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Shadow economy

A recent BR Research analysis points towards alarming growth in Pakistan’s shadow economy. The story titled ‘The shadows are growing longer’ (published: 10 January 2013) estimated that the country’s informal sector is growing about 5-6 percent per annum due to lack of documentation, a culture of tax evasion and an ever present war economy. The central bank’s third quarterly report 2012 also notes that is vibrant, creating a disconnect between the formal and informal economy.

This warrants immediate attention of the policymakers since a large shadow economy promotes conflicts at various levels. In effect, it also challenges the writ of the state and pushes any country towards state failure. Here is how:

It is true that there is no empirical relationship between shadow economy and war economy, ie the presence of shadow economy cannot be construed as a cause of conflict. However, studies have shown that the existence of shadow economy has time and again proven to facilitate conflicts by way of redistributing resources and power.

The conflicts in the context of war economy can be of several types. And these are often financed by shadow economy such as the blood diamonds in the case of Sierra Leone or opium in the case of Afghanistan and Pakistan since the 1980s, or drugs and guns business in Karachi, Pakistan.

Other types of conflicts that a shadow economy can breed include ethnic or civil strife arising out of socio-economic disparity amongst the masses. It is no happy coincidence, therefore, that countries with bigger percentage of shadow economies are also marked with lower degree of development (See graphs).

By their very nature, shadow economies are characterised by wide gaps in income levels. Compared to formal sector, where regulation often demands employee benefits or the provident fund etc, the presence of informal sector means that more and more people will be relying on government welfare programme, and thereby a burden on national exchequer. While a completely failed or fragile state may not have a welfare programme, those weak states that do, are faced with additional burdens resulting from the persistence of shadow economy.

A study by German scholar Macus Ruge also claims that shadow economy is closely connected with the development of the state and the political goods and services it provides.

The study titled ‘Determinants and Size of the Shadow Economy – A Structural Equation Model’ reveals a strong negative correlation between shadow economy and ‘administrative system’ of the state (-0.92); the latter was indexed out of 14 variables indicators, including bureaucratic quality and regulatory system.

Shadow economy was also found to be negatively correlated to ‘constitution, trust and values’ (-0.89), which was indexed out of 11 indicators, including rule of law, regime durability and democratic accountability.

In other words, the existence of informal economy adds risks to the state’s ability to build the political network and offer political goods such as infrastructure. This leads to the following vicious cycle. Conventional shadow economy (which may be defined as undocumented, untaxed trade in otherwise legal goods and services) leads to lower tax revenues. This reduces the quality and the quality of public services provided by the state. In turn, there is mistrust on the government’s ability to supply public good and services which encourage individuals and businesses to move further into the shadow economy and thereby erode the quality and quantity of political deliverables even more.

The cycle can then potentially give birth to conflicts due to a socio-economic disparity. The disparity aggravates the picture by forcing people to either slip into conventional shadow economy or otherwise start trading in illegal goods (also a part of shadow economy in larger definition), leading to conflicts. And to support conflict, the need for shadow economy increases even more. The bottom line is that if Pakistan’s informal economy is growing faster than the formal economy, then an urgent action is needed to reverse the situation and bring people in the ‘formal’ bracket.

(The writer is a development consultant)

Sohaib Jamali, "Shadow economy," Business recorder. 2013-01-16.
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