It is a well-tested hypothesis in economics that when the formal sector becomes expensive and complicated, people prefer to opt for informal alternatives, which bolsters the shadow economy.

Due to stringent state policies in Pakistan, the informal sector in 2023 was valued at approximately $457 billion, nearly 64 per cent larger than the formal sector.

A common misconception is that the informal and black economies are similar notions. Look under the hood, in reality, the black economy refers to the underground economy constituted by black and illegal money, such as corruption, bribery, and money laundering.

Conversely, the informal economy consists of money that is not channelled through the formal financial sector and tax net. Historically, prior to the emergence of the financial system, entire economies were informal — this did not mean they were illegal.

In Pakistan, influential segments of society aim to create confusion among the masses about the informal and black economy to divert attention from black money and illegal activities. By using the same connotation for both the black and informal economies, they dilute the severity — and concentration — of the masses’ attention from black money.

Most small and medium enterprises (SME) operate within the informal economy, representing 75pc of employment in main jobs outside agriculture according to some estimates and contributing over 40pc to the GDP. These businesses often operate for fear of being considered illegal.

According to the Vice Chancellor of Pakistan Institute of Development Economics Nadeem Ul Haque, this misconception allows Federal Board of Revenue (FBR) officials to exploit them, further entrenching their position in the informal sector and hindering potential growth.

The FBR’s differentiated treatment of non-filers has created a phobia among SME owners

Why do people not use formal channels that are secure and rapidly growing even while having legal sources of earning but instead remain in the informal sector? The most important factors in this regard are tax rates and administrative sludge.

First, consider the FBR process, which categorises taxpayers into three groups — filer, non-filer, and late-filer — each treated differently with varying tax rates.

According to Nadeem Ul Haque, instead of increasing the number of filers, the FBR’s differentiated treatment of non-filers has created a phobia among SME owners and customers, driving them to rely on cash transactions.

According to State Bank data from 2023, cash in circulation constitutes 30pc of the total money supply (M2), or around 11pc of the national GDP. In contrast, this figure is around 5pc or less in neighbouring countries. This disparity underscores the reluctance to engage with formal financial systems due to the perceived complexity and punitive nature of the tax system.

The government’s approach in budget FY25 to increase tax revenue will decrease the income and earnings of existing tax filers, thereby enhancing the reluctance — phobia — among non-filers to join the tax net and the formal financial sector.

When we talk about the efficiency and accountability factor, according to a study by Lahore University of Management Sciences, for every Rs100 of tax collected, only Rs38 reaches the government, while Rs62 is distributed among the taxpayer, tax collector and tax practitioner, resulting in significant unrealised tax revenue.

The projected tax revenue for the current fiscal year is estimated at Rs12.97 trillion, with indirect taxes contributing over 57pc of this total. Notably, 65pc of the indirect taxes are derived from sales tax, which has experienced a significant 36pc increase compared to the previous year.

This uptick indicates a considerable rise in the prices of goods and services, as well as the overall cost of doing business in Pakistan. On the direct taxation front, the government collected Rs3.72tr last year. The budgeted amount for this year is Rs5.51tr, reflecting a 48pc increase in income tax.

However, the number of taxpayers has not correspondingly increased. Consequently, the existing taxpayers are shouldering this substantial financial burden. As a result of these fiscal pressures, there has been a notable contraction in the middle class, shrinking from 40pc to 35pc over the last year.

When we talk about the largest market, real estate, property values in Pakistan can be assessed based on two official metrics: the district collector (DC) and FBR rates. However, these rates frequently fail to capture the nuances of the dynamic real estate market.

One major issue is the infrequency with which these rates are updated — typically, revisions occur only once every five years. This lag in updating exacerbates the problem, often resulting in a systematic undervaluation of properties relative to real-time market prices.

Consequently, during real estate transactions, it is common for buyers and sellers to mutually agree on the actual market value of a property but report a significantly lower value on official documents. This practice, primarily aimed at adhering to the outdated DC and FBR rates, facilitates tax avoidance by minimising the recorded transaction value.

The writer is an assistant professor (PhD Financial Economics) at the National University of Modern Languages, Islamabad. Email: abwahid.fms@gmail.com

Published in Dawn, The Business and Finance Weekly, July 8th, 2024