The dichotomy of the undocumented sector is that the more an economy declines or trends towards recession, the more the undocumented sector thrives. As revenues dwindle and margins tighten, an increasing number of businesses opt out of the documented economy to survive, saving on government taxes and levies. In 2018, Schneider and Buehn (S&B) estimated the size of the informal sector in various countries based on their income groups. According to their study, which grouped informal sectors as a percentage of the total economy: a) Lower-income countries typically have around 41% of their economy in the informal sector, b) Lower-middle-income countries have around 39%, c) Upper-middle-income economies around 24%, d) Other high-income countries also hover around 24%, and e) OECD countries have the lowest informal sector at around 20%. They further asserted that the larger the economy, the smaller the informal sector as a proportion of the total economy. Additionally, their regional analysis estimated the informal sector’s size as follows: i) Latin America and the Caribbean 40%, ii) Sub-Saharan Africa 38%, iii) South Asia 34%, iv) Europe 23%, v) Middle East and North Africa 23%, and vi) East Asia 22%. This implies that larger informal sectors are more prevalent in lower-income and developing countries.

So, what do S&B recommend countries do to minimise the informal sector in their economies? Principally, they suggest that strong IT systems are key. The more efficiently and broadly a business’s data is compiled, the less likely it becomes for that business to operate under the radar. An efficient and responsive IT system directly improves management controls, expands tax bases and revenues, enhances trade facilitation and organisational productivity, and promotes multidirectional communication through a harmonised information management structure. More importantly, the study argues that a tax system can only be successful if it reflects the reality of taxpayers. Unless taxpayers take ownership of the national tax system by genuinely believing that their and the market’s interests lie in remaining within the established taxation framework, the system will never succeed. This is where our tax system and tax-collection culture have generally failed, as people often find it coercive and, in many cases, grossly unfair. Needless to say, reforms are required—something that has been discussed extensively over the years but has yet to materialise tangibly. It is also important to note that knee-jerk operations, amnesties, frequent changes, raids, and harassment never work. A good and effective reform process is always slow and ongoing to establish fairness and transparency. S&B argue, based on evidence from almost all global economies, that to succeed, it is imperative for governments to construct a tax regime that stimulates inclusive growth and guarantees a fair and impartial sharing of the overall tax burden. Furthermore, a progressive tax regime can be developed and nurtured by a government consciously finding suitable ways (according to the local environment) to reduce cash in the economy and eliminate foreign currency-based transactions in the domestic economy to the barest minimum. Additionally, at some stage, it would be necessary to make it mandatory, under an operational legal framework, that transactions beyond a certain size or a total business quantum beyond a certain threshold can only be carried out through a Limited concern. Lastly, arbitrary tax breaks or exemptions under any pretext should be avoided unless absolutely necessary to target the poorest of the poor or to support particularly poverty-stricken areas.

In Pakistan, regrettably, the overall performance of our revenue collector, the FBR, has been quite lacklustre over the years, with little progress made on implementing key tax reform recommendations suggested by various financial institutions, including the World Bank. While there is no doubt that there is great potential and opportunity to enhance tax revenues in Pakistan, to harness this potential, the long-elusive tax reform drive must be adopted without further delay. Essentially, the main reforms should aim to establish a taxation system that shifts the burden away from existing taxpayers. More importantly, it should be packaged in a way that not only garners ownership from a wide spectrum of productive Pakistanis but also ensures that it boosts investment and productivity rather than hampering them. However, what we have seen in this budget is that while the government has maintained its seemingly insincere rhetoric on the need for reforms in the FBR and the taxation system per se, it has implemented some rather punitive higher tax slabs without first fixing the system. As a result, the increasingly draconian tax regime that has been launched, coupled with the removal of key balancing features—such as a separate bracket for exports or the recognition that it is the government’s responsibility, not the businesses’, to bring entities or individuals into the tax net—today runs the risk of making Pakistan an unappealing destination for both domestic and foreign businesses. It is not surprising, then, that in July 2024 alone, Pakistanis registering with the Dubai Chamber of Commerce to do business in the Gulf posted a dramatic 17% growth rate over total registrations to date.

Dr Kamal Monnoo
The writer is an entrepreneur and economic analyst. Email: kamal.monnoo@gmail.com