Pakistan's Informal Sector Drives Consumer-Led Economic Boom

[Riaz Haq]

Car sales increased 14 percent in February from a year earlier. Cement sales are rising with growing housing demand for increasing population. Lucky Cement, Pakistan’s biggest publicly traded construction materials company, is expected to post record earnings this year. Rising farm prices of bumper crops are pumping hundreds of billions of rupees each year into Pakistan's rural economy.

Contrary to government statistics of a stagnant economy, packed shopping malls and waiting lines at restaurants tell a different story-- the story of growing discretionary incomes of Pakistani consumers today.

So where is the disconnect between these two opposite views of Pakistan's economy? Naween Mangi of Businessweek answers it in her piece "The Secret Strength of Pakistan's Economy". She attributes it to the fast growing informal sector of the nation's economy that evades government's radar, illustrating it with the story of a tire repair shop owner Muhammad Nasir. Nasir steals water and electricity from utility companies, receives cash from his customers in return for his services and issues no receipts, pays cash for his cable TV connection, and pays off corrupt police and utility officials and local politicians instead of paying utility bills and taxes.

Here's an excerpt from Mangi's Businessweek story:

"The rhythms of life in the underground economy remain largely undisturbed. After work, Nasir and his friends sometimes hire a rickshaw to head to the beach or to a religious festival. The driver, part of the flourishing local transport business, doesn’t turn on the meter because he doesn’t have one. On his way home, Nasir stops to buy cooking oil, wheat flour, and sugar at a small grocery store that isn’t officially there. Out of about 1 million shops, up to 400,000 are grocery stores, and most of them are not registered and don’t pay taxes, according to Rafiq Jadoon, president of the City Alliance of Markets Association. In the evening, Nasir unwinds in front of the television. He watches an Indian movie transmitted by a local cable operator to whom he pays a monthly fee—in cash."

The estimates of the size of Pakistan's underground economy vary from 30% to 50% of the official GDP of just over Rs. 18 trillion (US$200 billion). Businessweek's Mangi claims that the government is losing as much as Rs. 800 billion (US$9 billion) in taxes from the informal sector...nearly enough to wipe out Pakistan's current fiscal deficit.

In my view, there are two major problems that arise from the underground economy described by Mangi. First, the massive tax evasion fosters Pakistan's dependence on foreign aid which comes with strings attached and infringes of national sovereignty. Second, the widespread theft of electricity is largely responsible for the huge circular debt and the ongoing power shortages that affect all aspects of life and scare away investors. The sooner the government and the people realize the severe downsides of the underground economy, the better it will be for Pakistan.

Related Links:

Haq's Musings

Rural Consumption Boom in Pakistan

Pakistan's Tax Evasion Fosters Aid Dependence

Poll Finds Pakistanis Happier Than Neighbors

Pakistan's Rural Economy Booming

Pakistan Car Sales Up 61%

Resilient Pakistan Defies Doomsayers

Land For Landless Women in Pakistan

Pakistan's Circular Debt and Load-shedding

[Riaz Haq]

How Informal Sector Affects the Formal Economy in Pakistan? A Lesson for Developing Countries

https://journals.sagepub.com/doi/full/10.1177/2277978719898975

There have been multiple estimates for the informal sector of Pakistan (Ahmed & Ahmed, 1995; Ahmed & Hussain, 2008; Arby et al., 2010; Aslam, 1998; Gulzar, Junaid, & Haider, 2010; Iqbal, Qureshi, & Mahmood, 1998; Kemal, 2003; Kemal, 2007; Kemal & Qasim, 2012; Kiani, Ahmed, & Zaman, 2015; Mughal, Schneider, & Hayat, 2018; Shabsigh, 1995; Yasmin & Rauf, 2003), yet most of the studies are limited to measuring the informal sector only. However, Shabsigh (1995) explored the relationship between fiscal deficit and informal sector, while Yasmin and Rauf (2003) and Kemal (2007) attempted to explore the nexus between informal and formal sectors. The estimates of the first author were based on simple ordinary least squares (OLS) without accounting for cointegration among variables. On the other hand, Kemal (2007) used vector autoregression (VAR), and his results showed unidirectional causality from informal sector to nominal GDP. Further, they used Johansen Cointegration test and Error correction model to conclude that shadow economy has a positive effect on the formal sector in short- as well as long run. We, however, argue that the effect of the informal sector on official economy may be of asymmetric in nature in the long and short run, emanating from two contrasting propositions:
1.
First, the informal sector, being more dynamic and extensive, is considered a safe haven for informal employment and production activities stemming from its capacity to avoid the bureaucracy and legalities. This may be supporting the economic activity in the long run when the income and savings from the informal sector are spent on consumption goods being produced by the formal economy. Furthermore, countries with relatively high incidence of poverty and weak social welfare institutions may use the informal sector as a substitute for social security.
2.
On the contrary, informality is a burden on exchequer, particularly when it comes to revenue collection in the short run; hence, it restrains the formal economic activity by raising the cost of being formal; that is, taxpayers have to bear the cost of tax evaders. Lower tax collection implies less expenditure on public utilities and lower productivity and economic growth.
The above contrasting propositions also seek strength from Khan, Khwaja, and Olken (2015) who used an experimental study on performance-based incentives to tax officials in Pakistan. Although they showed that the tax revenue increased, however, bribe requests also increased by 30 per cent, which depicts a clear burden on economic growth in the short run. Therefore, we hypothesize that the informal sector may affect the formal economy positively in the long run and negatively in the short run.