THE INFORMAL ECONOMY OF PAKISTAN: AN INSTITUTIONAL AND FISCAL POLICY PERSPECTIVE

Abstract

This paper takes a crucial step in incorporating the institutions which have focused on informal sector and tax evasion in Pakistan. The study highlights the imperative role of institutions and fiscal policy, which are largely identified as the major constituent in the development of an informal economy. The study uses GMM (Generalized Method of Moments) regressions to deal with potential endogeneity and to strengthen the validity of results. The informal sector in Pakistan covering the period from1984 to 2018 provides ample evidences that (i) effective fiscal policy is capable of executing functions that can imitate the institutional quality variables, (ii) development of institutions shrink the informal sector and increase in the tax rates induces informal economy, (iii) tax evasion and informal economy moves in the same direction and, (iv) government development expenditures helps in decreasing the size of informal sector but the impact is insignificant. The article states that as a consequence of these complex interrelations between fiscal policy, institutions and tax evasion, the development of informal economy in Pakistan is intricate, which is the very reason that Pakistan is among one of the world’s lowest tax to GDP ratio countries and facing significant challenges for the realization of its potential tax revenues. Failure of policy makers to take these associations into account while formulating policies can produce many unforeseen outcomes.