Our informal economy

According to the growth diagnostics framework I discussed in one of my previous articles, high taxation is one of the potential candidates for becoming a binding constraint to economic growth in a country, as high rates of taxes increase the cost of doing business and consequently reduce the profit of the business concerns. Firms and businesses respond to high taxes either through change of location or through underreporting their output (eg, through double bookkeeping) or through operating informally (ie, not registering with the tax authorities).

The response depends on the type of firms (eg, multinational or national), or their size (small or big) and nature (capital-intensive or labour-intensive). Thus, high taxes promote informality and if we go by this thesis, then high taxation should explain the huge informal economy of Pakistan, which is now estimated at above $90 billion.

Concerns regarding informal economy generally arise on the following grounds: First, informal economy creates biases and economic distortions. Second, it does not contribute to the state kitty as the firms and businesses operating in the informal sector are not registered with the tax authorities. Third, a huge informal economy is indicative of low trust between the government and business agents, and lack of confidence in economic and business regulations, procedures and policies.

Fourth, informality retards a country’s subsequent economic development, because informal entrepreneurs cannot use their wealth as collateral for loans to finance investments. Fifth, informality has social costs as well. Almost all countries have social security plans, labour welfare laws and safety regulations for the welfare, security and protection of labourers working in factories and other workplaces. But such laws will be applicable to formal businesses as informal businesses hide their business activity from regulators.

But the key question is: what causes the ballooning of the informal economy? Various elements are responsible for a large informal economy. High formalisation costs, high taxation, huge regulatory burden and corruption, and poor enforcement are considered prime reasons of Pakistan’s informal economy. The costs of formalisation are both monetary and non-monetary. These costs may be prohibitively high.

According to the World Bank’s Doing Business Report 2013, a Pakistani entrepreneur must complete 10 procedures to start a business. These take at least 21 days. The cost involved in meeting the procedural requirements is 9.9 percent of per-capita income.

Simple back-of-the-envelope calculations show fulfilment of these requirements consumes your income of 36 days. Is the cost very high? To arrive at a conclusion let us analyse this in the light of some regional and developed countries. In the case of India, the total number of procedures involved is 12, the time involved is 27 days and the income earned by an average Indian in 182 days is spent in the fulfilment of procedural requirements.

For Sri Lanka, the total procedures are five and seven days are required, on average, while a Sri Lankan will earn the income required as start-up costs in 70 days. In the case of Bangladesh, seven procedures are involved and the time taken is 19 days, and an average citizen of Bangladesh would earn the money required to formalise the business in 92 days.

In the US the procedures involved are six and it takes six days to register your business. A US citizen can earn in five days the money required in the registration of his business. In the UK the number of procedures involved are 19, the days required to start a business are 13, and it takes the earnings of two-and-a-half days to cover procedural costs and formalities. For countries like Sweden, Finland and Switzerland, the start-up costs are much lower in terms of per-capita income.

Where do we stand in terms of start-up costs? Compared with the regional countries we do not lag behind as far as ease of starting business is concerned. Rather, Pakistan fares better. We lag behind the developed countries not in terms of number of procedures but in the time and costs involved in meeting the procedural requirements. Certainly, we need do to further improve our processes and reduce start-up costs, but the present start-up costs are not a big constraint for formalisation of a business. So formalisation costs we can be ruled out as a key reason for informality in Pakistan.

Is high taxation a big impediment for firms and businesses here? According to the Doing Business Report, the total tax rate for Pakistan is 35.3 percent. For India, Bangladesh, and Sri Lanka it is 61.8 percent, 35 percent and 50.1 percent, respectively. So tax rates are on the lower side, compared with those in regional countries like India and Sri Lanka.

The tax rates are higher compared with Pakistan even in developed countries like: the US (46.7 percent), the UK (35.5 percent), Sweden (53 percent), Norway (41.6 percent), Finland (40.6 percent), Australia (47.5 percent), and Belgium (57.7 percent). Therefore, high tax rates do not appear to be a big impediment to formalisation of businesses in Pakistan.

Even otherwise, if high tax rates are the chief cause of informal economy, then common sense tells us that informal economies should be larger in the developed countries where tax rates are much higher compared to Pakistan’s. But such is not the case. Then, why do businesses go underground in Pakistan? Why do not they formalise their activities? Let us first see what empirical evidence suggests on this issue.

In their paper titled ‘Dodging the grabbing hand: the determinants of unofficial activity in 69 countries’, Prof Eric Friedman, et al, have shown that higher tax rates are not associated with a larger unofficial economy. On the contrary, countries with high regulatory burdens on enterprises, higher corruption, poor rule of law and lower tax revenues tend to have huge informal economies.

These findings are relevant in our case. Pakistan’s informal economy consists of small and medium-sized retailers, wholesalers and manufacturers. Firms operating in the informal sector are reluctant to formalise their businesses, despite the formalisation costs being comparatively low. There is a perception that by getting their activities registered the firms will entangle themselves in a cobweb of corruption and regulations. But despite all their reservations, the dividends of formality outweigh the benefits of informality not only for the state but for informal businesses as well. If they are in the formal sector, they will have access to finance and modern technology. They will be able to exploit the economies of scale, thus having positive implications for costs and productivity.

But formalising the activities will not be possible unless mistrust between the economic agents and the state is reduced. It will be possible by reducing corruption, strengthening institutions and strictly enforcing the rule of law. A three-pronged comprehensive strategy focusing on reduction of the cost of operating formally (eg, reducing bribery and red-tape), incentivising informal businesses to go formal (eg, some type of fixed tax in the beginning, technical support to keep records and facilitating access to credit), and enhancing the enforcement capacity of government agencies is needed to reduce informality.

Any strategy that lacks incentives for formalisation of business activities is doomed to be a complete disaster as happened in 2000-01 when a drive for the documentation of the economy failed miserably in the face of stiff resistance from the unregistered sectors of the economy.

The writer is a graduate from Columbia University with a degree in economic policy management.Email: jamilnasir1969@gmail.com