A critical evaluation of assessment of the estimates of underground economy and tax evasion in Pakistan

1. A Critical Evaluation of AssessmentA Critical Evaluation of Assessment
of the Estimates of Undergroundof the Estimates of Underground
Economy and Tax EvasionEconomy and Tax Evasion
in Pakistanin Pakistan
M. Al i KemalM. Al i Kemal

2. Black Economy & Tax EvasionBlack Economy & Tax Evasion
 Black EconomyBlack Economy
 Tax evasionTax evasion
 Some other terms areSome other terms are
 Secondary EconomySecondary Economy
 Hidden EconomyHidden Economy
 Irregular EconomyIrregular Economy
 Unrecorded EconomyUnrecorded Economy
 Informal EconomyInformal Economy
 Underground Economy etc.Underground Economy etc.

3. OccurrenceOccurrence
 Cash transactions are common such asCash transactions are common such as
 ConstructionConstruction
 Illegal SaleIllegal Sale
 SmugglingSmuggling
 Drug TraffickingDrug Trafficking

4. CausationCausation
 High tax rateHigh tax rate
 RecessionRecession
 High unemploymentHigh unemployment
 Negative public attitudes towards governmentNegative public attitudes towards government

5. AffectsAffects
 High tax ratesHigh tax rates
 Reduction in government servicesReduction in government services
 Unfair competitionUnfair competition
 Ineffectiveness of monetary and fiscal policiesIneffectiveness of monetary and fiscal policies
 Uneven playing field for honest businessUneven playing field for honest business

6. ObjectivesObjectives
 Re-estimate the old modelsRe-estimate the old models
 Re-specify the model by using latest econometricRe-specify the model by using latest econometric
techniquestechniques
 Estimate the size of underground economy and taxEstimate the size of underground economy and tax
evasion.evasion.

7. Methods for EstimationMethods for Estimation
 Direct MethodDirect Method
 Indirect MethodIndirect Method
 Monetary ApproachMonetary Approach
 Fiscal ApproachFiscal Approach
 Labour Market ApproachLabour Market Approach

8. Monetary ApproachMonetary Approach
 To finance daily or short term needsTo finance daily or short term needs
 LegalLegal
 IllegalIllegal
 Black Economy is largely funded through cashBlack Economy is largely funded through cash

9. Limitations of Monetary ApproachLimitations of Monetary Approach
 Currency is the sole medium of transactionCurrency is the sole medium of transaction
 No black economy activity before the startingNo black economy activity before the starting
(benchmark) period(benchmark) period
 Income velocity of money in both legitimateIncome velocity of money in both legitimate
and black economies is identicaland black economies is identical

10. Various Monetary ApproachesVarious Monetary Approaches
 11stst
approach focuses on ratio of currency inapproach focuses on ratio of currency in
circulation to demand deposits and othercirculation to demand deposits and other
definitions of moneydefinitions of money
 Guttmann’s MethodGuttmann’s Method
 CC/DDCC/DD
 Tanzi’s MethodTanzi’s Method
 CC/M2CC/M2
 8.1% - 11.7% for 1929-76 (1980)8.1% - 11.7% for 1929-76 (1980)
 3.6% - 5% for 1929-80 (1983)3.6% - 5% for 1929-80 (1983)

11. Various Monetary ApproachesVarious Monetary Approaches
 2nd approach is based on QTM2nd approach is based on QTM
 Feige MethodologyFeige Methodology
 Assumed that total bank deposits are used in irregularAssumed that total bank deposits are used in irregular
purchasespurchases
 Difference between total transactions and the actual GDPDifference between total transactions and the actual GDP
is the black economyis the black economy
 Problem is readily available dataProblem is readily available data
 3rd approach concentrates on the large3rd approach concentrates on the large
denomination banknotesdenomination banknotes
 Method does not give size of black economyMethod does not give size of black economy

12. Fiscal ApproachFiscal Approach
 At Household LevelAt Household Level
 If expenditure exceeds income in a same time periodIf expenditure exceeds income in a same time period
then households may have been involved in blackthen households may have been involved in black
economy activityeconomy activity
 Unlikely to generate accurate estimatesUnlikely to generate accurate estimates
 Data problemData problem
 At National LevelAt National Level
 Difference between income and expendituresDifference between income and expenditures
measure of GDP (IRD)measure of GDP (IRD)
 There are other reasons for discrepanciesThere are other reasons for discrepancies
 Poor indicatorPoor indicator

13. Labour Market ApproachLabour Market Approach
 The basis of the labour-market approach is theThe basis of the labour-market approach is the
number of workers who are active in the blacknumber of workers who are active in the black
economy and/or the total number of hourseconomy and/or the total number of hours
worked.worked.
 No Data in PakistanNo Data in Pakistan

14. Review of Studies on PakistanReview of Studies on Pakistan
 Shabsigh (1995)Shabsigh (1995)
 Period: 1975-1990Period: 1975-1990
 Simple linear formSimple linear form
 Stagnant growth pattern from 1975 to 1990Stagnant growth pattern from 1975 to 1990
),,,,,( ARIMADTMTPCBSRPCYf
DD
CC
=

15. Review of Studies on PakistanReview of Studies on Pakistan
 Ahmed and Ahmed (1995)Ahmed and Ahmed (1995)
 Period: 1960-90Period: 1960-90
 Log Linear FormLog Linear Form
 51.96% in 1960, 35.09% in 199051.96% in 1960, 35.09% in 1990
 Question of reliability of data on money supplyQuestion of reliability of data on money supply
before 1975before 1975
( )






=
+






=
D
GDP
Tax
if
M
BBCC
D
GDP
Tax
if
M
CC
,,
2
,,
2

16. Review of Studies on PakistanReview of Studies on Pakistan
 Iqbal Qureshi and Mahmood (1998)Iqbal Qureshi and Mahmood (1998)
 Period: 1970-1996Period: 1970-1996
 Simple Linear FormSimple Linear Form
 20.2% in 1973, 36.8% in 1990 and 41.7% in 199620.2% in 1973, 36.8% in 1990 and 41.7% in 1996






= −1)
2
(,,,,,,
2
t
M
CC
DBSPCYgR
GDP
TT
GDP
DT
f
M
CC

17. Review of Studies on PakistanReview of Studies on Pakistan
 Aslam (1998)Aslam (1998)
 Period: 1960-98Period: 1960-98
 Log Linear FormLog Linear Form
 29% in 1960, 43.9% in 1990, 43.8% in 1996, and29% in 1960, 43.9% in 1990, 43.8% in 1996, and
35.5% in 199835.5% in 1998






=
+
DYg
GDP
Tax
if
M
FCACC
,,,
2
)(

18. Estimates of Underground EconomyEstimates of Underground Economy
( 1975 – 1990)( 1975 – 1990)
0
10
20
30
40
50
60
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990
Ahmed and Ahmed (1995) Iqbal, Qureshi and Mahmood (1998)
Aslam (1998) Shabsigh (1995)

19. What did we get…?What did we get…?
 Functional formFunctional form
 Benchmark periodBenchmark period
 Inclusion and Exclusion of VariablesInclusion and Exclusion of Variables
 Velocity of moneyVelocity of money
 Estimates are entirely based on parametersEstimates are entirely based on parameters
 Incomparable EstimatesIncomparable Estimates

20. DataData
 Data SourcesData Sources
 Annual Report of State BankAnnual Report of State Bank
 Currency in circulation, M1, M2, total number of bankCurrency in circulation, M1, M2, total number of bank
deposits, total number of bank accounts, interest rate,deposits, total number of bank accounts, interest rate,
and foreign currency accountsand foreign currency accounts
 Economic surveyEconomic survey
 GDP, GNP, inflation, real per capita income, and totalGDP, GNP, inflation, real per capita income, and total
tax revenuestax revenues
 CBR Annual ReportCBR Annual Report
 Sales tax on imports and custom dutiesSales tax on imports and custom duties
 Period: 1976 to 1998Period: 1976 to 1998
 Reliability of data on money supply & Non-availabilityReliability of data on money supply & Non-availability
of data on banking servicesof data on banking services

21. Construction of VariablesConstruction of Variables
 Banking ServicesBanking Services
 M2 = M1 + time deposits + Other DepositsM2 = M1 + time deposits + Other Deposits
 Real interest rate=nominal interest rate-inflation rateReal interest rate=nominal interest rate-inflation rate
 international trade taxes = custom duties + sales tax oninternational trade taxes = custom duties + sales tax on
importsimports
 Domestic taxes = tax revenues – international trade taxesDomestic taxes = tax revenues – international trade taxes
 Growth rate of GDPGrowth rate of GDP
t
t
tsBankAccoun
tsBankDeposi
1
1
−
−−
t
tt
GDP
GDPGDP

22. ReplicationReplication
 Ahmed and Ahmed (1995)Ahmed and Ahmed (1995)
 Unclear ResultsUnclear Results
 Significance and Signs, RSignificance and Signs, R22
and DWand DW
 Estimates of UGE and TEEstimates of UGE and TE
 Aslam (1998)Aslam (1998)
 Unclear ResultsUnclear Results
 Significance and Signs and RSignificance and Signs and R22
and DWand DW
 Estimates of UGE and TEEstimates of UGE and TE
 Iqbal, Qureshi and Mahmood (1998)Iqbal, Qureshi and Mahmood (1998)
 More stable that the above twoMore stable that the above two
 Significance and Signs and RSignificance and Signs and R22
and DWand DW
 Estimates of UGE and TEEstimates of UGE and TE

23. Estimation ProcedureEstimation Procedure
 Stationarity testStationarity test
 Jacque-Bera testJacque-Bera test
 Coefficient of variationCoefficient of variation
 CorrelationCorrelation
 Functional formsFunctional forms
 Inclusion and Exclusion of variablesInclusion and Exclusion of variables

24. ModelModel
 CCCC = currency in circulation= currency in circulation
 FCA= Foreign Currency AccountsFCA= Foreign Currency Accounts
 M2M2 = Money Supply= Money Supply
 DTDT = Domestic Taxes= Domestic Taxes
 YY = GDP at current market prices= GDP at current market prices
 TTTT = Trade Taxes= Trade Taxes
 BSBS = Banking Services= Banking Services
 GG = Growth Rate of Real GDP= Growth Rate of Real GDP
 DD = Dummy variable defines 1 for 1990 to 1998 and zero= Dummy variable defines 1 for 1990 to 1998 and zero
otherwiseotherwise
 εε = Error Term= Error Term
 Subscript t shows time periodSubscript t shows time period
ttt
ttt
DGBS
Y
TT
Y
DT
M
FCACC
ελϕγδβα ++++





+





+=




 +
−− 112

25. Methodology to Estimate UndergroundMethodology to Estimate Underground
Economy and Tax EvasionEconomy and Tax Evasion
 IMIM =[{(CC+FCA)/M2}=[{(CC+FCA)/M2}tt-{(CC+FCA)/M2}-{(CC+FCA)/M2}wtwt]*M2]*M2
((The difference gives us indication of howThe difference gives us indication of how
much currency holding is tax inducedmuch currency holding is tax induced))
 LM=M1-IMLM=M1-IM
 VV =Y/LM=Y/LM
 UGE=IM*VUGE=IM*V
 TE=UE*(Tax/Y)TE=UE*(Tax/Y)

26. Expected signsExpected signs
 Domestic TaxesDomestic Taxes +ve+ve
 International Trade TaxesInternational Trade Taxes +ve+ve
 Banking ServicesBanking Services +ve+ve
 GrowthGrowth –ve–ve
 DummyDummy +ve+ve

27. Empirical findings and ResultsEmpirical findings and Results
Variable Coefficient t-Statistic
Constant 0.233 2.39
Lag of Domestic Taxes 0.921 1.13
Lag of International Trade Taxes 0.167 0.22
Banking Services 2.80E-05 3.22
Growth Rate of Real GDP -0.275 -1.18
DUM90 0.037 2.73
R2
= 0.94 F = 40.17 D.W. = 1.93

28. EstimatesEstimates
Years UGE TE Years UGE TE
1980 13.31 1.82 1990 13.4 1.87
1981 13.73 1.92 1991 13.4 1.7
1982 14.87 2.11 1992 14.07 1.91
1983 15.67 2.11 1993 17.06 2.27
1984 14.43 2.01 1994 19.38 2.56
1985 14.68 1.9 1995 19.62 2.67
1986 13.59 1.91 1996 21.71 3.11
1987 13.95 2.02 1997 27.38 3.65
1988 13.82 1.91 1998 27.11 3.62
1989 12.13 1.74

29. Underground Economy as % of GDPUnderground Economy as % of GDP
0
5
10
15
20
25
30
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

30. Tax Evasion as % of GDPTax Evasion as % of GDP
0
0.5
1
1.5
2
2.5
3
3.5
4
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

31. ConclusionsConclusions
 Changing time period, functional forms,Changing time period, functional forms,
exclusion or inclusion of variables, changing theexclusion or inclusion of variables, changing the
benchmark period change the results drasticallybenchmark period change the results drastically
 Benchmark period 1980Benchmark period 1980
 Very sensitive to velocity of moneyVery sensitive to velocity of money
 γγ(V,UGE)= 98.4%(V,UGE)= 98.4%
 γγ(V,TE) = 97.4%(V,TE) = 97.4%

32. ConclusionsConclusions
The estimates should not be taken as precise measures, itThe estimates should not be taken as precise measures, it
could be taken as broad indications of trends and ofcould be taken as broad indications of trends and of
orders of magnitude because they are sensitive to theorders of magnitude because they are sensitive to the
assumptions (Tanzi, 1983)assumptions (Tanzi, 1983)

33. ConclusionsConclusions
 Underground economy and tax evasion asUnderground economy and tax evasion as
percentage of GDP doubled in the last nineteenpercentage of GDP doubled in the last nineteen
yearsyears
 Underground economy as percentage of GDPUnderground economy as percentage of GDP
and tax evasion as percentage of GDP increasedand tax evasion as percentage of GDP increased
sharply in the last seven yearssharply in the last seven years
 10.6% (UGE)10.6% (UGE)
 11.4% (TE)11.4% (TE)
 After 1993 rate of increase in undergroundAfter 1993 rate of increase in underground
economy is greater than the rate of increase ineconomy is greater than the rate of increase in
formal economyformal economy