What is Hidden, in the Hidden Economy of Pakistan? Size, Causes, Issues, and Implications

Transcription

1 The Pakisan Developmen Review Vol. 49:4 Par II (Winer 2010) pp Wha is Hidden, in he Hidden Economy of Pakisan? Size, Causes, Issues, and Implicaions AHMED GULZAR, NOVAIRA JUNAID, and ADNAN HAIDER * 1. INTRODUCTION The informal economy is iniially considered as he subsidiary secor in erms of is conribuion o he overall economy. However, i received he focus of aenion wih he publicaion of Peer Gumann s esimaes for sizing he informal economy (i.e. US $ 200 billion in 1976) for he US economy especially in he conex of achieving he goal of inclusive growh and developmen. The informal economy is recognised wih differen names in differen counries/regions hroughou he world. For example, he Swedish and Russian erm i as Hidden Economy, he English call i Fiddle, he Japanese recognise i as Hidden Incomes, he French idenify i as Travail au noir, he Ialian consider i as The Lavorno Nero, while in Pakisan i has been analysed as an Hidden Economy or Informal Economy. The informal economy includes all hose economic aciviies which are no repored or no included in he Naional Income Accouns. These include boh legal and illegal economic aciviies. According o he Resoluion adoped by he 15h Inernaional Conference of Labour Saisicians (ICLS), he legal side of he informal economy comprises of unis such as household enerprises, engaged in he producion of goods and services wih he primary objecive of generaing employmen and income o he persons concerned, no necessarily wih he deliberae inenion of evading he paymen of axes or oher legislaive or adminisraive provision. These unis ypically operae a a low Ahmed Gulzar <ahmed_g2008@live.com> is Research Officer a Naional Transpor Research Cenre (NTRC), Minisry of Communicaions, Islamabad, and Research Scholar a Deparmen of Economics, Pakisan Insiue of Developmen Economics, Islamabad, Pakisan. Novaira Junaid <novairajunaid@homail.com> is Research Scholar a Beaconhouse Naional Universiy (BNU), Lahore, Pakisan. Adnan Haider <adnan.haider@sbp.org.pk> is Research Analys a Research Deparmen, Sae Bank of Pakisan, Karachi, and PhD Fellow a Deparmen of Economics, Pakisan Insiue of Developmen Economics, Islamabad, Pakisan. Auhors Noe: The views in his paper are hose of he auhor(s) and no hose of he insiuions, hey are aached wih. Auhors are responsible for any error and emission. Finally feedback/commens are srongly welcomed. Auhors would like o hank Dr Waqar Masood Khan, Dr Hafiz A. Pasha, and Muhammad Kazim Idrees, Chief Naional Transpor Research Cenre (NTRC) for heir valuable views/ commens on he above subjec for maerialising his comprehensive sudy. We are also graeful o Dr Zafar M. Nasir (paper discussan a 26h AGM, 2010) for his useful commens/suggesions which improved he qualiy of he paper.

2 666 Gulzar, Junaid, and Haider level of organisaion, on a small scale, and wih labour relaions mosly based on causal employmen. Expendiure for producion is ofen indisinguishable from household expendiure. The unis as such canno engage in ransacions or ener conracs wih oher unis, nor incur liabiliies. A self explanaory Figure 1 provides a simple visual srucure of formal and informal secors and heir iner linkages. Fig. 1. Hierarchical Srucure of Formal and Informal Secors 1 The illegal economic aciviies as par of he informal economy include; smuggling, hef, prosiuion, narcoic/forbidden commodiy rade, gambling ec. Naional Income Accouns (NIA) as per design also exclude many aciviies such as moonlighing, unregisered employmen, unregisered income earned hrough FOREX, under reporing of reail sales, illegal employmen (child labour), suspec invenory evaluaions, ransfer of money hrough hundi, hidden renals and barer business. All hese economic aciviies by heir naure ac as an aemp o evade huge amoun of axes, hereby causing burden on he public reasury. The persisen failure o manage economic sysem as refleced by a low ax-gdp raio, an incredible increase in energy requiremens, persisen upward inflaionary movemens especially in food iems and consumer durables explains much of underlying ruh of neglecing he quanificaion, causes and implicaions of he informal economy wih in he public policy framework. Moreover, he informal economy appears o have grea respec for geographical and geopoliical boundaries especially in he curren phase of Pak-India and Pak-Afghanisan relaions and Pakisan s logisic suppor o NATO forces in he wake of War agains Terrorism. The desrucion of 2005 Earhquake and calamiies of he recen flood in 2010 add a greaer poenial o he expansion of he hidden economy. From socio-economic poin of view, he unbridled price hike especially 1 The secors in he formal secor and informal secor are idenified only in he conex of Pakisan on he basis of reviewed lieraure and discussions wih he expers in he relevan fields.

3 Hidden Economy of Pakisan 667 in food iems and consumer durables, incessan increase in he prices of elecriciy and peroleum goods, he implemenaion of new GST/VAT sysem may give an informal aiude o he general living syle. A inernaional level, here is much conemporary debae abou he role of he informal secor in an economy and is poenial in lessening povery. The size and significance of he informal secor in Asia, conribuing abou 41 percen in he GDP, makes i a vial poin of analysis for undersanding he brun of he downurn in he emerging economies of he region. Thus, i is he need of he hour o find ou wheher or no he informal secor cushions agains he self-perpeuaing evil of povery, and helps he sricken economy o escape from he seamrolling noose of recession in Pakisan. These facs moivae us o underake he curren sudy and analyse he informal economy from differen aspecs in Pakisan. Ideally, he correc measuremen of he informal economy requires he aggregaion of all legal/illegal hidden economic aciviies. Since, i requires an effecive check and balance which is quie unworkable especially in he underdeveloped and he developing economies. The only way lef which is raher crude in is naure, is he indirec approach o esimae he size of he informal economy wih he available daa on macro economic variables. Our conribuion in his paper is o esimae he size of informal economy hrough five indirec approaches namely; Moneary Approach, Modified Moneary Approach hrough Dynamic OLS (DOLS), Elecriciy Consumpion Approach, Srucural Muli-Indicaors Muli-Causes (MIMIC) Approach and Labour Marke Approach. This blend of various approaches has been adoped for he firs ime in case of Pakisan. 2 The oher objecives of his sudy include; he deerminaion of causes, issues/implicaions of he informal economy in Pakisan and provide useful policy implicaions in order o ascerain he desired policy goals of inclusive growh and developmen especially in he conex of he 18h amendmen and he 7 h Naional Finance Commission (NFC) Award. The res of he paper is organised as follows: Secion 2 oulines he review of relevan lieraure. Secion 3 discusses he daa and empirical mehodology in deail. Secion 4 analyses he resuls and discussions. Secion 5 conains he causes and implicaions of he informal economy which emerge from he analysis. Finally, Secion 6 comprises of he conclusion (also conaining some public policy guidelines) of he paper whereas resuls are repored in he appendix par of he paper. 2. REVIEW OF RELEVANT LITERATURE The informal economy by is srucure works hrough he proliferaion of labourinensive underakings and backward and forward linkages wih he formal economy; see for insance, Williams and Tumusiime-Muebile (1978). Consequenly, i acs as a cushion agains povery and income inequaliy, especially during exernal shocks: see for example, Frey (1997). Across he emerging marke economies, he informal secor coninues o expand in boh absolue and relaive erms. Is growh has been largely due 2 In auhors opinion, here is a need o conduc his sudy o produce more accurae and reliable esimaes of he size of he informal economy over he period of analysis wih he help of differen approaches a once. A sudy by Ahmed (2009) surveyed various empirical sudies on informal economy in he case of Pakisan. The auhor shows his reservaions on he empirical esimaes of he size of informal economy available in all previous sudies. He concludes ha informal economy and ax evasion esimaes are unreliable and highly doubful.

4 668 Gulzar, Junaid, and Haider o he weak capaciy of he formal privae secor o generae adequae employmen and incomes due o high growh raes of labour force and rural-urban migraion in he developing areas as noed by Sehuraman (1997). Over he decades, he informal economy sared o arac he aenion of economiss and policy makers as a resul of which many approaches have been adoped o esimae he acual size of he informal economy, bu each is ied wih is own limiaions. Ou of all, firs one is he labour marke approach, he roos of which originae from he labour marke by considering he number of workers acively paricipaing in he informal economy and heir oal number of hours worked. However, Pyle (1989) argues ha i is no possible o accuraely measure he number of hours worked and he average produciviy. Moreover, his approach is useful for counries having small informal economy. Feige (1979) srived o guessimae he size of he US economy from he sandpoin of paymens and ransacions. Based on famous Fischer s equaion of exchange MV=PT, he assumed he aggregae money supply o be a good qualiy indicaor of he oal size of he informal economy. The ransacion mehod resuled in a negaive hidden economy for he period , which illusraed a falling informal economy in he era of World War II. An earlier aemp on his approach was made by Cagen (1958), who was ineresed in explaining he long run behaviour of he currency o money supply over he period Tanzi (1980) re-hypohesised he same link o obain esimaes for he US black economy. He assumed ha currency was used o carry ou ransacions in he black economy and high axes were responsible for he increased size of he black economy. In addiion o menioned sudies, O Higgins (1981) also used he moneary approach by aking he raio of currency o M1 and raio of currency o M3 as dependen variables in esimaing he underground economy for Unied Saes for he period Schneider (2002) esimaed he size of he informal economy in 110 developing, ransiional and OECD counries by using he currency demand approach, he physical inpu mehod and he srucural modelling approach. The resuls concluded ha he average size of he informal economy as a percenage of official GNI in he year 2000 was 41 percen for he developing counries, 38 percen for he ransiional counries and 18 percen for he OECD counries. A large burden of axaion and social securiy conribuions combine wih governmen regulaions were he main deerminans of he size of he informal economy. For many years, he informal economy has been he cenre of aenion of many researchers in Pakisan, 4 making remendous effors o quanify he acual size of his par of he overall economy hrough various approaches. Shabsigh (1995) adoped he same roue of moneary approach o esimae he underground economy for he period He used raio of currency in circulaion o oal demand deposis (M2-currency in circulaion) as a dependen variable while real per capia income, real rae of ineres, per capia banking services, average axes on impors, expors and domesic aciviies were 3 According o Cagen (1958, page. 312), Some people evade axes by making as many ransacions as possible wih currency and no reporing o he ax collecor. 4 Earlier aemps have been made by Burki (1982) who highlighs various issues relaed wih urban informal secor of Pakisan and Ahmad, e al. (1991) who sudied he dynamics of learning and earning profile of Pakisan s informal secor.

5 Hidden Economy of Pakisan 669 chosen as explanaory variables. He concluded ha he size of he black economy was 21 percen of he oal GDP in 1975 and declined slighly o 20.4 percen in 1990, hus implying a orpid underground economy. Ahmed and Ahmed (1995) adoped he moneary analysis o esimae he size of he black economy using daa for he period hrough Tanzi s approach. The inclusion of bearer bonds along wih currency in circulaion revealed ha he level of ax evasion has increased over he number of years bu he black economy as a percenage of GDP regisered a decline in Pakisan. They concluded ha he size of he informal economy declined from 52 percen in 1960 o 35 percen in Aslam (1998) also used Tanzi s mehodology o esimae he size of he underground economy by aking he log-raios of currency in circulaion and foreign currency accouns o M2 as a dependen variable, while log of oal ax revenues as a percenage of GDP, log of ineres rae on ime deposis and log of dummy variable for period were aken as independen variables. Auhor s esimaes reveal ha he underground economy has been increased from 29 percen in 1960 o 43.9 percen in Iqbal, e al. (1998) used he raio of currency in circulaion o M2 as he dependen variable while real ineres rae, real per capia income growh, banking services, domesic axes as percenage of GDP, inernaional rade axes as percenage of GDP, dummy variable for he period and a lagged dependen variable o accoun for he ineria in he money marke were aken as independen variables. They have also esimaed he secoral decomposiion of he underground economy. The resuls concluded ha he underground economy increased from 20.2 percen in 1973 o 51.3 percen in Khalid (2002) esimaed he underground economy for Pakisan using moneary approach bu his esimaes are differen from hose of Kemal (2003) due o differen benchmark periods aken ino consideraion. In addiion o his, Khalid (2002) added he real rae of ineres and GDP per capia as independen variables while Kemal (2003) used GDP growh as a proxy o economic developmen, he resuls became eviden ha he underground economy as a percenage of GDP increased afer 1991, reached a maximum in 1998 and hen declined. Yasmin (2004) adoped he moneary approach o measure he underground economy (UGE) hrough ax evasion in Pakisan over he period Esimaing he currency demand equaion o consruc he size of he underground economy and ax evasion, he resuls demonsraed ha he underground economy has increased enormously from Rs 12 billion in 1974 o Rs 1085 billion in Kemal (2003) used he same dependen variable as above while he explanaory variables were ax-gdp raio, banking services, GDP growh rae and a dummy variable for he period o esimae he size of informal economy for Pakisan from He concluded ha he informal economy increased from 20 percen in 1974 o 54 percen in 1998 and hen declined o 37 percen in Kemal (2007) revised he old aemp of Kemal (2003) and used he bes fi moneary approach o esimae he underground economy and ax evasion for Pakisan for he period The updaed esimaions showed ha he underground economy and ax evasion were increasing rapidly in he early 1980s and his rae acceleraed in he

6 670 Gulzar, Junaid, and Haider 1990s. The rae of increase slowed down ill 1999 and hen followed an increasing rend ill The underground economy ranges from 54.6 percen-62.8 percen of GDP in 2005 while he ax evasion ranges from 5.7 percen-6.5 percen of oal GDP in Ahmed and Hussain (2008) made a comprehensive exercise o obain he laes esimaes for he size of he informal economy in Pakisan for he period by aking ino accoun he ax and ariff reforms of 1990s. Based on he mehodology of Ahmed and Ahmed (1995) wih sligh modificaions, hey came up wih he conclusion ha he black economy has a declining rend as a percenage of GDP due o he ax reforms involving raionalisaion of ax raes. Moreover, he inclusion of bearers bond in he model also increases he size of he black economy. The informal secor as a percenage of GDP remained a 2 percen during 1960s, 17 percen during 1970s, 15 percen during 1980s and 13 percen during 1990s. Similarly, he ax evasion as a percenage of GDP remained a 5 percen during 1960s, 19 percen during 1970s, 16 percen during 1980s, and 11 percen during 1990s and so on. Finally, in a recen sudy by Arby, e al. (2010), he size of he informal economy in Pakisan is esimaed by using modified moneary approach by employing auoregressive disribued lagged (ARDL) model based approach, elecriciy consumpion approach and muli-indicaors and muli-causes (MIMIC) model approach for he period The modified moneary approach showed ha he underground economy increased from less han 30 percen in 1960s o 33 percen in 1990s and hen declined o 23 percen in 2000s. The elecriciy consumpion approach showed ha he informal economy increased from abou 5 percen in 1970s o 29 percen in 1990s and hen declined o 27 percen in 2000s. However, he MIMIC model showed ha he informal economy was around 30 percen of he oal GDP in Pakisan over he sample period. I also showed ha business cycle in informal economy moved wih he business cycle of he formal secor economy in Pakisan. 3. DATA AND METHODOLOGICAL SETUP This secion briefly oulines he empirical seup by illusraing daa and various srucural and saisical approaches o esimae he informal economy for Pakisan Daa To esimae he informal economy using various approaches, daa over he annual frequencies from is used on various economic, poliical, insiuional and demographical variables. Deails on he consrucion and he sources of he daa se are provided in Table 1of he appendix Mehodologies In order o esimae he informal economy, we used various srucural and saisical approaches. The lis of approaches sar from simple moneary approach as of Tanzi (1980), modified moneary approach using Dynamic Ordinary Leas Square (DOLS) echnique of coinegraion, srucural esimaion approach using muli-indicaors muli-causes (MIMIC), elecriciy consumpion approach (EC) and labour marke approach using saisical accouning. The nex subsecions consis of descripions on each mehodology in deail.

7 Simple Moneary Approach Hidden Economy of Pakisan 671 This secion provides a simple moneary approach consisen o he seminal aemps of Tanzi (1980) for esimaing he informal economy of Pakisan. Following his approach, i is a need o ge esimaes of he following regression: Where, CFM 2 0 1TY 2POP 3INF 4CFM 2 1 BS Y R DD CFM2 = raio of currency in circulaion and residen foreign currency accouns o money supply TY = raio of overall ax o GDP POP = overall populaion INF = rae of inflaion CFM2 ( 1) = lagged variable used for he raio of currency in circulaion and residen foreign currency accouns o money supply DD = dummy variable aking he value of 1 from (o capure he impac of foreign currency accouns afer 1990 ) BS = oal number of bank deposis / oal number of bank accouns Y = real growh of GDP R = weighed average rae of reurn on deposis. For each year, he final prediced value of raio of currency in circulaion and residen foreign currency accouns o money supply is compued by subracing he regressed values of raio of currency in circulaion and residen foreign currency accouns o money supply wihou including he ax variable (CFM2) w from he regressed values of raio of currency in circulaion and residen foreign currency accouns o money supply including he ax variable (CFM2) in he regression equaions. Afer subracion, he final prediced value of raio of currency in circulaion and residen foreign currency accouns o money supply is equal o he coefficien of oal ax o GDP raio imes he acual value of oal ax o GDP raio for each year as shown below; (CFM2) = TY + 2 POP + 3 INF + 4 CFM DD + 6 BS + 7 Y + 8 R (CFM2) w = POP + 3 INF + 4 CFM DD + 6 BS + 7 Y + 8 R CFM2 = (CFM2) (CFM2) w = [ TY + 2 POP + 3 INF + 4 CFM DD + 6 BS + 7 Y + 8 R ] [ POP + 3 INF + 4 CFM DD + 6 BS + 7 Y + 8 R ] CFM2 = (CFM2) (CFM2) w = TY + 2 POP + 3 INF + 4 CFM DD + 6 BS + 7 Y + 8 R 0 2 POP 3 INF 4 CFM2-1 5 DD 6 BS 7 Y 8 R The soluion o above yields: CFM2 = 1 TY. The final prediced value of raio of currency in circulaion and residen foreign currency accouns o money supply is divided by 100 so as o remove he percenage. From here, his esimaed series CFM2 is 5

8 672 Gulzar, Junaid, and Haider muliplied wih M2 o ge he illegal money. In order o calculae legal money in he economy, he series of illegal money is subraced from he series of M2 for each year. Moving ahead, velociy of money in he underground economy is esimaed by dividing he oal GDP wih legal money. Assuming ha he velociy of money is same for boh legal and illegal money in he economy, he final esimaions for he underground economy is obained by muliplying he illegal money wih he velociy of money for each respecive year. Tax evasion for each year is calculaed by muliplying he underground economy wih oal ax o GDP raio. Illegal money (IM) = CFM2 * M2 Legal money (LM) = M2-IM Velociy (V) = GDP / LM Informal Economy (IE)= IM * V Tax Evasion (TE) = IE * (oal axes / GDP) IE as % of GDP = (IE / GDP) * 100 TE as % of GDP = ( TE / GDP) *100 According o Tanzi (1980), he final esimaes from he moneary approach compuing he size of he underground economy for any counry should no be considered as precise esimaes, because hey are sensiive o assumpions raher, i would be highly expedien o consider hem as broad indicaors of a flucuaing rend over he period of analysis Modified Moneary Approach using Dynamic OLS The mos recen sudy in he case of Pakisan by Arby, e al. (2010) defined a new approach named modified version of he moneary approach using Auoregressive Disribued Lag 5 (ARDL) model. According o auhors, i is heir seminal aemp o use ARDL modelling approach o esimae he informal economy in case of Pakisan. Furher, his approach overcomes he problem associaed wih he esimaion of informal economy hrough simple moneary approach of Tanzi (1980) as he resuls of simple moneary approach may be spurious. Since, he ARDL modelling approach allows using differen order of inegraion series, while compuing long-run esimaes; his approach is also capable o handle he problem of endogeneiy hus providing unbiased coinegraed esimaes. Using he ARDL approach, he auhors succeeded in esablishing a long run dynamic relaionship beween he currency raio and oher associaed variables. Then, hey used he long-run coinegraed esimaes o compue informal economy for Pakisan. The coinegraion lieraure of ime series economerics has anoher credible approach named Dynamic Ordinary Leas Square (DOLS) developed by Sock and Wason (1993). This mehod is also useful for he invesigaion of long run relaionships among dependen and explanaory variables. The esimaion procedure works by esimaing he dependen variable on consan plus explanaory variables on level form and leads and lags a he firs differences. This mehod is superior o a number of oher esimaors as i can be applied o sysem of variables wih differen orders of inegraion; 5 This Co-inegraion approach is suggesed by Pesaran and Shin (1999) and Pesaran, e al. (2001).

9 Hidden Economy of Pakisan 673 see for example, Sock and Wason (1993). This mehodology is a subsiue of ARDL approach coinegraion as he inclusion of leads and lags of he differenced explanaory variable correcs for simulaneiy, endogeneiy, serial correlaion and small sample bias among he explanaory variables see, Sock and Wason (1993). We follow Arby, e al. (2010) specificaions o modify Tanzi s (1983) moneary approach of esimaing he informal economy. The model specificaion assumes he (CM) currency o M2 raio as a dependen variable and (T) ax burden proxies by ax o GDP raio, a proxy for financial secor developmen, marke ineres rae as a proxy of moneary policy, and lieracy rae as a proxy of human capial as key deerminans. The informal economy s compuaional procedure is based on DOLS esimaion procedure raher han ARDL. Thus, i enables us o use an alernaive esimaion mechanism and ge reliable esimaes. CM T F R H r 0 2 i p 1 FT i 2 r R 1 i p 3 i r 4 H 1 i p r 1 i p The usual long-run resricion is esed by Wald-Coefficien resricion ess as specified by Sock and Wason (1993). Once he coinegraion hypohesis is acceped, i is assumed ha here exiss a long-run relaionship beween he specified se of variables. The long-run model can be re-wrien from he above DOLS specificaions as: CM ˆ 0 ˆ 1T ˆ 2F ˆ 3R ˆ 4 H I is imporan o noe ha here is no need of normalisaion as DOLS provide direc esimaes. Given hese esimaes, one can easily compue informal economy as percenage of formal economy (GDP): ˆ1 T ˆ 4 Raio( IF / F) m E Where, IF is GDP of informal economy; F is he GDP of formal economy and m is he raio of near money o broad money, respecively Srucural Approach Using Muli-Indicaors and Muli-Causes (MIMIC) This secion formally layous a modern srucural approach named Muli- Indicaors and Muli-Causes (MIMIC) approach. I represens a saisical vis-à-vis economic relaionship among laen (hidden or unobserved) and manifes (observed) variables. The special srucural form assumes linear independen srucural relaionship (also called as LISREL) among unobserved and manifes variables. In an earlier aemp, Bollen (1989) presens he fundamenal hypohesis for srucural equaion modelling as: CS = ( ), where is he observed populaion covariance marix, is a vecor of model parameers, and CS is he covariance marix implied by he model. When he equaliy expressed in he equaion holds, he model is said o fi he daa. Thus, he objecive of his modelling approach is o explain he paerns of covariance observed among he laen and observed variables. A special version of his modelling approach is i T i

10 674 Gulzar, Junaid, and Haider he Muli-Indicaors and Muli-Causes approach. On one hand, i allows o consider he srucural equaion as a laen or hidden variable linked o a number of observable indicaors and on he oher hand o a se of observed causal variables, which are regarded as some of he mos imporan deerminans of he unrepored economic aciviy see for example, Schneider, Büehn and Monenegro (2010). The MIMIC model is build upon wo sors of equaions; he srucural one and he measuremen equaions sysem. The equaion ha capures he relaionship among he laen variable (IE) and he causes (X) is named as srucural model and he equaion ha links he indicaors (Z) wih he laen variable (non-observed economy) is called as measuremen model. According o Schneider, Büehn and Monenegro (2010), MIMIC model of he informal economy is expressed as: IE X Z IE Where, IE is he scalar laen or hidden variable (he size of informal economy in our case), Z Z,... Z ) is he ( 1 p) vecor of indicaors of he IE variable, ( 1 p X ( X1,... X q ) is he ( 1 q) vecor of causes of IE, ( p 1) and ( q 1) are he vecors of parameers and ( p 1) and ( q 1) are he vecors of scalar random errors. The and are assumed o be muually uncorrelaed: ( E ( ') E( ') 0. The MIMIC model assumes ha he variables are measured as deviaions from heir means and ha he error erm does no correlae o he causes: E ( ) E( x ) E( ) 0 and E ( x ') E( x ') 0. The variance of is abbreviaed by and is he ( q q). covariance marix of he causes x. The measuremen model Z IE represens he link beween he laen variable and is indicaors; he laen unobservable variable is expressed in erms of observable variables. Their ( p p) covariance marix is given by. Like he MIMIC model s causes, he indicaors are direcly measurable and expressed as deviaions from heir means: E( Z ) E( ) 0. I is assumed ha he error erms in he measuremen model do no correlae eiher o he causes E ( IE ') E( IE ') 0. x or o he laen variable IE. E ( x ') E( x ') 0 and The reduced form of he srucural equaions can be wrien as: Z X u, where, u. The error erm u is a (p 1) vecor of linear combinaions of he whie noise error erms and from he srucural equaion and he measuremen model: u ( 0, ). The covariance marix is given as: cov(u ), cov(, ), cov(, ) he diagonal covariance marix of. For idenificaion of MIMIC model, some condiions are available bu none of hem are necessary and/or sufficien condiions as shown by Bollen (1989). The necessary (bu no sufficien) condiion so-called he -rule, enunciaes ha he number of non-redundan elemens in he covariance marix of he observed variables mus be greaer or equal o he number of unknown parameers in he model-implied covariance

11 Hidden Economy of Pakisan 675 marix, see for example, Bollen (1989). On he oher hand, a sufficien (bu no necessary) condiion of idenificaion is ha he number of indicaors is wo or greaer and he number of causes is one or more, provided ha is assigned a scale o IE (MIMIC rule). For assigning a scale o he laen variable, i is needed o fix one λ parameer o an exogenous value. Alhough several economeric improvemens are inroduced in he las years, he mos imporan criicism o he MIMIC mehod is he srong dependence of he oucomes by he (exogenous) choice of he coefficien of scale ( ). Given an esimae of he vecor and seing he error erm o is mean value of zero, enable us o predic ordinal value for IE which is he relaive size of he informal economy a each sample poin. Then, if we have a specific value for IE a some sample poin, obained from some oher source, we can conver he wihin-sample predicions for IE ino a cardinal series. We use an average value from oher esimaions realised using he model specificaions o calibrae he ime-series of he informal economy. Arby, e al. (2010) sudy was he firs aemp o calibrae such MIMIC model informal economy resuls formally in he conex of Pakisani daa Elecriciy Consumpion Approach The elecriciy consumpion approach looks a physical indicaors, paricularly elecriciy usage, o esimae he size of he informal economy. For he firs ime, Kaufmann and Kaliberda (1996) used his approach a he Naional Accouns level o esimae he informal economies of pos-socialis counries. According o he auhors, elecriciy consumpion is he bes proxy of overall economic aciviy boh in erms of formal and informal economies. Various empirical sudies find ha elasiciy of elecriciy consumpion o official GDP is approximaely closed o one, see for insance, Dobozi and Pohl (1995) and Johnson, Kaufmann, and Shleifer (1997). From he Naional Income Accouns, he amoun of elecriciy needed o produce he official GDP is subraced from oal elecrical oupu. If here is some excess hen i is considered as informal economy. For our sudy we ake he raio of growh of oal elecriciy consumpion and official GDP (daa aken from he Economic Survey of Pakisan), wih deviaions from expeced levels subsequenly used as proxies of informal economic aciviy Labour Marke Approach The labour marke approach as discussed in economic lieraure is used no only o esimae he size of he informal economy bu i also renders an insigh of he causes and implicaions of informal economy in erms of employmen generaion and increasing or decreasing inequaliy in income levels in boh high growh period and slow growh period. This approach also helps o undersand he rend of migraion of people from formal o informal secor and vice versa which gives a key policy implicaion for susainabiliy as well as produciviy of employmen generaion in he secor, see for insance, Gennari (2004). I also helps in demarcaing beween formal and informal secors and heir relaionship beween hemselves. 6 6 Ghayur (1994) sudy highlighs he imporance of labour marke informaion sysem for informal secor in he case of Pakisan.

12 676 Gulzar, Junaid, and Haider For he purpose of analysis, he overall economy is disaggregaed ino wo main secors namely; agriculure secor and non-agriculure secor. Minimalism of he nonagriculure secor ino formal and informal secors has lead o a sep ahead, where hese wo secors are furher divided ino heir respecive sub-secors on he basis of reviewed lieraure. The formal analysis is based on various hypoheses. Keeping in view he differen resuls of various sudies, we es he following wo kinds of hypoheses. Firs denoes main hypoheses based on sylised facs of various sudies and second denoes relaed hypoheses subjec o various condiions. Main Hypoheses: (Behaviour of employmen and income per capia growh raes in formal and informal secors during fas and slow growh periods) The growh of employmen in he formal secor (e f2 ) is lower han he growh of employmen in he informal secor (e i2 ) during slow growh of he economy. Mahemaically; e f2 < e i2 The growh of real income per worker in he formal secor (Y f2 ) during a slow growh period is lower han he growh of real income per worker in he formal secor (Y f1 ) during he fas growh period. Mahemaically; Y f2 < Y f1 The overall produciviy in he informal secor during slow growh of he economy is less han zero. Mahemaically; Y i2 e i2 < 0 Relaed Hypoheses: When he growh of real income per worker in he oal non-agriculural secor during a fas growh period (Y 1 ) is greaer han he growh of real income per worker in he oal non-agriculural secor during a slow growh period (Y 2 ), i.e., Mahemaically; Y 1 >Y 2 The growh of employmen in he formal secor (e f1 ) is greaer han he growh of employmen in he informal secor (e i1 ) during a fas growh period. Mahemaically; e f1 > e i1 The growh of employmen in he formal secor (e f2 ) is less han he growh of employmen in he informal secor (e i2 ) during a slow growh period. Mahemaically; e f2 < e i2 The growh of real income per worker in he formal secor (Y f1 ) is greaer han he growh of real income per worker in he informal secor (Y i1 ) during a fas growh period. Mahemaically; Y f1 > Y i1 The growh of real income per worker in he formal secor (Y f2 ) is less han he growh of real income per worker in he informal secor (Y i2 ) during a slow growh period. Mahemaically; Y f2 < Y i2 In order o es various hypoheses regarding formal and informal secors, secondary annual daa for he period has been aken for he purpose of a ime

13 Hidden Economy of Pakisan 677 series analysis. The daa on percenage share of employed labour force above 10 years of age has been aken from various issues of labour force survey (LFS) for he fiscal years , , , , and The daa on average monhly income has been aken from various issues of household inegraed economic surveys (HIES) for he fiscal years , , and Addiionally, seps involved in calculaing he informal secor as percenage of overall GDP hrough labour marke approach are as follow: For Unpaid Family Workers Daa for oal employed civilian labour force (10 14 year bracke) and female employed civilian labour force (10 14 year bracke) is aken from various issues of he Labour-Force Survey. Nex, oal employed labour force (millions) is muliplied wih he above menioned employed civilian labour force (oal and female) which is hen subraced from oal employed labour force o ge he res of he labour force employed in all age limis. Moving ahead, daa for unpaid family workers for boh sexes and female is obained from various issues of Labour-Force Survey which is divided by 100 o remove he percenage. Esimaes for he unpaid family workers in he informal secor are acquired by muliplying he remaining employed labour force employed in all age limis wih he daa on unpaid family workers for boh sexes and female (afer dividing by 100) for each year. However, he number of unpaid family workers in he formal secor is calculaed by subracing he esimaed number of unpaid family workers in he informal secor from he oal unpaid family workers for boh sexes and female. Nex, he esimaed number of unpaid family workers in each respecive year in he informal secor is added o he number of workers lying in he age bracke of years. Toal per-capia income is furher calculaed by dividing he oal GDP wih oal labour force employed for each year. In order o ge he per-capia income of unpaid family workers in he informal secor, oal per-capia income is muliplied wih he sum of esimaed number of unpaid family workers in each respecive year in he informal secor and number of workers lying in he age bracke of years. Lasly, he informal secor as percenage of overall GDP is esimaed by dividing he per-capia income of he informal economy wih oal GDP and muliplying his fracion wih 100 as given in Table 2D. For Self-employed Labour Force Similar esimaions as above are done hrough he labour marke approach by incorporaing he self-employed labour force ino he pool of informal economy. Anoher esimae hrough Labour Marke Approach is done wih he addiion of self employed labour force ino he pool of informal economy. 4. RESULTS AND DISCUSSION The main focus of his secion is o provide comprehensive inerpreaions abou he size of he informal economy obained from various mehodologies. Furhermore, i also our objecive o highligh he significan facors which cause he informal economy in case of Pakisan.

14 678 Gulzar, Junaid, and Haider In our firs aemp we esimaed he size of he informal economy of Pakisan using basic moneary approach. The moneary regression is esimaed using ordinary leas squares procedure by uilising daa from The resuls are repored in Table 3 of he appendix. One can easily draw conclusion from he resuls ha all financial and moneary variables are significan vis-à-vis ax burden plays a dominan role. The informal economy (as percen of GDP) obained from his approach is also ploed in Figure A1. I shows ha he raio increased in mid 90 s and hen slowed down in he auocraic regime. The figures of informal economy in mid 2000 s show an increasing rend, bu hen here is some downward rend for he pas wo years. The size of informal economy as percen of GDP remains from 32 percen-38 percen. The esimaed ax evasion resuls are also ploed in Figure A2. I shows ha ax evasion (as percen of GDP) remains from 3 percen 4 percen wih small cyclical flucuaions over he sample period. The resuls of modified moneary approach using DOLS model are repored in Table 4 of he appendix. The DOLS model is iniially esimaed for seing i = 1 o 4 leads and lags. Afer using Akaike informaion crierion we resric our model by inclusion of one lead and lag variable. The DOLS model is hen esimaed using maximum likelihood procedure. Using Sock and Wason (1993) specificaions, we es he coinegraion among seleced variables by imposing Wald resricion es. The resricion resuls finally enable us o accep he hypohesis ha all variables are coinegraed. Using he long run esimaes obained from ML procedure, we compued informal economy (as percen of GDP) and repored our annual esimaes from in he Table 7 of appendix. The annual esimaes show ha he informal economy has increased iniially and hen here is a consisen declining rend over ime, bu he pace of his decline is quie slow. On an average, in he few years he informal economy (as percen of GDP) remained a 20 percen 22 percen. In our hird aemp, we have esimaed he size of he informal economy using MIMIC model. Arby, e al. (2010) only considered one specificaion of informal economy in case of Pakisan. Bu in our sudy, we have considered hree specificaions of MIMIC model by uilising various economic and insiuional variables. The resuls of all hree specificaions are given in Table 5 and in subsequen Figure A3 of appendix. I is ineresing o noe ha while incorporaing corrupion and size of governmen indicaors in one specificaion as given in model- C, he esimaed raio of informal economy o formal remains a 50 percen 60 percen, which is quie high. However, oher specificaions which consider economic of freedom and oher economic sabiliy variables also show quie reasonable esimaes. We apply simple average procedure by aking mean of all hree specificaions o overcome biasness. The average esimaes are hen repored in Table 7. Our average esimaes are very close o Arby, e al. (2010) single specificaion of MIMIC model resuls. We also compare our esimaed resuls wih he resuls available in a recen sudy by Schneider, Büehn and Monenegro (2010) for Pakisan. Our MIMIC model resuls of all hree specificaions are closed o Arby, e al. (2010) bu less hen (in erms of size) he resuls of Schneider, Büehn and Monenegro (2010). Finally, our average resuls show ha he size of he informal economy (as percen of GDP) remains around 28 percen over he sample period.

15 Hidden Economy of Pakisan 679 These resuls also show ha ax burden, unemploymen rae, economics of freedom, corrupion, governmen size, openness and inflaion are significan deerminans and play a dominan role in expansion/conracion of he informal economy in Pakisan. In our fourh aemp, we have esimaed he size of he informal economy using he physical indicaor approach, namely; he elecriciy consumpion approach. The resuls of his approach are repored in Table 7 of he appendix. The resuls of he informal economy (as percen of GDP) remained a 40 percen-50 percen. These esimaes may no be reliable as hey over-esimae he informal economy. As Arby, e al. (2010) noed, his approach do no incorporae self-generaion of elecriciy by economic agens which boomed in mid 90s due o crisis in official secor of power generaion and disribuion in Pakisan. In our final aemp, we have used labour marke approach o esimae he size of informal economy from The resuls of his approach are repored in Table 7 of he appendix. This approach is based on unpaid family workers as well as self-paid family workers where he labour force beween years is also included in he labour force pool of he informal economy. Published daa for 10 years has been used which is obained from he Labour-Force Survey and he Household Inegraed Economic Survey. The esimaed resuls based on unpaid family workers are consisen wih our MIMIC average esimaes of hree specificaions while he esimaes which include self-paid family workers are also consisen wih he esimaes of elecriciy consumpion mehod. I explains he hidden characerisics of he economy ha he coage indusry, Small- Scale and Manufacuring indusries (generally no regisered) canno be capured by he simple moneary and simple labour approach bu he demand for he elecriciy o run he facories can be capured by he elecriciy consumpion approach. The labour marke approach faciliaes us o es he hypoheses ha wheher or no he informal economy is a cushion agains povery and income inequaliy. I also helps o undersand he behavioural paern of growh of informal, formal and overall economy and is iner linkages vis-à-vis spillover effecs. In order o es hese hypoheses, he percenage share of employed labour force and deflaed yearly average incomes in nonagriculural, formal and informal secors are divided ino he above menioned growh periods (See, Tables 15A and 15B). The resuls of he annual cumulaive growh raes are given below. The resuls explain ha during slow growh of he economy, he growh of employmen in he formal secor (e f2 ) is lower han he growh of employmen in he informal secor (e i2 ). Moreover, he growh of real income per worker in he formal secor during a slow growh period (Y f2 ) is lower han he growh of real income per worker in he formal secor during he fas growh period (Y f1 ). Moreover, he overall produciviy in he informal secor (Y i2 e i2 ) during slow growh of he economy is less han zero. I furher subsaniaes ha when he growh of real income per worker in he oal nonagriculural secor during a fas growh period (Y 1 ) is greaer han he growh of real income per worker in he oal non-agriculural secor during a slow growh period (Y 2 ). The growh of employmen in he formal secor (e f1 ) is less han he growh of employmen in he informal secor (e i1 ) during a fas growh period. The growh of real income per worker in he formal secor (Y f1 ) is less han he growh of real income per worker in he informal secor (Y i1 ) during a fas growh period. The growh of employmen in he formal secor (e f2 ) is less han he growh of employmen in he

16 680 Gulzar, Junaid, and Haider informal secor (e i2 ) during a slow growh period. The growh of real income per worker in he formal secor (Y f2 ) is less han he growh of real income per worker in he informal secor (Y i2 ) during a slow growh period. EMPLOYMENT Annual Cumulaive Growh Rae (ACGR) Fas Growh Period Slow Growh Period ( o ) ( o ) Non-Agriculure e 1 e Formal Secor e f1 e f Informal Secor e i1 e i INCOME Annual Cumulaive Growh Rae (ACGR) Fas Growh Period Slow Growh Period ( o ) ( o ) Non- Agriculure Y 1 Y Formal Secor Y f1 Y f Informal Secor Y i1 Y i Over he period of analysis, on average, he flucuaion in employmen share in non-agriculure of 2.88 from he mean value of million is mainly caused by he informal secor. The flucuaion in he employmen share of informal secor is 2.43 million from he mean value of million which is much larger han ha of 0.77 million from he mean value of 7.00 million (See, Table 11A). The esimaed average yearly income in formal secor resuls in less flucuaions han average yearly income in he non-agriculure secor by Rs from he mean value of Rs Two sub-secors namely; mining and quarrying and elecriciy, gas and waer, are mainly responsible for flucuaions in he average yearly income in he formal secor. The esimaed average yearly income in mining and quarrying is he highes among all subsecors in he formal secor while, he average yearly income in elecriciy, gas and waer is he lowes. The increase in average yearly income in mining and quarrying can be aribued o large amouns of invesmen in he secor on yearly basis from The lowes mean of average yearly incomes in elecriciy, gas and waer was due o he sharp decline in incomes over he period which was caused due o a sharp decline in he rae of invesmens in he preceding years. Over he period of analysis, here was a flucuaion in he average yearly income in he informal secor. On average, he average yearly income in he informal secor flucuaes more han he flucuaions of average yearly income in non-agriculure secor

17 Hidden Economy of Pakisan 681 (formal and informal secor) by Rs from he mean value of Rs , where he maximum value is Rs , minimum value is Rs and he range is Rs Two sub-secors namely; wholesale and reail rade and ranspor and communicaion are mainly responsible for he flucuaions in yearly average income in informal secor. Over he period of analysis, he average yearly income in wholesale and reail rade was esimaed o be he highes among all sub secors due o an unprecedened increase in invesmen leading o an increase in average yearly income from while, average yearly income in ranspor and communicaion was he lowes. This is due o he fac ha in he informal secor, he average yearly income of base year in ranspor and communicaion was much lower han he yearly average incomes of oher sub-secors. (See, Table 11B). Over he range of analysis where he growh rae of he real GDP is above 5 percen, he growh rae of employed labour force in he formal secor remains consan while ha of he informal secor sharply decreases. I can be concluded ha he growh of real GDP in Pakisan is consumpion led growh and no an employmen led growh. Moreover, i also jusifies he poin ha inequaliy increases wih high raes of growh of real GDP in Pakisan. There exiss a negaive relaionship beween growh raes of real GDP and growh raes of average yearly income in he informal secor. (See, Figures A5, A6). On he basis of acual esimaed values, he hypohesis is rue ha growh of real GDP resuls in relaively higher increase in growh rae of average yearly income in he formal secor and vice versa. Moreover, an increase in he growh rae of real GDP resuls in a relaively larger decline in he growh rae of average yearly income of he informal secor. Simulaneously, on he basis of rend line, here is an inverse relaionship beween growh rae of real GDP and growh rae of average yearly income in formal and informal secors (paricularly, over he range where GDP is above 5 percen), See Tables 9 and CAUSES AND IMPLICATIONS OF INFORMAL ECONOMY The focus of his secion is o provide an insigh of he causes and implicaions of he hidden economy and likely consequences on he macroeconomic variables Causes of Informal Economy On he basis of our analysis and reviewed lieraure, he main causes/facors of informal economy include; culural consrains, high raio of per-capia income and highes currency denominaion noe, low lieracy rae, high cos of doing business, devaluaion of currency, ransfer of money hrough hundi, low growh rae of public secor developmen expendiures in he righ direcion and curren srucure of financial sysem boh in erms of growh and service delivery. Facors which may add o he poenial expansion of he informal economy in fuure include; recen desrucion of waer bomb (see, Table 18), imposiion of new GST/VAT sysem, decreasing rae of general purchasing power, increasing rae of cross border smuggling, price hike of elecriciy and peroleum goods and weak law enforcemen and increasing corrupion. High denominaion currency noes are considered as one of he major causes of he exisence and expansion of he informal economy in Pakisan. On average, he per-capia per monh money holding is less han Pak Rs 4000 which is he maximum purchasing power a any day in a monh. However, i is significanly less han he high denominaion

18 682 Gulzar, Junaid, and Haider currency noe i.e., Rs This simple fac explains ha Rs 5000 is no used for general ransacions in he formal secor. I leads o he fac ha he demand for Rs 5000 noe may be aribued o is use for non-producive busles as well as illegal aciviies such as hoarding, hef, currency scam (as occurred in pas few years), illegal ransfer of money and conribues significanly o he size of he informal economy. Second indicaor explaining he same fac is ha he raio of per-capia income and highes denominaion currency noe of Pakisan is exremely low relaive o ha of developed and developing counries (See, Tables 2A, 2B, 2C). Corrupion, inflaion and ax evasion are no only causing an expansion in he size of he informal economy (See, Tables 3, 4, 5) bu also hampering he growh rae of informal economy, hereby adding more o economic uncerainy, income inequaliy and povery. According o our esimaes, he informal economy consiues abou 30 percen o 35 percen of he oal economy over he period of analysis. As per he design of he New Tax sysem and he curren economic srucure of he counry, VAT can only be imposed on he formal secor of he economy. I can lead o a diversion in he resources as well as generaion of wealh from formal secor o informal secor, hereby causing he expansion of he informal secor a he expense of he formal secor. Therefore, i will give an impeus o he growh of ax evasion hus leaving he growh of axes consan even during he fas growh periods in fuure as happened in he previous years (See, Table 16). In he wake of he recen desrucion by waer bomb if copped wih he curren saus quo, hen i will again lead o he expansion of he informal economy which furher adds more o he convenional characerisic of he naional economy. The social and culural consrains (including rural life and convenional menaliy as major issues) pose a grea difficuly o conver he informal economy ino formal economy where illieracy adds more o i Issues/Implicaions of he Informal Economy The mos imporan implicaions ha emerged from our empirical analyses are enlised below Role of Informal Economy on Povery Alleviaion and Socio-Economic Sabiliy The role of he informal economy is ambiguous in erms of alleviaing povery. I generaes low salary jobs which have an uncerain impac on he severiy of povery subjec o inflaion. During high inflaionary period, i is unable o sop he brualiy of povery. As shown in he above analysis, i conribues owards he income inequaliy in real erms hrough wo ways; firs, by keeping incomes low, second; by simulaing inflaion. I is also eviden from he above analysis ha here are sabiliy issues in he employmen and income generaion as large flucuaions have been found in he informal secor which gives an uncerain aspec o he economic condiions and discourages he invesmen. Cheema, e al. (2008) explains ha Norhern Punjab is a he boom of he ladder of povery followed by Cenral Punjab, Wes Punjab and Souhern Punjab. The ranking of hese four regions of Punjab on he basis of informal economy is he same as on he

19 Hidden Economy of Pakisan 683 basis of povery. I manifess he srong posiive relaionship beween he exisence of povery and informal economy. The informal economy causes high inflaion rae which resuls in declining he living sandards as he growh of income in his secor is less han ha of inflaion rae as shown in he following able. The indices values of Food & Beverages and Whea are he highes in he mos backward region of he counry where he informal economy dominaes. In his way, he exisence of informal economy shows he convenional and backward characerisic of he overall economy and conribues owards he divergence wihin he counry as concluded by Ahmad and Ahmed (2008) on he basis of inerciy variaion in prices. The social implicaions of he exisence and growh of he informal economy especially during sagflaion is swear as he employed labour force sar shifing from legal o illegal aciviies so ha hey can mee heir consan consumpion. The unemployed labour force provide ready recrui in he ranks of erroriss and dacois ec. I is eviden from he fac ha he increasing rae of erroris aacks, hef of naional income and resources, surmouning corrupion and increasing rae of smuggling are primarily originaing from he areas where informal economy dominaes he formal economy. Province/Capial Food and Beverages Index Whea Index Punjab Sindh NWFP Balochisan Islamabad Source: Ahmed and Gulzar (2008) Acs as a Consrain agains an Effecive Public Policy Implemenaion Significan size of he informal economy will resric he effeciveness of VAT in order o increase he ax o GDP raio. The basic consrain on he successful implemenaion of VAT lies in he fac ha all he financial ransacions will be made hrough banks. However, he significan size of he informal economy and biased growh of he financial secor (growh of financial secor has been less han he requiremen in rural area) under lock almos 50 percen of he effeciveness of VAT before hand, as one of he basic characerisics of informal economy is ha he ransacions are made in cash and hrough barer sysem in i. I also limis he success of he igh moneary policy during inflaion as high ineres raes do no arac he poor/low salary people o save more because of heir high marginal propensiy o consume as deermined by Kuznes. As explained above, he esimaion of he informal economy also explains he fac ha hisorically, he informal economy caused low ax o GDP raio by hree ways; firs; informal economy conribues nohing o he Tax oll and all he ax collecions are made from he formal secor, second; i also provides he cushion o evade axes in he formal secor which amouns o abou 3 percen of he oal GDP as explained above, hird; i hampers he growh of formal secor as he share of informal economy o he overall economy did no decrease significanly over he period of analysis as shown in he Table 7 of he appendix.

20 684 Gulzar, Junaid, and Haider Implicaions of he Informal Economy in Conex of Globalisaion and Free Markes In he conex of globalisaion and free markes, he informal economy is grealy responsible for less value addiion in he goods sold in he inernaional marke as well as equally responsible for resraining he poenial of he counry o produce high value added producs by resraining he shif of echnology even in formal secor hrough is backward and forward linkages wih i. Consequenly, he echnological shif in manufacuring secor (i.e., formal secor) is relaively lower han ha of Pakisan as shown below. I works in hree ways; firs; as i resuls in low savings and low capial formaion, second; low resource consrain in formal secor, hird; pus capaciy consrain on labour force and resrain he labour force produciviy hrough underemploymen, disguised employmen, providing low salary and early age employmen (child labour). Technological Shif in Manufacuring Secor Source: UNDP, Implicaions of he Informal Economy in he Conex of he 18h Amendmen and he 7h NFC Award Under he 18h Amendmen, he concurren lis has been abolished and all subjecs have been delegaed o he provinces hus puing a es of he provincial capaciy o perform all he funcions in he curren sae and also bring improvemens in areas ha are in line wih he spiri of he 18h Amendmen. However he prisine objecives of he 18h Amendmen and he 7h NFC Award of srenghening he federaion and empowering he provinces hrough fiscal decenralisaion may be hampered by he exisence of he informal economy, if he proper arrangemens for he ransformaion of he informal economy ino formal economy are no made. These arrangemens include; saring of public secor developmen projecs ha can generae permanen businesses ha are adapable o change as well as business communiy in he areas of informal economy in order o guaranee permanen and high paid jobs. If he meso policies of he federal and provincial governmens remain, hen no only he benefis of he wo hisoric breakhroughs may no be reaped as such policies provide simulus o he exisence and growh of informal economy bu hese may have adverse impacs on he overall economy hrough increasing income inequaliy and povery among provinces which is ever dangerous for an overall naional characer of he federaion.