[Analytics] Understanding the informal economy of Pakistan

The Federal Board of Revenue (FBR) has been actively taking steps, especially in the recent past, to increase documentation of the economy. Along with increasing the tax base in the country, this is basically to decrease the informal sector of the economy, which according to some estimates is at least one-third of the GDP (gross domestic product) of Pakistan. Omer Javed specially for the Pakistan Today.

At the same time, as the formal sector grows, it will also allow government to better safeguard the rights of the labour– including better addressing the child labour issue– previously involved in the informal sector.

The importance of the informal sector is paramount in developing countries in general, basically due to its sheer size. It is therefore important to measure it in a better way, a message which has also been recently voiced by the managing director (MD) of the IMF (International Monetary Fund), Kristalina Georgieva at the beginning of the 7th IMF Statistical Forum. In that she underlined the importance of use of technology in better measuring informality, which generally is mostly concentrated in the agriculture and retail sectors.

Moreover, she pointed out that while the digitization of economies has provided more opportunity to involve informal employment, yet research indicates that ‘Poverty levels among people in informal employment are, on average, twice as high as that of people in formal employment… because of low productivity, low incomes, and limited access to government benefits’.

The IMF MD also highlighted the large involvement of women in the informal sector, where as per the ILO (International Labour Organization) ‘in developing economies, 92 percent of women workers are informally employed’, which is indeed a very high number, and points to the fact that women, more than men, are suffering from lack of safeguard of labour rights there. For example, in Pakistan, cottage industry appears to employ a lot of women in the informal sector, who in turn are therefore most affected by the lack of safeguards of labour rights, including the application of minimum wage.

Given the above methods, extensive studies need to take place in Pakistan to understand the true extent of informal sectors. Here, the work being done at the 7th IMF Statistical Forum also needs to be internalized for employing useful techniques in understanding the dynamics and size of the informal sector in the case of Pakistan

That said, the information on labour market statistics in the informal sector is quite limited, and therefore requires better effort by individual governments and multilateral agencies like the IMF. The focus of the IMF’s forum towards this will indeed help in this regard. Here, it may be pertinent to indicate the main methodologies with regard to measuring the informal economy, as outlined in the IMF’s May 2017 Sub-Saharan Africa’s ‘Regional Economic Outlook: Restarting the Engine Growth’ report.

Here, to measure the size of the informal economy, the most commonly used direct approaches ‘…rely on surveys and samples based on voluntary replies, or tax auditing and other compliance methods. While providing great detail about the structure of the informal economy, the results are sensitive to the way the questionnaire is formulated and to respondents’ willingness to cooperate. Consequently, surveys are unlikely to capture all informal activities’.

Then there are the ‘indictor’ or indirect approaches, which measure from a macroeconomic perspective, whereby the first approach approximates the size of the informal economy through measuring the ‘discrepancy between national expenditure and income statistics’; with the approximation in calculation mainly creeping through the assumption that ‘all the components of the expenditure side are measured without error and constructed so that they are statistically independent from income factors’.

In the second indirect approach, the informal economy’s size is approximated through the ‘the discrepancy between the official and actual labor force’, yet the main weakness in this approach is the presence of other explanatory factors– like ‘business cycle, difficulty in finding a job, and education and retirement decisions’– for the downward fluctuation in the labour force participation rate (assuming total labour force participation is constant) other than that ‘…can be interpreted as an increase in the importance of the informal economy’.

Third is the ‘electricity approach’ whereby ‘…the difference between growth of electricity consumption and growth of official GDP as a proxy for the growth of the informal economy’. Yet disadvantages of this approach include ‘…(1) not all informal economy activities require a considerable amount of electricity (for example, personal services) or the use of other energy sources (for example, coal, gas), hence only part of the informal economy growth is captured; and (2) the electricity-overall GDP elasticity might vary significantly across countries and over time’.

Other indirect approaches include fourthly the ‘transaction approach’ and fifthly the ‘currency demand approach’, which may also be looked into for usefulness of measurement in the specific situation of an economy. The next approach in this regard, is the ‘multiple indicators-multiple cause (MIMIC) approach’. Although being quite exhaustive in nature, the approach nonetheless is not without criticism. Here, explicitly considered are ‘…several causes as well as the multiple effects of the informal economy… [making use]… of the associations between the observable causes and the effects of an unobserved variable, in this case the informal economy, to estimate the variable itself. The estimated MIMIC coefficients allow us to determine only relative estimated sizes of the informal economy in a particular country over time. In order to convert these measures into percent of GDP values we need to apply a benchmarking or calibration procedure’.

Given the above methods, extensive studies need to take place in Pakistan to understand the true extent of informal sectors; where all the above approaches are adopted to generate better statistics, and overall to reach greater clarity on the size and different aspects of this sector. Here, the work being done at the 7th IMF Statistical Forum in this direction, also needs to be internalized for employing useful techniques in understanding the dynamics and size of the informal sector in the case of Pakistan.

Omer Javed holds PhD in Economics degree from the University of Barcelona, and previously worked at International Monetary Fund.

Tags: Pakistan