V. The underground economy and government budget deficit
1. The long-run relation
2. The short-run dynamics
VI. Underground economy and private investment
1. Size of underground sectors
2. Ratio of the underground sectors to the formal GDP
3. Ratio of the underground sectors to the formal sectors
4. Unit root test
5. Cointegration equations
6. Unit root test of residuals
7. Optimum lags of controlled and manipulated variables
8. causality equations
9. Unit root test
10. Cointegration equations
11. Unit root test of residuals
This paper estimates the size of the underground economy (UE) in Pakistan and assess its economic impact during 1975–1991. It estimates the underground economy’s GDP and its components — the domestic sector which measures the underground overall domestic absorption and the export and import sectors — providing insights into the dynamics of the UE. Furthermore, the estimated data were used to assess empirically the impact of the UE on the Government’s fiscal position and on the investment-output relation.
The results confirm the existence of large UE in Pakistan. The UE’s GDP averaged 22.6 percent of formal GDP during the study period, with a growth rate slightly higher than that of the formal GDP. The domestic component of the UE’s GDP averaged 35.4 percent of the formal GDP and had grown at an average annual rate of 9 percent, a much higher rate than the formal domestic sector’s growth rate of 5 percent. The size of the UE in the import sector relative to formal import sector, averaging some 35 percent of formal import sector, was the largest among the various components of UE’s GDP. The data also show that the relative size of UE in the external sector had grown significantly relative to the domestic sector since the beginning of economic reforms in Pakistan in 1987, reflecting increased opportunities created by the opening of the economy.
Analyzing the relation between the UE and the fiscal position of the Government suggests a mutual dependency between the size of the UE and fiscal deficits. Continued fiscal deficits had contributed to the growth of the UE. In turn, the growth of UE was a significant factor in the continued problem of containing the fiscal deficits. The analyses of the role of the UE in the national income-expenditure cycle show a leakage of resources from the formal economy to the UE via private investments, with an overall net loss in economic efficiency.
Finally, the paper proposes long- and short-run policies, based on fiscal restrain and economic liberalization, to reduce the size of the UE.