A Critical Evaluation of A Critical Evaluation of Assessment of the Assessment of the

Estimates of Underground Estimates of Underground Economy and Tax Evasion Economy and Tax Evasion

in Pakistanin Pakistan

M. Ali KemalM. Ali Kemal

Black Economy & Tax Black Economy & Tax EvasionEvasion

Black EconomyBlack Economy Tax evasionTax evasion Some other terms are Some other terms are

Secondary EconomySecondary Economy Hidden EconomyHidden Economy Irregular EconomyIrregular Economy Unrecorded EconomyUnrecorded Economy Informal EconomyInformal Economy Underground Economy etc. Underground Economy etc.

OccurrenceOccurrence Cash transactions are common such Cash transactions are common such

asas ConstructionConstruction Illegal SaleIllegal Sale SmugglingSmuggling Drug Trafficking Drug Trafficking

CausationCausation High tax rateHigh tax rate RecessionRecession High unemploymentHigh unemployment Negative public attitudes towards Negative public attitudes towards

government government

AffectsAffects High tax ratesHigh tax rates Reduction in government servicesReduction in government services Unfair competitionUnfair competition Ineffectiveness of monetary and Ineffectiveness of monetary and

fiscal policiesfiscal policies Uneven playing field for honest Uneven playing field for honest

business business

ObjectivesObjectives Re-estimate the old models Re-estimate the old models Re-specify the model by using latest Re-specify the model by using latest

econometric techniques econometric techniques Estimate the size of underground Estimate the size of underground

economy and tax evasion.economy and tax evasion.

Methods for EstimationMethods for Estimation Direct MethodDirect Method Indirect MethodIndirect Method

Monetary ApproachMonetary Approach Fiscal ApproachFiscal Approach Labour Market ApproachLabour Market Approach

Monetary ApproachMonetary Approach To finance daily or short term needsTo finance daily or short term needs

LegalLegal IllegalIllegal

Black Economy is largely funded Black Economy is largely funded through cashthrough cash

Limitations of Monetary Limitations of Monetary ApproachApproach

Currency is the sole medium of Currency is the sole medium of transactiontransaction

No black economy activity before No black economy activity before the starting (benchmark) periodthe starting (benchmark) period

Income velocity of money in both Income velocity of money in both legitimate and black economies is legitimate and black economies is identicalidentical

Various Monetary Various Monetary ApproachesApproaches

11stst approach focuses on ratio of approach focuses on ratio of currency in circulation to demand currency in circulation to demand deposits and other definitions of deposits and other definitions of moneymoney

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)

Various Monetary Various Monetary ApproachesApproaches

2nd approach is based on QTM2nd approach is based on QTM Feige MethodologyFeige Methodology

Assumed that total bank deposits are used in Assumed that total bank deposits are used in irregular purchasesirregular purchases

Difference between total transactions and the Difference between total transactions and the actual GDP is the black economyactual GDP is the black economy

Problem is readily available dataProblem is readily available data 3rd approach concentrates on the 3rd approach concentrates on the

large denomination banknoteslarge denomination banknotes Method does not give size of black Method does not give size of black

economyeconomy

Fiscal ApproachFiscal Approach At Household LevelAt Household Level

If expenditure exceeds income in a same If expenditure exceeds income in a same time period then households may have time period then households may have been involved in black economy activity been involved in black economy activity

Unlikely to generate accurate estimatesUnlikely to generate accurate estimates Data problemData problem

At National LevelAt National Level Difference between income and Difference between income and

expenditures measure of GDP (IRD)expenditures measure of GDP (IRD) There are other reasons for There are other reasons for

discrepanciesdiscrepancies Poor indicatorPoor indicator

Labour Market ApproachLabour Market Approach The basis of the labour-market The basis of the labour-market

approach is the number of workers approach is the number of workers who are active in the black economy who are active in the black economy and/or the total number of hours and/or the total number of hours worked. worked.

No Data in PakistanNo Data in Pakistan

Review of Studies on Review of Studies on PakistanPakistan

Shabsigh (1995)Shabsigh (1995) Period: 1975-1990Period: 1975-1990

Simple linear formSimple linear form Stagnant growth pattern from 1975 Stagnant growth pattern from 1975

to 1990to 1990

),,,,,( ARIMADTMTPCBSRPCYfDDCC

Review of Studies on Review of Studies on PakistanPakistan

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 supply Question of reliability of data on money supply

before 1975before 1975

DGDPTaxif

MBBCC

DGDPTaxif

MCC

,,2

,,2

Review of Studies on Review of Studies on PakistanPakistan

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 20.2% in 1973, 36.8% in 1990 and

41.7% in 199641.7% in 1996

1)

2(,,,,,,

2 tMCCDBSPCYgR

GDPTT

GDPDTf

MCC

Review of Studies on Review of Studies on PakistanPakistan

Aslam (1998)Aslam (1998) Period: 1960-98Period: 1960-98

Log Linear FormLog Linear Form 29% in 1960, 43.9% in 1990, 43.8% in 29% in 1960, 43.9% in 1990, 43.8% in

1996, and 35.5% in 19981996, and 35.5% in 1998

DYgGDPTaxif

MFCACC ,,,2

)(

Estimates of Underground Estimates of Underground Economy ( 1975 – 1990)Economy ( 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)

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 Estimates are entirely based on

parametersparameters Incomparable EstimatesIncomparable Estimates

DataData Data SourcesData Sources

Annual Report of State BankAnnual Report of State Bank Currency in circulation, M1, M2, total Currency in circulation, M1, M2, total

number of bank deposits, total number of number of bank deposits, total number of bank accounts, interest rate, and foreign bank accounts, interest rate, and foreign currency accountscurrency accounts

Economic surveyEconomic survey GDP, GNP, inflation, real per capita income, GDP, GNP, inflation, real per capita income,

and total tax revenues and total tax 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-Reliability of data on money supply & Non-availability of data on banking servicesavailability of data on banking services

Construction of VariablesConstruction of Variables Banking Services Banking Services

M2 = M1 + time deposits + Other Deposits M2 = M1 + time deposits + Other Deposits Real interest rate=nominal interest rate-Real interest rate=nominal interest rate-

inflation rate inflation rate international trade taxes = custom duties + international trade taxes = custom duties +

sales tax on imports sales tax on imports Domestic taxes = tax revenues – Domestic taxes = tax revenues –

international trade taxes international trade taxes

Growth rate of GDPGrowth rate of GDP

t

t

tsBankAccountsBankDeposi

1

1

t

tt

GDPGDPGDP

ReplicationReplication Ahmed and Ahmed (1995)Ahmed and Ahmed (1995)

Unclear ResultsUnclear Results Significance and Signs, RSignificance and Signs, R22 and DW and 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 DW and 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 DW and DW Estimates of UGE and TEEstimates of UGE and TE

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

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 = Dummy variable defines 1 for 1990 to 1998 and

zero otherwisezero otherwise = Error Term= Error Term Subscript t shows time period Subscript t shows time period

tttttt

DGBSYTT

YDT

MFCACC

112

Methodology to Estimate Methodology to Estimate Underground Economy and Underground Economy and

Tax EvasionTax Evasion IMIM =[{(CC+FCA)/M2}=[{(CC+FCA)/M2}tt-{(CC+FCA)/-{(CC+FCA)/

M2}M2}wtwt]*M2]*M2((The difference gives us indication of how The 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)

Expected signsExpected signs Domestic Taxes Domestic Taxes +ve+ve International Trade Taxes International Trade Taxes +ve+ve Banking Services Banking Services +ve+ve Growth Growth –ve–ve Dummy Dummy +ve+ve

Empirical findings and Empirical findings and ResultsResults

Variable Coefficient t-StatisticConstant 0.233 2.39Lag of Domestic Taxes 0.921 1.13Lag of International Trade Taxes 0.167 0.22Banking Services 2.80E-05 3.22Growth Rate of Real GDP -0.275 -1.18DUM90 0.037 2.73

R2 = 0.94 F = 40.17 D.W. = 1.93

EstimatesEstimatesYears UGE TE Years UGE TE1980 13.31 1.82 1990 13.4 1.871981 13.73 1.92 1991 13.4 1.7

1982 14.87 2.11 1992 14.07 1.911983 15.67 2.11 1993 17.06 2.271984 14.43 2.01 1994 19.38 2.561985 14.68 1.9 1995 19.62 2.671986 13.59 1.91 1996 21.71 3.111987 13.95 2.02 1997 27.38 3.651988 13.82 1.91 1998 27.11 3.621989 12.13 1.74

Underground Economy as % Underground Economy as % of GDPof GDP

0

5

10

15

20

25

30

1980198119821983198419851986198719881989199019911992199319941995199619971998

Tax Evasion as % of GDPTax Evasion as % of GDP

0

0.5

1

1.5

2

2.5

3

3.5

4

ConclusionsConclusions

Changing time period, functional Changing time period, functional forms, exclusion or inclusion of forms, exclusion or inclusion of variables, changing the benchmark variables, changing the benchmark period change the results drasticallyperiod change the results drastically

Benchmark period 1980Benchmark period 1980 Very sensitive to velocity of moneyVery sensitive to velocity of money

(V,UGE)= 98.4%(V,UGE)= 98.4% (V,TE) = 97.4%(V,TE) = 97.4%

ConclusionsConclusions

The estimates should not be taken as The estimates should not be taken as precise measures, it could be taken precise measures, it could be taken as broad indications of trends and of as broad indications of trends and of

orders of magnitude because they orders of magnitude because they are sensitive to the assumptions are sensitive to the assumptions

(Tanzi, 1983) (Tanzi, 1983)

ConclusionsConclusions Underground economy and tax evasion Underground economy and tax evasion

as percentage of GDP doubled in the last as percentage of GDP doubled in the last nineteen years nineteen years

Underground economy as percentage of Underground economy as percentage of GDP and tax evasion as percentage of GDP and tax evasion as percentage of GDP increased sharply in the last seven GDP increased sharply in the last seven yearsyears 10.6% (UGE)10.6% (UGE) 11.4% (TE)11.4% (TE)

After 1993 rate of increase in After 1993 rate of increase in underground economy is greater than underground economy is greater than the rate of increase in formal economy the rate of increase in formal economy