Undocumented Economy: A Bane for Pakistan’s Economic Growth

Undocumented Economy A Bane for Pakistan’s Economic Growth by Quratulain Babar

The following article, “Undocumented Economy: A Bane for Pakistan’s Economic Growth“, is written by Quratulain Babar, a student of Sir Syed Kazim Ali. Moreover, the article is written on the same pattern, taught by Sir to his students, scoring the highest marks in compulsory subjects for years. Sir Kazim has uploaded his students’ solved past paper questions so other thousands of aspirants can understand how to crack a topic or question, how to write relevantly, what coherence is, and how to include and connect ideas, opinions, and suggestions to score the maximum.

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Outline

1-Introduction
2-What is the Undocumented Economy?
3-Pakistan’s Undocumented Economy: Current Scenario

4-Why Undocumented Economy is a Bane for Pakistan’s Economic Growth

  • ✓Poor revenue collection: a substantial burden on the economy
  • ✓Deteriorating fiscal capacity: a major culprit behind the fragile economy
  • ✓Money laundering: a nightmare for the economy
  • ✓Reduced labour productivity: an impediment to economic growth

5-Factors Influencing the Undocumented Economy in Pakistan

  • ✓Unjust tax system
  • ✓Incapacitated banking sector
  • ✓Rampant corruption

6-Way Forwards to Contain the Undocumented Economy of Pakistan

  • ✓An overhaul of the tax system
  • ✓Improvement in the performance of the banking sector
  • ✓Measures to reduce corruption

7-Conclusion

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Answer to the Question

Introduction

The undocumented economy, often referred to as an informal or shadow economy, has been a great concern for economies worldwide, particularly in the developing world. Pakistan, being no exception, faces its own set of economic challenges due to this parallel economy as the country has a significant informal sector. For instance, the country faces difficulty collecting revenue due to the undocumented economy. This peril leads to further economic issues like budgetary constraints. Moreover, money laundering – a product of the undocumented economy – is causing huge losses to the economy. This jeopardy is fuelled by many factors, like the structural issues in the taxation system, poor performance of the banking sector, and rampant corruption. Hence, the government needs to take bold steps to counter all the factors contributing to the undocumented economy.

What is an Undocumented Economy?

An undocumented economy refers to the economic activities that go unrecorded and untaxed by the government authorities. It is also called the black economy, informal economy, grey economy, underground economy, the unofficial economy, and the shadow economy. According to the International Monetary Fund (IMF), the informal economy is a worldwide phenomenon consisting of activities with market value that would contribute to tax income and gross domestic product (GDP) if documented. Moreover, almost all the transactions made in the informal economy are through cash, for example, payments to contractual workers, illegal sales transactions, transactions involved in smuggling and money laundering, and cash payments to shopkeepers who do not provide valid cash memos. Generally, self-employed persons are involved in tax evasion and underground economic activities because of a lack of lack of a formal documentation system of self-employed persons and their activities.

The Undocumented Economy of Pakistan: Current Situation

Currently, the informal sector shares a major chunk of Pakistan’s economy. According to a World Bank Report, the total size of the undocumented economy in Pakistan is around $457 billion. The sector encompasses various entities, such as street vendors, domestic workers, small businesses, and large portions of the real estate sector. Along with unregistered trades, many registered and documented sectors are also involved in the undocumented economy. To avoid tax, they conceal their production and assets from tax authorities. Moreover, this sector employs a large portion of the population; for example, according to the Labour Force Survey 2020-21, nearly 75% of the total labour force in Pakistan is engaged in informal sector employment.

Why the Undocumented Economy is a Bane for Pakistan’s Economic Growth

The country’s economy is grappling with many challenges due to the undocumented economy, which are discussed below.

Poor revenue collection: a substantial burden on the economy

First, the undocumented economy is the primary reason for poor revenue collection by the government. To illustrate, this sector usually escapes from the formal taxation system, and businesses and individuals operating in the informal sector do not comply with tax regulations, leading to a loss of potential tax revenue. For instance, it is estimated that income tax evasion is almost five times the collected amount. The loss of revenue is then either filled through the increase in tax rates or the price of inelastic goods. To reduce the prices, the government reduces the money supply and increases the interest rate, which reduces the credit creation and the level of investment. Moreover, the lack of funds also reduces the government’s ability to invest in public services, like education, healthcare, and infrastructure essential for economic growth. Thus, the underground economy results in poor revenue collection, leading to multifaceted challenges for the economy.

Deteriorating fiscal capacity: a major culprit behind the fragile economy

In addition, the informal economy deteriorates the government’s fiscal capacity, which has a domino effect on the country’s overall economic performance. Poor revenue collections due to the undocumented economy result in budgetary constraints. This pushes the country into the vicious cycle of economic crisis; for example, the government has to borrow loans to fill the fiscal gap created by the low revenue collection, increasing the debt burden. According to the World Bank’s Pakistan Federal Public Expenditure Review, the country’s fiscal deficit, averaging 6.2pc of GDP during the last decade, has been one of the main reasons behind the nation’s rapidly burgeoning public debt and growing trade gap. Hence, the undocumented economy is pushing the country to the verge of economic catastrophe.

Money laundering – a nightmare for the economy

Another economic repercussion of the undocumented economy for the country is money laundering – an illegal process of making large amounts of money generated by criminal activity, such as drug trafficking, terrorist funding, and smuggling. Undoubtedly, the lack of documentation and regulation opens room for illicit activities; its glaring manifestation is the illegal tobacco trade in the country. In this regard, Stop Illegal Trade’s representative said that there are 52 tobacco companies in Pakistan, and only 2 of them, with 60% market share, contribute to the 98% taxes collected from the sector. On the other hand, about 50 companies with 40% market share pay only 2% of the taxes from the sector. This is causing a loss of Rs. 77 billion annually to the national exchequer through tax evasion. Thus, the undocumented economy is at the forefront of the economic challenges faced by the country and is closely linked to money laundering.

Reduced labour productivity: an impediment to economic growth

Further, the informal economy hampers labour productivity in the country, impeding economic growth. For instance, the informal economy is highly unregulated and lacks the enforcement of labour laws and standards. This leads to poor working conditions, low wages, and a lack of job security and worker benefits. Such conditions reduce productivity and economic opportunities. For example, according to the London School of Economics, labour productivity has increased only 1 per cent since 2007. Undoubtedly, the informal economy is direly affecting economic productivity.

Factors Influencing the Undocumented Economy in Pakistan

This menace has its roots in many factors, which are discussed below.

Unjust tax system

One of the primary reasons for the increase in the undocumented economy is the complex and unfair tax regime of the country. To illustrate, the active registered companies – petroleum, banking, and manufacturing sector – and the salaried class bear the brunt of tax collection. On the other hand, major sectors, such as agriculture, are given exemptions due to their political clout. Moreover, the number and rate of taxes are so high; for instance, a few years back, more than a hundred different taxes were in operation in our country, out of which most frequently charged 77 taxes included 20 federal taxes, 19 provisional taxes, 14 local taxes, and 24 other levies and surcharges. These factors make the documentation of the economy difficult.

Complex procedures of formal banking

Another contributor to the informal economy is the complexity of banking procedures. The complex procedures constrain the masses from opening bank accounts. According to the Access to Finance Study, only 14% of all rural and urban Pakistanis use a financial product or service, including savings, credit, and insurance. It is due to the inability of the financial sector to provide services to the nearby residents as it takes twice as long in Pakistan to open an account as it does in the rest of South Asia. Thus, the impotence of the banking sector is contributing to the expansion of the undocumented economy.

Unprecedented corruption

Moreover, corruption by certain authorities, in collusion with businessmen, increases the volume of the informal economy. For example, corrupt taxation officers take bribes from certain taxpayers and do not conduct their audits properly. They benefit these taxpayers on under-invoicing, cash payments, and inadmissible expenses. According to a study conducted by the Lahore University of Management and Sciences (LUMS), out of Rs. 100, the government receives only Rs. 38, and Rs. 62 is pocketed by taxpayers, tax collectors, and tax practitioners. With this corruption, a large chunk of informal revenue goes untaxed.

Way Forward to Contain the Undocumented Economy of Pakistan

The issue can be addressed by taking certain practical measures.

An overhaul of the taxation system

First, there is a dire need to revamp the structural flaws in the taxation system. This can be done by making clear laws with communicable tax procedures. Moreover, providing incentives to the taxpayers with some direct social and material advantages is required. There is also a need to make the tax laws equitable by bringing all politicians into the tax net and taxing the agriculture income. It will help in the documentation of the economy.

Improvement of the banking sector

Second, the banking sector must be improved to reduce the undocumented economy. In this regard, an overhaul of the banking procedures is required. For instance, it is required to simplify the procedures and reduce red tape mechanisms, which are the major hurdles in the documentation of the economy. Further, the financial sector should expand its network, so every citizen can access financial services. Thus, unless the banking sector is revamped, it would be difficult to contain the rise of the undocumented economy.

Measures to curb corruption

Third, the government needs to take harsh measures to reduce corruption. In this consideration, filing annual returns and asset declaration forms should be mandatory for all politicians and bureaucrats. Along with that, the government should also conduct regular audits of officers. In addition, the government should increase the salaries of tax officers so that they work honestly without being involved in corruption. These steps will help reduce corruption, leading to a decrease in the informal economy.

Conclusion

In conclusion, a large informal economy is a grave concern for the government. It has disastrous effects on the country’s economy, which is manifested in many forms. To explain, the falling tax collection, increasing fiscal deficits, and decreasing labour productivity threaten Pakistan’s economic growth. Thus, the government should counter the factors, structural flaws in the tax regimes and corruption, influencing the growth of the undocumented economy.

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