The Significance of the Informal Economy

Updated: Nov 14, 2019

By Shahid Mehmood The contribution of the informal economy to any non-agriculture GDP can range from 17 percent to 60 percent[1]. In Pakistan, estimates suggest that the size of the informal economy has increased from Rs. 12 billion in 1974 to an estimated Rs. 1085 billion in 2002[2]. In 1971 informality was about 20 percent of GDP which increased to 54 percent in 1998, declined to 37 percent in 2002 and went up to 63 percent in 2007[3].

Informal economic activities are those which are not reported to government authorities. The large majority of informal businesses are involved in legal activities, however, their incomes remain untaxed. Tax avoidance, however, may not always be their primary motivator. They do not record a major portion of their transactions for reasons ranging from procedural complexity to inadequate profit levels. Cultural resistance to modern record-keeping and a general distrust with the state’s tax ecosystem also keep citizens from participating in the formal economy.

In 2017-18, the formal economy accounted for only twenty-eight percent of Pakistan’s labor force[4].  The remaining 72 percent was entirely absorbed by the informal sector. Within the informal sector employment, 44 percent are self-employed individuals. Only 3 percent of informal sector entrepreneurs are likely to be employers. However, 47 percent of the total informal economic labor force is employees and 9 percent are working in their family businesses. A vast majority of the informal labor is working in the wholesale, retail trade, and repairing industry, followed by manufacturing, construction, and transportation. Informal employment is both a substitute for and complement to, formal sector employment because heterogeneous groups exist within the informal sector[5]. Significant problems emerge in terms of human resource working in the informal sector, a few common ones include:

  • Unconventionally long working hours

  • No social security benefits

  • Low credit access from formal financial institutions

  • Human Resource development is often ignored[6]

Informal sector employment usually comprises of rural to urban migrants, with relatively little education and low skill levels. According to Development Sector researcher Zeenat Hisam, “The informal economy is a barrier to inclusive growth. It excludes the majority of the labor force from accessing opportunities of productive growth in the economic realm”

The large spread of the informal sector incentivizes workers and entrepreneurs to indulge in informal economic activity since this means escaping predatory taxation imposed at various tiers of the government. Most experts would concede that the size of Pakistan’s informal sector is not less than 35 percent of the formal sector. That would indicate that the government is losing out on the collection of Rs. 536 billion annually in income taxes[7]. Many experts believe that the weak capacity of the state to track the informal sector is a primary challenge in formalizing the informal economy. However, according to Ifran Wahab, President of the Overseas Investors Chambers of Commerce and Industry (OICCI), “It is the high cost of doing business that drives investors into the informal sector”.

Entrepreneurs in the informal sector use informal means of financing their businesses, usually using cash from their personal capital, or from family members. Their expenditures are usually mixed in with household expenditures. Such convention greatly inhibits formalization and registration of business assets and liabilities.

According to Andrew Wilson, the Regional Director at CIPE, “Research has consistently shown that entry barriers such as lengthy registration requirements, licensing and inspection requirement and complicated taxation policy are the key reasons for entrepreneurs remaining in the informal sector.”

Any policy framework aimed to formalize the existing informal sector will only work if employers and employees both perceive the benefits of formalization to be greater than operating in the informal sector. As the state moves towards a broader tax net, it should take steps to reduce the number of taxes, reduce the cost of revenue collection and simplify the tax filing procedure. Broadening Access to credit is just as vital, and together with the regularization of informal forms of property, there would be a natural increase in voluntary tax registration and filing. Allowing informal sector entrepreneurs access to pension instruments would help them to improve working conditions for their employees.


Labour Force Survey of Pakistan 2017-2018

Labour Force Survey of Pakistan 2017-2018

LIST OF REFERENCES [1] the contribution of informal enterprises to non-agricultural GDP in 26 countries in Africa, Asia, and Latin America ranged from 17 per cent in the Republic of Korea to 58 per cent in Ghana (estimates by Jacques Charmes for ILO 2002)

[2] Yasmin, B. and H. Rauf (2003), “Measuring the underground Economy and its Impact on the Economy of Pakistan”, The Lahore journal of Economics, Vol. 9 (2): 93 – 103

[3] Kemal, M. A. (2003), “Underground Economy and Tax Evasion in Pakistan: A Critical Evaluation”, Research Report No. 184, Pakistan Institute of Development Economics (PIDE)Kemal, M. A. (2007), “A Fresh Assessment of the Underground Economy and Tax Evasion in Pakistan: Causes, consequences and Linkages with Formal Economy, PIDE Working Paper # 13, Pakistan Institute of Development Economics

[4] Labour Force Survey 2017-18, Govt. of Pakistan.

[5] KAY, D. D., (2011), “The Relationship between Formal and Informal Employment in South Africa”, unpublished Master’s Thesis, Urbana, Illinois.

[6] Elegbede, Tunde (2011).  The Challenges of Human Resource Management Practices in the Informal Sector in Nigeria. Chinese Business Review

[7] This calculation is based on taking 35 percent of the total income/direct tax revenue of the government at the end of Fiscal Year 2017-18, which stood at Rs. 1536 billion.