SHADOW ECONOMY, TAX EVASION AND FACTOR PRICE DISTORTIONS IN PAKISTAN

Abstract

The study re-examines the informal sector and extent of tax evasion for Pakistan from 1980 to 2023. It considers a modified monetary method for estimation. This approach hypothesizes that an increase in tax burden causes a rise in cash transactions thereby giving rise to informal economic activity, while keeping other things the same. The study employs ARDL method after checking for stationarity of the data. Short run dynamics of ARDL are used to evaluate the volume of black economy in Pakistan as there is a weaker analogy about existence of long run cointegration between variables. To formulate currency demand equation, the study uses tax to gdp ratio as a proxy for tax burden, interest rate and inflation (GDP deflator) for factor price distortions, credit provided to private sector domestically for privatization and currency ratio as a proxy for weighing cash transactions. Through the currency demand approach, the shadow economy and tax evasion as a percentage of GDP is calculated. According to the study, the mean volume of underground economic activity remained 38.12% of GDP and tax evasion remained 3.92 % of GDP. The greater incidence of tax evasion in Pakistan suggests greater tax revenue losses for the government and difficulty in formulating effective macroeconomic policies.