Hurdles being faced in documenting economy – Part I

The economy of Pakistan, like any other economy is of two types: 1) documented or formal economy and 2) undocumented or black economy. Documented economy connotes that the business as well as employment is registered with the relevant registration authorities, as well as taxation authorities. On the other hand, undocumented economy is not registered with the authorities and consists of the following two types:

a) Legal businesses which may be unreported (for tax evasion) or unrecorded (due to practical difficulties in documentation)

b) Illegal businesses activities which are restricted or banned by the state; for example, trading in alcohol in Pakistan.

Undocumented or informal economy does not contribute to fiscal revenue and is also more susceptible to potentially damaging activities e.g. terrorist funding. Percentage of the unrecorded business has declined in developed economies over past few decades primarily due to digitalization of processes and the appealing perks of the registered businesses. However, the rising trend of unrecorded economy is a major challenge for developing countries. In Pakistan, informal economy is soaring and is under-reported to be around half of the GDP.

Hurdles in Documentation

Over the last several years Pakistan has been experiencing a growing fiscal deficit which surfaced mainly on account of poor tax collections and the situation can hardly be controlled even if the expenditures are kept at low, particularly the development expenditure, which in turn results into slowing down the economy. Tax-to-GDP ratio in Pakistan has conventionally remained below the 15 percent average in the South Asia and it squeezed to 11.6 percent in the year 2018-19 due to escalating fraction of undocumented economy.

Obstructions faced by Pakistan in documentation of the economy are endless. However, following are the major hurdles i.e. the leading causes of failure of documentation policies, which can be classified into three categories.

  1. Structural Hurdles
  2. Sector Specific Hurdles
  3. International Trade Hurdles

In this article, impediments falling under structural hurdles have been analyzed below in depth:

1- Structural Impediments
a) Complex Layering of Formal & Informal Economy

In the research studies of the economy of Pakistan conducted by ILO in 2017, it was highlighted that the sectors of Pakistan’s economy consist of complex layers of the documented and undocumented value chains which make the documentation of the whole economy very difficult, unless the value chains are individually studied at higher cognitive levels for identification of informal supplies at various stages of the production and supply cycle. Among the problematic supply chains, the garment and textile industries are worth mentioning. Informal supplies in such case may be documented by encouraging the small-scale businesses/suppliers to join together to form the documented co-operative societies to reap the benefits of economies of scale.

Another quandary of the value chain complexity is the forward and backward integration wherein informal practices are amalgamated with the documented business lines. For example, the sugar mills cultivate the sugarcane themselves under the backward integration and attempt to control the supply network of the sugar. The identification of the unrecorded sales fraction becomes very tough in business cycles where the entire value chain is controlled by the same entity because the data for cross-verification is not available for such segments of the economy.

b) Workforce Structure & Trends

According to updated Poverty Reduction Strategy Paper (PRSP) of Pakistan, almost four-fifths of the labor force in non-agriculture sectors works for the undocumented economy. Moreover, the informal economy expands with the rising size of unemployed workers in the formal economy, which results in further expansion of informal economy as the increased flow of labor force towards the informal sector, in turn, increases the output of the informal sector i.e. creates a cyclic effect of expansion of the informal economy.

In Pakistan, the government also hesitates in eradicating labor-intensive informal sector due to the pressure of rising unemployment rate because the formal economic activity is incapable to accommodate the otherwise unemployed workers. Such expansion in informal sector due to economic crisis in the formal sector can only be seized if the underlying problems of the documented economy are rectified by the effective monetary and fiscal strategies. Secondly, the workforce also lacks the technical skills required in the national as well as international documented markets. Studies have found that the rise in higher education in the youth has negative relationship with the growth of informal sector.

Therefore, the revamp of the education system of Pakistan is necessary to improve the Human Capital Index (HCI) to generate the skill pool required for the growth of legalized businesses. Besides exclusion from taxation, the workers are also exploited by the employers in the informal entities. This dilemma may be resolved by educating the laborers about their state-protected employment rights e.g. minimum wage rate, working hours etc. in the documented sector. Their whistle blowing may also help the state in the identification of such undocumented businesses and forcefully document them under the stance of employment rights exploitation, regardless of the volume of their business revenue.

c) Preference of Cash Over Bank Dealings

In Pakistan, besides the business community, the consumers also prefer to deal in cash. According to a report published by McKinsey Global, where share of digital payment is 55 percent in UK and 49 percent in USA, it is less than 1 percent in Pakistan. State Bank of Pakistan (SBP) reported that more than 60 percent of business is conducted in cash in the economy of Pakistan. Cash based employment is common in hiring labor for construction, production factories and other similar small scale businesses. Cash based businesses, services and employments are very difficult to be monitored effectively, thus a major proportion of economic output evades documentation and taxation simply due to the fact that it operates under the shade of cash dealings.

d) Complexities of Wealth/Income Declaration Processes

A study conducted in 2019 by PwC in collaboration with World Bank has ranked taxation system of Pakistan at 161 out of the 190 countries, with respect to the ease of filing tax return and the total time required to be spent in meeting the taxation requirements.

Pakistan was ranked at 172/189 in the study published by World Bank seven years ago (2014). Thus, the position has improved slightly due to the introduction of electronic return filing leading to the reduction of the personal interaction with the taxation authorities. But still, for the community, the tax collection and submission in Pakistan demands significant time and efforts for taxation as compared to other countries. The electronic return filing process is not user-interactive. Moreover, in the electronic declarations, on-hand facilitation is also very limited. Although the tax consultancies have grown in number for tax registration/filing support but the cost of their service is borne by the return filers themselves. It keeps discouraging their aspiration for documenting their activities. Boosting the share of formal economy in the economic activity is far from reach unless the electronic process is made user-interactive and supreme quality facilitation desks are made available free of cost by the state.

e) Bureaucratic Corruption Due to Manual Systems

Corruption reduces transparency in the formal sectors and is an important cause of the swelling informal economy. Specifically, corrupt practices in the taxation system are an impediment in the strategic plans of increasing the tax base because they create the perception that the undocumented business assets/ profits can be prevented from seizure/penalties through corrupting the tax officials, if confiscated.

f) Trust gap in documentation

In Pakistan, the lack of public confidence in tax collection system is an important cause of under-documentation of the economy. Public confidence in the taxation system is the first to get affected during economic crisis. People think that heavy taxation makes their income susceptible to malpractices in the public expenditure. Another factor of declining public confidence is the lack of sufficient perks for tax filers, discouraging the informal economy from registering for taxation. Moreover, in recent years, various amnesty schemes have been announced with varying rate of success. While such amnesty schemes have increased the tax base and revenue, in actual, they have shaken the confidence of tax filers as amnesties allow the concealed income streams to be taxed at much lower rate than regular taxpayers. Therefore, the government must cover the trust gap between the registered businesses and the state by reducing the money laundering opportunities for the undocumented businesses in the form of amnesties.

(To be continued….)

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