The Underground Economy: Estimation, and Economic and Policy Implications -- The Case of Pakistan

WP/95/101-EA
The Underground Economy: Estimation, and Economic and Policy
Implications -- The Case of Pakistan
by Ghiath Shabsign


This paper estimates the size of the underground economy (UE) in
Pakistan and assesses its economic impact during 1975-91. It estimates the
underground economy's GDP and its components -- the domestic sector, which
measures the underground overall domestic absorption, and the export and
import sectors -- providing insights into the dynamics of the UE.
Furthermore, the estimated data were used to assess empirically the impact
of the UE on the Government's fiscal position and on the investment-output
relation.

The results confirm the existence of large UE in Pakistan. The UE's
GDP averaged 22.6 percent of formal GDP during the study period, with a
growth rate slightly higher than that of the formal GDP. The domestic
component of the UE's GDP averaged 35.4 percent of the formal GDP and had
grown at an average annual rate of 9 percent, a much higher rate than the
formal domestic sector's growth rate of 5 percent. The size of the UE in
the import sector relative to formal import sector, averaging some 35
percent of formal import sector, was the largest among the various
components of UE's GDP. The data also show that the relative size of UE in
the external sector had grown significantly relative to the domestic sector
since the beginning of economic reforms in the Pakistan in 1987, reflecting
increased opportunities created by the opening of the economy.

Analyzing the relation between the UE and the fiscal position of the
Government suggests a mutual dependency between the size of the UE and
fiscal deficits. Continued fiscal deficits had contributed to the growth of
the UE. In turn, the growth of UE was a significant factor in the continued
problem of containing the fiscal deficits. The analyses of the role of the
UE in the national income-expenditure cycle show a leakage of resources from
the formal economy to the UE via private investments, with an overall net
loss in economic efficiency.

Finally, the paper proposes long- and short-run policies, based on
fiscal restrain and economic liberalization, to reduce the size of the UE.