How to formalise the informal economy

Updated 29 Jun 2020

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President of the Pakistan Businessmen and Intellectual Forum Mian Zahid Husain says 62pc of the trade is in the informal sector. — APP/File
President of the Pakistan Businessmen and Intellectual Forum Mian Zahid Husain says 62pc of the trade is in the informal sector. — APP/File

THE PTI government has made strenuous efforts to document the economy with an exclusive focus on increasing tax revenues with partial success.

The number of registered taxpayers has touched a record high of 2.7 million but the tax collection has not been significant owing to clogged economic activities and stubborn resistance from a strong segment of those sought to be brought in the tax net.

The formalisation of the informal economy is not only important for raising tax revenues but for technology-driven, skilled-based upgrading of economic activities, scaling up the operational size of small enterprises, boosting and diversifying production and improving the lot of low-wage earners.

Given the formidable size of the informal sector embracing multidimensional activities, the government’s target to raise economic growth to 4-5 per cent and increase total revenue to 3pc of GDP over the next three years, the need for formalising the informal economic activities cannot be emphasised enough.

Though the estimates about the size of the informal economy vary, it is generally quoted at 35pc or one-third of the country’s GDP. However, depending on the methodology adopted, the estimates of its size go up from 50-60pc to 90pc of the GDP.

In 2019-20 agriculture, much less affected by Covid-19, and small industries in the informal sector, though affected by lockdown, have posted positive growth as opposed to the sharp contraction in all economic activities in the documented sector.

Studies show that large-scale enterprises in the documented sector have hidden part of their production and assets from regulatory and tax authorities

The Covid-19 triggered lockout has also brought into the spotlight the plight of millions of wage earners in the undocumented sector who have lost their jobs. Around 67pc of urban employment is in the informal sector. Outsourcing of non-core activities by firms and hiring informal contract labour by industry to cut costs is a normal practice.

The informal sector provides 70pc of the total jobs in non-agriculture economic activities. Then agriculture, which is largely in the informal sector, provides employment close to 40pc of the country’s total working labour force.

International research reports indicate that poverty levels among people with informal employment in developing states are, on an average, twice as high as that in the documented sector because of low productivity, low incomes and limited access to government benefits.

According to the International Labour 0rganisation, 92pc of the women workers are informally employed. In the non-agricultural segment, the key sectors of the informal employment are stated to be wholesale and retail trade, manufacturing, services industry, community/social and personal services, construction and transport.

Quoting a survey, President of the Pakistan Businessmen and Intellectual Forum Mian Zahid Husain says 62pc of the trade is in the informal sector.

Informal enterprises are not only household-based or small-scale entities. In reality, studies show that large-scale enterprises in the documented sector have hidden part of the production and assets from regulatory and tax authorities.

There is also a view that the informal sector complements and provides cheap inputs and supports the formal economy. Many firms neither operate wholly in the formal sector nor in the informal sector. Those accused of lower tax morality express greater concerns about public sector corruption, high tax rates, cumbersome procedures, distributive injustice and what they call the unfairness of the authorities, says an analyst.

In the views of certain international experts and the local business leaders, Pakistan’s complicated tax structure coupled with a few other factors is chiefly responsible tax evasion. It has multiple taxes and tax collecting agencies, some with duplicating functions, with a fewer than average tax take.

On the other hand, the main constraint facing small enterprises in the informal sector is that of finance. Bank credit which would help these enterprises grow into bigger units is not forthcoming in any meaningful way. Microfinance is expensive. And experts say the average life-span of small and micro enterprises in the informal sector is shorter than that of their counterparts in the formal sector. This labour-intensive, technology and skill-deficient sector, is neither taxed nor regulated or monitored by the government. The sector is also not eligible for the government’s liberal stimulus packages as available in the documented sector.

The first detailed report of the Federal Board of Revenue titled ‘Tax Expenditure’ shows that income tax exemptions and concessions amounted to Rs138billion in 2019-20: Rs108bn for balancing and modernisation to 1,135 firms and Rs30bn for new business initiatives.

“It is vital to capitalise on the potential of the informal sector for sustained stimulation of economic growth,” says Professor Zafar Mahmood of School of Social Sciences and Humanities, National University of Sciences and Technology, Islamabad.

A wide range of studies recommend diverse approaches for a transition from informality to formality. In his research paper on ‘Formalising the informal economy’, Mr Mahmood highlights two factors which need to be taken into account in formulating official policies. First, for enterprises, he says, the transition to formality needs to make good sense. Second, the government should create a sense of trust by utilising the tax collected for the welfare of the taxpayers.

This, he adds, will stimulate business for further growth and documentation of the economy. Perhaps that explains the government’s inability to boost substantially tax collection as its recent documentation drive was motivated by a single objective: to raise more tax revenue.

Experts say lack of proper focus on fixing the informal sector is creating a major disconnect in economic policy formulation. Professor Mahmood advises authorities to shed ‘anti-informality bias in policies.’

While comparing the nation’s philanthropy versus tax compliance, Mian Zahid Husain says: there is mistrust between public and government He quotes Transparency International’s report on Pakistan’s charity spending which shows that Pakistanis spends 2.5pc of its GDP on charity compared to 2.2pc in the US, 1.3pc in the UK and 0.2pc in India.

It is time to focus on measures that enable enterprises operating in the informal sector to make a smooth transition to the formal sector.

Published in Dawn, The Business and Finance Weekly, June 29th, 2020