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Factors that accelerate Informal Economy

 Factors that accelerate Informal Economy

In Pakistan, the tax gap is estimated to be over 11 percent of GDP – a fact that signifies the huge potential for tax revenue. The tax authorities need to exploit this potential in order to mobilize additional tax revenue of more than Rs 3.3 trillion that will jack the tax-to-GDP ratio up from the current 11.5 percent to 23.3 percent. The huge tax gap – almost equal to tax collection of Rs 3.33 trillion – signifies that the size of informal economy in Pakistan is as large as that of the formal economy. Largely, the causes of informal economy are rooted in the tax system. Size and structure of tax burden, efficiency of tax administration in collecting taxes, penalty policy, complexity or fairness of the tax system and compliance costs determine the size of the informal economy.

Higher tax burden

There is no denying the fact that higher tax burden increases the size of informal economy. It is because increasing the tax burden makes it more cost-effective to operate in the informal sector. In Pakistan, the tax base is extremely narrow with 1.26 million tax return filers for the tax year 2017. Tax burden of the assigned tax targets has always been on existing taxpayers. Nonetheless, in view of the narrow tax base and low voluntary tax compliance in the country, many forms of withholding tax are being used to collect taxes from informal sectors; though provisions relating to presumptive tax regime are regressive in nature. The sales tax rate of 17 percent is considered significantly high; many supplies are, however, subject to reduced and even zero rates. Moreover, exemptions are available to many low-income societal groups. Major portion of the tax collection comes through indirect taxes. It means a significant tax burden is on consumption sector which directly affects the low-income groups.

Weak enforcement measures

The tax gap of 11 percent of GDP further signifies taxman’s limited capacity to detect tax evasion. First, the tax administrators do not have human resource enough in number to catch each and every tax-evader. Second, capacity and skill level of the tax administrators is also too limited to detect tax evasion. Third, the tax authorities do not always get assistance from other law-enforcement agencies in nabbing the tax-evaders. Fourth, there are no adequate financial and logistic resources placed at the disposal of the tax authorities so as to facilitate them in carrying out the cumbersome work of conducting investigations against the tax fraudsters. Fifth, tax audits are not being conducted so effectively that they create deterrence against tax-evasion. As tax-evaders fear little of being caught for tax recovery along with penalties and additional taxes, they continue to operate in the informal sector. Sixth, the tax authorities have the capacity to select and conduct audit، thereupon، of only tax affairs of the return filers. Persons not registered for tax purposes continue operating in the informal sector.

Inadequate tax audits

Businesses and individuals do not always cooperate with the tax authorities during audits of their tax affairs. Audits are largely concluded either ex parte or they are based on third-party information, such as from banks. In a number of disputed cases, huge tax liability is assessed on the basis of third-party information such as bank statements or income tax returns. The assessment orders are declared void and of no legal effect by the courts if they are not based on specific provisions of the tax statutes. An immediate reasoning for the poor quality of assessment work is the pressure of reporting every month the number of assessments and quantum of the tax demand created, which is used as one of the criteria for assessing performance of the tax authorities. Knowing the lacunae in tax audit policy and weaknesses of the tax authorities in the conduct of audits, taxable persons foresee little probability for detection of tax evasion. Furthermore, decisions of the appellate authorities in favour of the taxable persons regarding sales tax liability during the period when the taxable persons were liable to be registered also encourage them to operate in the informal economy.

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About Bilal Hassan

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The writer is a graduate in Taxation Policy & Management from Keio University Japan and has certification in International Economics and Law & Economics from Faculty of Economics Keio University, JAPAN. He can be accessed at

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