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