Informal economy rakes up interest rates, corruption, poverty

LAHORE: It is in Pakistan’s interest to get rid of its informal economy, as creditable research reveals that interest rates and country’s credit risks become higher as the size of informal economy increases along with increase in corruption and poverty.

The economic planners in Pakistan have tried to reduce the size of informal economy through indirect taxation like general sales tax on utility bills and withholding taxes. However, these taxes are made part of cost by the operators of the informal economy. This puts undue burden on the hapless consumer.

It is extremely difficult to assess the actual size of the informal economy due to its inherent mysteriousness. The term itself is controversial that includes black, grey, shadow or hidden transactions. All unrecorded, unreported, illegal, subterranean, underground, parallel, clandestine money also comes under informal economy. Most of the economic ills of Pakistan are due to the huge size of the informal economy.

It has jeopardised our balance of payments. Our fiscal deficit is due to shadow economy as the government has not been able to exploit the actual tax potential.

The informal sector operates on obsolete technology providing extremely low paid jobs. The employees of the informal sector are from the poorest segment of the society. At low salaries they remain poor throughout their life. Quality employment is restricted due to presence of informal sectors.

The other consequence of shadow economy is the loss of competitiveness of the country vis-à-vis other economies. This is because the productivity of low tech informal sector is lower than the high tech formal sectors.

The formal sectors are handicapped by high tax rates like 16 percent sales tax and up to 25 percent income tax on their earnings.

Economic freedom of the formal sector is also jeopardised as many high tax sectors become no go areas for them and are dominated by informal operators.

The most devastating impact of shadow economy is on crowding out of public investment in social sectors and infrastructure development.  This deteriorates educational outcomes, health and the development of human capital.

The expansion of the informal sector shrinks the tax base and revenues; the increase in tax rates in order to compensate for the loss in revenues motivates many formal operators to go informal that has trapped the economy into a vicious circle. This has compelled successive governments to print money to substitute for lost tax revenues.

This is in fact running away the long-term solution since it just covers up the problem and eventually leads to inflation and destabilisation in the economy. The informal sector becomes a nightmare to macroeconomic policy makers, since it increases both model and estimation risk.

The informal sector however cannot prosper without the connivance of the government machinery. With the expansion of the informal sector, the incentive of the corrupt to protect it also increases. No vendor, shopkeeper, contractor or small manufacturer can operate without the tacit approval of concerned authorities. The rent that they get from their area of influence depends on the growth of informal economic operations. If tax evasion is addressed by authorities, it will open new avenues of growth, enhance the sovereign credit rating and cut the lending costs for the businesses. Tax evaders get the public services free of cost. This dilutes the amount that the government spends on taxpayers and poorer segments of the society.

Informal economy also flourishes because operations in the documented sectors are cumbersome, subjected to high taxes, stiff regulations and corruption. Small entrepreneurs then prefer to partner with the corrupt without joining the formal sector. There is a downside to complete stamping out of tax evasion as it could have adverse negative impact on vulnerable segments of society, particularly if the economy is in distress.

A recently conducted research revealed that economies like United States, Austria and Japan having informal sector in the range of 8-11 percent of GDP faced low lending costs of less than 4 percent. However, countries like Panama, Peru and Honduras where more than 50 percent of the economy is untaxed faced double the lending costs. Pakistan also has 40-50 percent of untaxed economy that has kept its lending costs very high.