Formalization of the informal economy | Political economics

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Any business that makes money but does not pay taxes, employs people but does not follow labor laws, or runs a business but does not hold a license is part of an informal sector of the economy. So basically, the informal sector is the part of an economy that doesn’t obey the law.

Where is this sector in Pakistan? Does it stimulate economic growth or does it exploit the poor? What is its impact on society as a whole? According to the Pakistan Businessmen and Intellectuals Forum (PBIF), the informal economy accounts for 35% of Pakistan’s GDP. It stimulates business activities and provides jobs for millions of people in need. It also exploits the poor in wages and working hours. It demoralizes taxpayers and law-abiding people.

Pakistan needs to formalize its informal economy and overcome all obstacles to the formalization process. One such barrier is the heavy use of cash which poses a serious threat to formalization and makes it difficult for the government to trace most transactions.

In real estate business, for example, cash transactions are used to avoid documentation of wealth. Tackling this problem requires an effective policy. Anyone buying a property should be asked to attach a bank instrument with the ownership documents as proof of legitimate financing. In addition, we also need to have a simpler digitized payment system to minimize the use of cash for off-book transactions.

Second, the government should work to expand its tax base so that it is easier for everyone to run legal businesses while paying a reasonable amount of tax. Each budget brings new rates and charges for those who already pay their taxes. Meanwhile, those who work outside the law do not have to pay anything. This discourages any taxpayer who abides by the law and helps the state collect their revenue.

The informal sector grows stronger when the formal sector is overtaxed. Therefore, the competitiveness of the tax-compliant industry is affected both domestically and globally.

Third, the world has digitized tax systems, but the Federal Board of Revenue still needs to upgrade its system for some very basic issues. There are thousands of high earners who do not file any tax returns and still enjoy the benefits of being a filer.

When an informal economy formalizes, workers receive their fair share and the state and its legislation are on their side in the event of exploitation by employers. Employers obtain legal status and become eligible for bank credit.

A declarant pays 1% property tax while a non-declarer pays 2%. So, when such an individual buys land, he only pays 1% to the government pretending he is a registrant. The government never tries to verify whether the plot was even shown in their asset declaration or not.

Fourth, all institutions relevant to business must be linked so that no one tries to operate outside the law. For example, after registering a company with the Securities and Exchange Commission of Pakistan, there must be a proper system in place at the Federal Board of Revenue which should verify whether the company exists or not. If so, it should be checked whether it has been registered for sales tax or not.

Sometimes companies are registered but do not file any declarations. This is usually because they use personal bank accounts. The company is an independent entity and has nothing to do with its owners. However, people often go this route and use their personal bank accounts instead of business accounts to hide their sales.

Governments should have a database at the FBR indicating when a particular CNIC number is sought. This way, it would be easier to trace those who hide their sales.

Fifth, it’s not all about the money. FBR’s attitude also drives some companies to evade taxes and discourages them from complying with the law. Most entrepreneurs don’t register their business because they think government officials would blackmail them if they showed them their assets. This lack of trust must be reduced, the personal involvement of managers with entrepreneurs must be limited and companies must receive the respect and recognition they deserve.

Finally, some companies are legally registered but hide part of their production and thus partly escape taxation. Some of them supply raw materials to informal enterprises.

In this regard, the policy of the previous government should be reintroduced. A CNIC copy was required for every purchase order over Rs 50,000. As a result, every legal business would show their sales and provide CNIC details of their buyers. In this way, the raw materials supplied to the informal sector would be traceable.

When an informal economy formalizes, everyone benefits; both legal and corporate. Employees receive their fair share, and the state and the law are on their side in the event of exploitation by employers. Employers gain legal status, become eligible for bank credit, and are exposed to customer liability.

So far, no government has been able to fully integrate the informal sector into the formal sector. What we need to do is reduce its size without affecting poor employees.


The author is a Chartered Accountant (UK). He can be contacted at [email protected]


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