THE tax and tariff reforms during the 1990s can be regarded as the first comprehensive exercise of its kind and therefore it becomes desirable to gauge their impact on the black economy and on tax evading practices.

With some modifications, this paper uses the standard monetary approach to obtain the latest estimates of the size of the black economy and its macroeconomic implications.

If the underground economy is large and significant, there is a clear evidence of market distortions, poor governance and of disproportionate administrative regulations.

The phenomenon has been discussed and defined in economic literature under many different names such as unofficial, informal, unregistered, unobserved, shadow, subterranean, parallel, hidden, invisible and irregular.

Conceptually, there are four classifications of the underground economy according to the particular institutional rules they violate. These are: illegal economy; unreported economy; unrecorded economy and informal economy.

Moreover, as Schneider and Frey (2001), point out, the notion of underground or the black economy should not be identified only with illegality. Most of the activities are perfectly legal but the taxes are evaded due to different reasons and due to loopholes in the economy itself.

The study addresses the issue of the size of the unreported economy in Pakistan and in estimating the resources that are lost due to tax evasion and its avoidance.

As is evident, a comparison of these studies in the context of Pakistan reveals contradicting results vis-à-vis the size of the black economy. Econometrically, the bases of these alternative results may include (i) choice of variables, (ii) choice of the estimation period, and (iii) choice of the functional form and underlying assumptions.

The data for our analysis covers the 1960 to 2003 period and is obtained from various issues of the Pakistan Economic Survey and the State Bank of Pakistan’s annual reports.

The black economy turns out to be at its peak during the early 1960s, when the corporate and personal income tax rates were high. The corporate income tax rate was 30 per cent including 30 per cent super tax during that time. This (aggregate corporate income and super tax of 60 per cent) rate dropped to 40 per cent during the late 1980s.

Likewise, the maximum personal income tax rate was 75 per cent during the 1960-64 period, which was the reason for the black economy to remain well above 30 per cent of the GDP during the same period.

The black economy kept declining during the 1965-75 period, when this rate was brought down within the 60-70 per cent range (Qureshi, 1989, pp.23). Furthermore, this rate was 56 per cent during 1980-1986, later brought down to 39 per cent in 1988 and subsequently to 28 percent in 1993 – the effect of which is consequently reflected by the shrinking black economy in the periods under review.

However, Kemal (2003), reports an increasing trend of the black economy during 1995 and 1998 – which is contrary to our results.

A possible explanation could be the tax reform effect, which was absent in Kemal (2003). Furthermore, results of Kemal (2003) are based on a special specification where lagged dependent variable is used as explanatory variable with a high positive co-efficient.

In the present study, the impact of tax reforms is dominating. The black economy as a percentage of GDP declined by nine percentage points in case of both currency ratio and currency bearer bond equation during 1996 and 1997. The corresponding decline in tax evasion as percentage of GDP was 39 per cent and 32 per cent, respectively, for both methods used.( Figure 1 and 2)

The black economy remained relatively high during the early 1990s at around 26 per cent of GDP. During that period, tax-to-GDP ratio was almost stagnant at 13 per cent and the rate of return on deposits was falling - a disincentive to withdraw from activities related to the black economy

Nevertheless, during 1996-97, tax-to-GDP ratio dropped to 12.7 per cent after touching its peak at 14 per cent, coupled with the increase in rate of return on deposits from 6.4 per cent to 6.8 per cent. Both these factors, especially the tax reform effect, played a significant role in slashing the black economy.

The further decline of tax-to-GDP ratio during the 1999-00 period, which does not appear to have great impact on the size of the black economy, was actually the result of re-basing of the country’s GDP. On the other hand, the sharp decline of rate of return on deposits from 1998 onwards, acted as a hurdle in reducing the size of the black economy.

Roughly, the inclusion of bearer bonds increases, on an average, the black economy as a percentage of the GDP by five percentage points each year. Bearer bonds were introduced during the mid 1980s to promote savings.

Later on, they became a handy medium of exchange due to their limited physical quantity requirement for any transaction as against currency and also because of their hassle-free acquisition.

The annual compound growth rate of currency in circulation and bearer bonds during the last two decades remained almost the same; i.e. at 12 per cent. Also the size of the black economy has slightly increased from 2000 onwards. This is, perhaps, due to the reduction of rate of return on deposits, which declined by more than 30 per cent during the 2000-2003 period, revealing the weak stance of the monetary policy.

During the same period, the effective coverage of indirect as well as direct taxes was increased. This brought some of the untaxed sectors into the tax net, causing the tax-to-GDP ratio to increase slightly by 0.26 per cent.

In this paper, an attempt has been made to estimate the size of the unreported part of the economy, that is the result of tax evasion. This becomes of special importance once the impact of taxation reforms is incorporated. Overall, the black economy has a declining trend as a percentage of GDP. This is due to the tax reforms involving rationalisation of tax rates.

Despite the fact that the black economy as a percentage of the GDP has decreased, the annual compound growth rate of the black economy during the sample period remained more than 11 per cent. At disaggregated level, this growth remained at two per cent during the 1960s, 17 per cent during the 1970s, 15 per cent during the 1980s and 13 per cent during the 1990s and onwards .

Similarly, tax evasion grew at the rate of 12 per cent. This growth remained at five per cent during the 1960s, 19 per cent during the 1970s, 16 per cent during the 1980s and 11 per cent during the 1990s and onwards.

Estimates of the black economy cannot be taken as precise measures. They can, nevertheless, be effectively used to deduce broad trends and directions.

In the light of above discussion, therefore, several suggestions pertaining to policy actions can be made. Although increase in the direct tax revenue is vital for a developing country because of its redistributive effects, the medium of this increase, nonetheless, cannot solely be the increase in tax rates since this gives rise to tax evasion.

Instead, broadening the tax base would be an ultimate solution. To supplement these efforts, official administration regarding the detection and preventing of tax evasion should be improved.

Tax reform process should be consolidated and integrated with other macroeconomic reforms. The presence of loopholes in the system and the prevailing corruption among the tax authorities cannot be ignored when dealing with the issue of evasion.

These inefficiencies must be dealt accordingly in order to curb the tax losses and to reduce the cost of being part of the reported economy.

(Edited excerpt from SPDC research report on “Estimating the Black Economy through Monetary Approach”: A Case Study of Pakistan”).