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The informal economy

February 22, 2013

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NEW estimates indicate that Pakistan’s informal economy is larger than previously approximated, and is expanding at a rapid pace. On the other hand, the formal sector appears to be on the retreat.

Indications to this effect have been around for several years. These indicators have included, among others, a rising share of informal jobs in total employment, a static share of output and employment of the formal manufacturing sector, a growing level of cash transactions in the economy, and an increase in estimates of the “tax gap”.

In addition, firm-level behaviour has also provided clues to the underlying trend in the economy. There are fewer listings on the stock exchanges, and some prominent de-listings, while a fairly significant number of previously formal small and medium enterprises have chosen to become Association of Persons over the past few years, according to some tax experts. Finally, according to some reports, the number of firms on the tax register (for income as well as sales tax) has declined in the past five years.

In fact, anecdotal evidence suggests that in the past few years, there have been instances of even large manufacturing units that have either completely or partially “shifted” production to the underground economy. Evidence to this effect has come from the Federal Board of Revenue (FBR) in the case of at least one significant sector of the economy — cigarettes — where a sharp dip in federal excise duty collection in 2009-10 was attributed to this phenomenon.

Reportedly, though unconfirmed, a similar trend has been observed in the case of some of the vegetable ghee and cooking oil units. Given the underlying factors at work, there is no reason why this trend should be restricted to these two sectors alone. Against this backdrop of mounting evidence of rising informality, a 2012 report by Pakistan Institute of Development Economics (PIDE) researchers M. Ali Kemal and Ahmed Waqar Qasim using a more robust approach than previous studies, suggests that the size of the informal economy in 2008 ranged between 74 per cent to 91 per cent of the formal, reported economy.

This is substantially larger than previous estimates of between 30 per cent to 50 per cent (albeit using different methodologies). If correct, this implies that the overall size of Pakistan’s economy, both reported as well as unreported, is around $420 billion, with private consumption at current prices amounting to a whopping $365bn in 2012 (which would explain the consumption “conundrum” I have written about previously).

The trend of rising informality of the economy is no cause for celebration. While a large informal sector acts as an important shock absorber for an economy gripped by a fairly lengthy period of sluggish jobs and income growth, the trend of growing informality — that too from an already elevated starting point, and at the expense of the documented economy — depicts the operation of very serious structural constraints for the country’s formal sector, and for its overall, long-run growth prospects.

While the formal sector may not be as labour-intensive as the generally smaller businesses in the grey economy, it is the driver of large-scale fixed investment, which creates multiplier effects for the informal economy as well. In addition, it is by far the largest source of tax revenue, through which the infrastructure needs of the entire economy — including of the informal sector — are financed.

Foreign direct investment, an important source of not just foreign exchange for the country but of entrepreneurial capital and technology, in addition to potential access to external markets, is invariably attracted by the formal sector of the economy, and hardly ever by the informal one.

The quality of jobs offered by the two segments of the economy also differs greatly. Jobs in the informal sector are almost always less secure and lower paying, and offer fewer opportunities for upward mobility due to a lack of training and employee development.

At a more fundamental level, the fact that economic agents are leaving the “safeguards” and “protection” supposedly offered by the institutional framework provided by the state, and are choosing to organise their economic activities on more informal, less organised “natural state” arrangements is a cause for serious concern. I have alluded to this aspect previously, while other commentators such as Jamil Nasir and Khurram Husain have also written recently on this institutional facet.

In the face of unambiguous and unequivocal evidence on the rising informality of the economy, the central question is: why is this trend taking place at all, and why is it appearing to be gathering pace?

Having set up and run my own small business in the formal sector for the past two years has given me some unparalleled insights. While Jamil Nasir in his article in January (in another newspaper) believes the tax structure is not a big contributor, and the regulatory burden is a bigger factor, my own experience suggests that it is both, the tax and regulatory burden, that are either preventing informal businesses from formalising, or are driving already documented firms into the informal economy.

Here’s how. For starters, a formally registered firm filing an income tax return has a 20 per cent disadvantage compared to an enterprise that is operating in the undocumented sector (the tax arbitrage for informal firms). But this is not the end of it. The direct costs of maintaining books, having the firm’s accounts externally audited by a professional auditor, hiring tax consultants and an accountant etc. are not insignificant.

More annoying from my perspective is the opportunity cost of devoting roughly 10-15 per cent of my management time to tax and SECP-related issues, not least of which are chasing up on tax deduction certificates and acting as a withholding tax agent for the government.

In addition, the number of corporate and tax-related filings that the company has to make each month, every quarter, and then on an annual basis is absurd. To incentivise informal sector players to formalise, both the Federal Board of Revenue (FBR) and the Securities and Exchange Commission of Pakistan (SECP) will have to reduce the number of filings, while the transactional relationship with FBR will need to be converted to “arm’s length” via the use of automation.

Finally, the government should consider a system of tax credits and rebates on investment and hiring by small registered businesses, and an initial lower income tax rate for newly corporatised firms as a powerful incentive. At the other end of the spectrum, the tax and regulatory burden on large, formal firms also needs to be reduced by a comprehensive broad-basing of the tax regime.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.