex and gradual process, but it is essential for development and monitoring of progress, as well as to develop and modify policies and interventions over time to achieve desired targets. To conclude, addressing corruption, tax structures and public awareness is essential to decrease the size of the informal economy and improve the country’s economic well-being.

Published in The Express Tribune, December 9^th, 2023.

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