Risks in growing informal economy

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Economic Updates - Economic Fundamentals

WHEN Mohammad Shafique was fired from his job as an electrical technician at a shopping mall in Lahore five years ago, he sold his motorcycle to start his own business of making UPS generators.

Initially, he worked from home. The business expanded quite fast thanks to rolling blackouts. Soon he rented a small house in Township area to set up a workshop, and hired two apprentices to help him.

Today he employs six people, lives in a rented three-bed house near his workplace, drives a four-year old 1000cc car, sends his nine-year-old son to a private school, and maintains a bank account to keep track of his finances — income and expenditure.

Besides supplying UPS generators in the market ‘on credit’, he also makes them ‘on order’ from his clients for their home and office. His customers are happy with him because he issues them proper receipts with his address and telephone number printed on it, and has never defaulted on his commitment to provide them a one-year after-sale warranty.

Auditors or tax authorities do not raise any objection to the receipts Shafique issues if any of his customers makes them a part of his firm’s expenditure or his income tax returns. Still, his own income remains off the government’s books and the ‘economic activity’ he generates doesn’t form part of the official estimates of the nation’s GDP (gross domestic product). He and his business are part of a very, very large and dynamic informal economy that dominates the struggling and slowing ‘official’ economy.

Indeed, it is this thriving informal economy which has sustained its half sister — the formal economy — for the last several years in the face of growing energy shortages, rising prices, and worsening security conditions in our cities. While an average, GDP growth of less than three per cent per annum in the last five years gives a depressing picture of the economy, the packed shopping malls and restaurants, the stellar growth in sales of luxury goods and imported and local cars, growing demand for modern housing, etc., tell quite a different tale.

While addressing the navy officers in Lahore a few weeks ago, SBP Governor Yasin Anwar himself admitted to the fact that the informal, undocumented economy has been a major source of ‘resilience’ for the national economy in the face of adversity.

”Informal or underground economy refers to economic activity that takes place outside the government oversight and regulations, and hence the income generated from it is not taxed nor included in official estimates of GDP,” notes Shahid Zia, a Lahore-based capital market analyst. According to him, the informal sector both supplies to and purchases goods and services from the formal, documented sector.

Zia says the unreported economic activities are part of all the economies, including the most developed ones like the United States, Germany and France. “But the size of the informal sector in those economies is small compared with Pakistan or many other underdeveloped or developed countries. Moreover, a person working in the informal sector of these economies always has incentives to become part of the formal, reported economy at some point or the other to grow and expand,” he asserts.

Although no exact estimates of the size of the country’s informal economy exist, a study by Ali Kemal of the Pakistan Institute of Development Economics says it was 91.4 per cent of the size of the formal economy in 2007/08 with the ability to generate tax revenues of more than nine per cent of GDP. This means that our official GDP of $210 billion is almost half the actual size of the economy and our tax-to-GDP ratio could improve to 18 per cent from below 10 per cent if this part of the economy is also brought under the tax net. Even Kemal’s estimates of the informal economy do not reflect its true size since the study “did not work out informal proportion of informal investment and excluded some of the transactions from private consumption”.

”There are a number of reasons for the phenomenal growth in the size of the informal sector. The most important one is the unwillingness of successive governments to tax the untaxed or under taxed sectors of the economy and allow exemptions to different lobbies under political pressure. When the economy is not fully taxed and documented, you create an alibi for many to work outside the government’s oversight,” emphasises Zia. “Working in the undeclared part of the economy helps you to significantly cut your costs, compete with your rivals and avoid hassles of dealing with corrupt tax machinery,” he notes.

Several international research studies show that the “main attraction of the undeclared economy is financial… (because) this type of activity allows employers, paid employees, and the self-employed to increase their take-home earnings or reduce their costs by evading taxation and social contributions… informal employment can provide a cushion for workers who cannot find a job in the formal sector.”

But, these studies also warn, “It entails a loss in budget revenues and, therefore, the availability of funds to improve infrastructure and other public goods and services. Besides, it leads to a high tax burden on the organised sector as well as the poor who are subjected to heavy indirect taxation to meet the revenue requirements of the government. It also evades corporate and labour laws… eroding the ambit of the regulators.”

Naeem Akhtar Sheikh, a chartered accountant, points out that the phenomenal growth in the undeclared economy over the years shows the erosion in the state’s authority in netting the people who should be paying taxes, and implementing its regulations and laws on all.

”Exclusion of the majority of people from the banking system, lack of laws discouraging cash transactions and tax exemptions to large parts of the economy are responsible for the growth of informal economy,” he says.

He notes that the government should be concerned about the expanding informal economy because it has negative consequences for growth, development and poverty in the longer run. “It may appear to be a big source of our economic resilience at present. But an underground economy as large as ours can contribute significantly to an economic meltdown if not taken care of soon.”

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