Estimating the Informal Economy and Tax Evasion in Pakistan: Insights from Monetary Approach

Abstract

The informal economy (INE) is a main point of discussion in the process of policymaking due to its wide-ranging economic ramifications. It distorts official macroeconomic indicators, leading to misguided policy decisions, and highlights untapped economic potential. Using the monetary approach, this study examines the size of the INE and tax evasion (TAXE) in Pakistan from 1980 to 2022. We employ currency demand (CD) method, driven by factors such as tax burden, banking services, inflation and economic instability, serves as the main causes of currency demand in Pakistan. Regression analysis of CD reveals that the tax burden significantly increases reliance on cash transactions, thereby expanding the INE. The study shows that the INE in Pakistan grew from 11.17% of GDP in 1980 to 44.14% in 2022, with a long-term average of 28.33%. Similarly, TAXE rose from 1.23% to 7.43% of GDP, averaging 4.49% over the study period. These trends demonstrate the persistent growth of informal activities, especially during periods of economic downturn and high inflation. The study highlights the need for simplified tax systems, broader tax bases, and improved financial inclusion to curb reliance on informal transactions and enhance fiscal efficiency.