Wednesday, 24 July 2013

IMF Agreement: Frieghtenning or Blessing

The article was published in the "Money Matters" on 22 July 2013 entitled "  External Debt     A blessing for an ailing economy"

The International Monetary Fund (IMF)’s bailout programme remains a hot topic in the country. And while the caretaker government refused to go back to the IMF, it only took the new government a few weeks to acquiesce to an ‘inevitable’ IMF deal.

Economists in the country are divided over the controversial programme and its pros and cons, while some seem to enjoy the empty rhetoric when it comes to the controversial loan programmes.

Some are even scared that Pakistan will be colonised if we take loans from the IMF, a sense of trepidation that partly arises from the mystification created by the media and politicians, who readily attack the IMF to improve their own standing with the people.  

Dr Meekal Ahmed and Dr Ashfaque Hasan Khan are among those who have been vocal about the country’s immediate need for the loans since it will raise our forex reserves, which have been declining for the last two years. Capital inflow will stabilise the exchange rate and country will not face the risk of default, they argue.

On the other hand, some have slammed, ridiculed and maligned the government for going back to the IMF despite campaigning against the “begging bowl”. However, most such commentators or analysts totally ignore the worrying balance of payments and other issues facing the country.

The word “IMF” in our society is dreaded and unpleasant to say the least. It is considered a sort of a phantom, which will steal our belongings while we sleep. Most believe that the IMF, which works like a bank and provides loans to countries with ailing economies, often, ends up maintaining a debt crisis in the country it aims to assist.

The IMF first carries out research on any given country and then suggests different options to help the country move towards development and eventually a successful repayment of their loan with interest. However, it is generally believed that the conditional loans are only repaid by requesting more assistance and without much improvement in the economy. It’s tough to totally disagree with this statement, nevertheless, there are number of misconceptions attached to it.

A survey using purposive sampling, one that is selected based on the knowledge of a population and the purpose of the study, to verify the public’s knowledge about the IMF and objectives associated with its loan programmes reveals that 90 percent of the respondents are simply clueless when it comes to the IMF and its functions.

Further, around 70 percent of the respondents are unaware about the role these loans play when it comes to exchange rate stability, increase in the debt repayment capacity, reducing the speed of forex depletion etc. Most significantly, more than 80 percent are not aware of the share of IMF loans in total debt.

The recent $5.3 billion bailout package signed between Pakistan and the IMF is a three-year programme under an Extended Fund Facility. Pakistan has requested an additional $2 billion, which will be considered by the IMF Executive Board on September 4, as the country has to repay $4.6 billion in the next three years and it does not posses significant investment in foreign exchange reserves. The only way to pay the amount is to borrow more or post a current account surplus by reducing imports and increasing remittances in the short run.

Before proceeding further it is important to understand what the Extended Fund Facility (EFF) entails. Among various IMF programmes, EFF was launched in 1974 to provide assistance to countries which were experiencing long-term payments imbalances because of structural impediments. It can also be used for an economy which has low growth and inherently weak balance of payments position. This programme’s duration is usually longer than other IMF programmes, such as Stand-By Arrangements between 3.25 and 5 years. Usually, the countries enrolled in this programme can repay the loans between 4.5 and 10 years. Another important characteristic of this programme is that IMF works with the country to design and implement adjustment policies to ensure that the particular country overcomes its structural weaknesses. Moreover, EFF is also available if country is facing serious medium-term balance of payments issues.

The IMF programme comes with conditionalities, which may or may not be optimal in the short-term but is certainly better in the long-term. But as Keynes pointed out “this long run is a misleading guide to current affairs. In the long run we are all dead,” the country’s future depends on our negotiators, who must protect the lives of their people and accept conditions which remove the obstacles to growth in the long-run without hurting people in the short run.

For the past two decades, IMF’s major focus has been on structural adjustment. It could be through the privatisation of state-owned enterprises or through fiscal austerity by raising share of direct taxes, removal or reduction in import duties and cutting down expenditures especially subsidies.

Pakistan has requested the IMF management to increase the present level of access of 348 per cent of quota ($5.3bn) to 500pc of quota ($7.3bn) with appropriate front loading of disbursements to match Pakistan’s repayment obligations under the previous IMF program-me to ensure that net outflows don’t exceed fresh disbursements.

The country can borrow up to 200 percent annually of their allocated quota under the EFF, which is equal to 600 percent over the three years. It seems the IMF delegation, which is due to come back in September to discuss the additional $2 billion request, is likely to approve Pakistan’s request as the government is simply accepting IMF advice and asking for less than the designated quota of 600 percent. 

The real question is what impact the IMF bailout package will have on our economy? After the agreement was singed between Pakistan and the IMF, the Karachi Stock Exchange (KSE)’s benchmark index rose by 211 points, a sign that the deal has boosted investors’ confidence. However, uncertainty surrounds whether the move will boost investors’ confidence across the board. With comparatively lower interest rates and policies geared towards reforming the economy towards macroeconomic stability, many are questioning whether private credit will increase and whether the government will continue borrowing from schedule banks.

Depleting reserves have put immense pressure on the exchange rate with the rupee already crossing the Rs100/$ mark. To prevent further depreciation, the State Bank of Pakistan (SBP) will inject foreign exchange into the market. However, this exercise may stabilise the exchange rate but the country will slowly but surely lose all of its forex reserves.

A more practical solution is to let the exchange rate move freely and invite capital to inflow into the country. Several options can be exercised such as reduction in the oil import which is one third of total transactions in the current account. Moreover, the country can invite more remittances into the country.

But in reality, it’s either wait for any of the abovementioned solutions or take loans from the IMF to correct the balance of payments issue. The inflow of forex reserves due to the IMF loan will stabilise the exchange rate to a certain limit. The stabilisation of the exchange rate will be short-lived with the pressure mounting soon after the payments to IMF are made. Moreover, if balance of payments problem persists which is normally the case in Pakistan then currency will depreciate further.

Overall the EFF arrangement will help stabilise the economy if everything goes well. Since forex inflow stabilise the currency in the short run, the State Bank of Pakistan will not need to intervene in the market.

Although the IMF loan has various conditions, including reduction in fiscal deficit, if the country manages to reduce the fiscal deficit there will be greater control on government borrowing, especially borrowing through SBP and commercial banks.  As a result, transitory component of money supply will be lessened. Hence there will be no surprise inflation. Therefore, monetary stability will be achieved along with stable growth, lower fiscal deficit and lower inflation. However, this does not mean that the growth rate will be higher.

And while certain members of the educated class continue to spew venom against the IMF, an organisation whose functionalities they don’t even understand, the current IMF bailout package is nothing short of essential for the country in many ways with repayment of previous loans amongst the most important component at present. The loan will stabilise the exchange rate in the short run, improve the position of portfolio investment and if everything goes the country will be on a stable path of economic growth in the next 4-5 years.
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Wednesday, 17 July 2013

Where and How to Invest?

The article is published in money matters with a name"Saving to invest" on Jully 16, 2013

Individuals consume and save part of their income which eventually becomes future consumption. They save to get a higher standard of living in future. After saving they invest in saving deposits, bonds, stock market shares or start their own businesses. Thus, an individual’s savings eventually become part of investment. This is one reason that in macroeconomics we always equate savings with investment. In the Harod-Domar Model, it is specifically pointed out that if we need more investment we either need to raise our savings or invite foreign savings into our country.

Why do we need investment and especially where do we need it? This question is frequently asked by the government while it formulates policies. Investors ponder where to invest. As far as the first question is concerned, the answer is very straight forward - growth.

Nevertheless, different investments have diverse outcomes depending on the time periods. For example, investment in education will have positive outcomes in the long run. Another example would be investing in infrastructure; roads and buildings which require significant amounts of investment and facilitate big businesses. Another area would be investing in reforms, which cost less money but take more time. The impact of reforms may not necessarily become evident right away but will certainly help people grow.

Aside from interest rate, a sole determinant of investment, four theories are discussed: (1) Accelerator (2) Profitability (3) Capital Accumulation and (4) Tobins q. All the studies have their theoretical justifications. Accelerator theory tells us how much investment is needed to get a certain level of GDP growth rate considering the current economic situation, even without a change in the measurement of GDP and other variables.

The theory of profitability treats profitability as a determinant to investment. Neo classical theories consider rental cost of capital and marginal productivity of capital that in the end results in capital accumulation if future discounted net revenues are maximised.

Capital accumulation overtime is the overtime investment in the country or any specific sector. Tobin’s q is a modified version of neo classical model, which says that if the market value of already installed capital is more than the replacement cost of the capital then firm keeps on investing.

Having talked about all the theories built on numerous assumptions, the question arises: what does the investor seek while making an investment decision? He looks at the profitability, cost of doing business, the country’s current economic situation, infrastructure, both hard and soft size of the market and provision of extra facilities. In a nutshell, if the investor thinks that his investment gives him good profit and the system runs smoothly then he will invest in the country. This implies there will be little or no hurdles and constraints.

Constraints are important in restricting and/or creating the investment climate. In the last PIDE Business Barometer, firms have pointed out that the energy crisis is the number one constraint in the current scenario followed by the law and order situation, inconsistent government policies and tax anomalies. Nevertheless, they have problems with a shortage of skilled labour, a high cost of doing business, corruption, too much bureaucracy involved in the system but they somehow know to deal with these things at higher transaction costs which reduce their profitability. The energy shortage cannot be considered to have been resolved until uninterrupted power is supplied to the industries.

The PML-N team started working on energy solutions before assuming power. The process has gained more momentum since the PML-N is now in a position to implement its plans. Budget 2013-14 focused more on economic revival than anything else. Even though several taxes have been imposed on the people such as GST and slabs of income tax have increased, to boost investment the industrial sector has got exemptions and corporate income tax has been reduced from 35 percent to 30 percent to encourage investment. However, as long as the energy problem persists, we can expect little investment in the country.

Aside from law and order, investment is also discouraged by a massive fiscal deficit and rising public debt. The government either prints money or borrows from the scheduled banks. In the case of the former, inflation is created, which pushes nominal interest rate up. The latter policy acts to crowd out private investment. Therefore, in both the cases, investment effectively declines. The present government is trying to reduce the fiscal deficit while repaying the public debt servicing payments. Moreover, a sum of Rs500 billion has been allocated for circular debt, which will mitigate the energy problem but will also place a burden on the fiscal deficit.

Last week, Ihtasham ul Haque pointed out several measures such as the visit to China and making policies with the UK even though Dubai group is also eager to finance several projects. These show that the government is striving to fix things quickly. It has short term policies and it is hoped that it also has some protection in place against long term repercussions which may include accumulating external debt, exchange rate stability and inflation stability. These three things would then effect investment and growth in the long run.

The prime minister’s visit to China was fruitful as China has promised to initiate several projects in Pakistan including those related to energy. However, the PML-N government is also interested in investing in roads and larger infrastructure, which costs large sums of money. If these projects are carried out under the PSDP program, then we are ignoring some important issues which need to be addressed such as education, health and reforms in all the sectors.

We have a history of the government sector investing in sectors such as the agriculture sector, manufacturing sector and services sector etc. Too much government involvement leads to inefficiency, corruption and a lack of governance. Moreover, the government’s presence in any sector crowds out private investment. Sajawal and Khan at PIDE studied the determinants of private investment and came up with the same results that to encourage private investment, the government needs to strengthen institutions, quality governance structure needs to be established, and entrepreneurship should also be promoted.

Returning to the question of where to investment, energy is undoubtedly a big problem currently going on in the country. However, do we need motorways from M1 to M10? Do we need bullet trains? Do we need ring roads? Yes, we do need these things but if these things are made with the help of foreign investors then let’s invest part of our PSDP on soft infrastructure which promotes a healthy environment for local entrepreneurs and foreign investors, facilitates the smooth running of the system, exterminates the hurdles of investment, registers land records and secures property rights, trims down the cost of doing business, reduces delivery time, needs less paperwork and involves less bureaucracy. These reforms would lead to vibrant markets which would enhance investment in the country.

Apart from investment in the bigger projects, certain reforms are needed which promote domestic commerce. In Islamabad Centaurus is the only mall and metro is the only big shopping departmental store, however, if city land laws are amended in such a way that anyone can open a big departmental store and build a mall at CDA-designated places, then lots of investment will be attracted to this sector as well, which will have a multiplier effect on GDP. Similarly, lots of other investment opportunities are present, especially in the service sector, which the private sector would have availed given that the laws too were properly implemented.
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Friday, 12 July 2013

Income tax slabs

Income Tax Slabs 2012-13
Where the taxable Income Exceed To but does not exceed rupees Rate Of Tax  Additional tax
0   400000 0.00%  
400000 to 750000 5.00%  
750000 to 1500000 10.00% 17500
1500000 to 2000000 15.00% 95000
2000000 to 2500000 17.50% 175000
2500000   10000000000 20.00% 420000

Income Tax Slabs 2013-14
Where the taxable Income Exceed To but does not exceed rupees Rate Of Tax  Additional tax
0   400000 0.00%  
400000 to 750000 5.00%  
750000 to 1400000 10.00% 17500
1400000 to 1500000 12.50% 82500
1500000 to 1800000 15.00% 95000
1800000 to 2500000 17.50% 140000
2500000 to 3000000 20.00% 262500
3000000 to 3500000 22.50% 362500
3500000 to 4000000 25.00% 475000
4000000 to 7000000 27.50% 600000
7000000 +   30.00% 1425000

Thursday, 11 July 2013

Wages in informal sector, money matters, feb 11, 2013

Informal Sector 
 The wage factor 
 By M. Ali Kemal 
While discussing urbanisation, we always talk about its benefits and ignore the problems associated with it. Hanzla Jalil at the Pakistan Institute of Development Economics (PIDE) pointed out that the crime rate rises with an increase in the size of urban sector due to lack of planning. Lack of planning is not only associated with developing countries but it is present in the cities of developed countries as well. Another problem which increases crime in the urban sector is unemployment, especially in the informal sector. This is despite the fact that most of the entrants in the urban sector start their own small businesses, which includes hawkers, street vendors, knife sharpeners, junk collectors, shoemakers, etc. However, immigrants from rural areas also come to work in the formal as well as in the informal sector. If they become a part of formal sector, which is legally registered and subject to government regulations, then all the government rules are applied on those employees and workers. However, if those immigrants become a part of the informal sector, which could be legal but not registered and not subject to government regulations, it does not incorporate in the formal statistics.

Apart from the above mentioned problems, lower wage rate in informal sector as compared to formal sector is one of the problems that we are focusing on in this article. The Harris-Todarro model focuses on rural-urban migration in which rural wage is less than urban wage rate and wage rate in the urban formal sector is downward sticky. Due to the rural and urban wage differential, people tend to move towards urban areas. However, the formal sector absorbs some of the emigrants and the rest work in the informal sector. It is generally believed that work offered to them in the informal sector is unproductive or underproductive. Thus, wages offered to them are lower than the existing wages in the market.

Underproductivity of employees in the informal sector has several reasons, such as unskilled labour migrating from rural to urban areas and skills not being used properly in the informal sector. Considering the former case, unskilled labour is less productive than skilled labour, thus unskilled labour’s wage rate is lower. These unskilled workers are household workers, waiters in smaller restaurants, especially, workers at tailoring shops, etc.

Apart from that, if we compare the wages of skilled labour in both the sectors, wages in the informal sector are lower than the informal sector. The first reason for having lower wages in the informal sector among others is underemployment. People are said to be underemployed if they work for hours less than they are required to do in a week (40 hours a week is generally considered to be definition of full time employed person). Since employees do not need workers on full time basis, they do not give them wages that are equivalent to wages of the formal sector. People migrate from rural to urban areas seeking jobs agreed on lower wages since those wages are either higher than rural wages or they were previously unemployed in the rural areas or there could be some other socio-economic reason. A study by A. R. Kemal and Zafar Mahmood at PIDE on the informal sector contradicts our first claim of low wages. According to the study, on average workers in the informal sector work for sixty hours per week. Thus, there is no underemployment.

Another reason for low wages in the informal sector is exploitation. Although it sounds quite rhetoric, it is a fact that exploitation of labour is present in both formal and informal sectors, especially when unemployment rate is high. However, the informal sector is more pinched by exploitation than the formal sector which further reduces wages in the informal sector.

The third reason is associated with legislation, i.e., minimum wage legislation. Since the informal sector does not come under government legislation, employers are not bound to give minimum wages to their employees. Thus, they give lesser wages to their employees than the minimum wage, i.e., Rs8,000. It is difficult for the government to reinforce this rule since the informal sector does not come directly under the control of government.

Activities in the informal sector are, in general, labour-intensive. Capital use in the activities is either obsolete or at least not up-to-date, which leads to low allocative efficiency. In several instances, it is locally manufactured or modified using old technology. Low level of technology has lower productivity, requires low skills, hence it leads to lower wages.

In general, the formal sector has trade unions or at least labour unions which protect the rights of workers. It is, however, absent in the informal sector. Normally, the informal sector employs a small number of workers (3.3 persons per enterprise, on average according to Ar. R Kemal and Zafar Mahmood’s study) and the need for union is not important. However, the employer either exploits that thing or he just needs part time workers. Moreover, he is not registered with the government, which is why he gives lower wages to workers.

Another reason associated with the wage differential between formal and informal sectors is the absence of competition in the market. Even though it is said that the informal sector is larger than formal and there are chances that competition prevails in the market, lack of information about the market, job insecurity, exploitation and absence of government regulations in the sector does not let competition play its role.

We have considered legal informal sector in this article. However, there is a debate on the wage rate in the illegal informal sector. Some researchers argue that wages are higher in the illegal informal sector since a few people are involved in it, which enhances labour productivity and hence they are paid well. Another reason for higher wages is the probability of getting caught by lawmakers, which urges them to ask for higher wages. Therefore, we can say that illegal informal sector is different from legal informal sector.

Informal sector is considered to be the backbone of an economy. The sector is assumed to be strongly associated with the formal sector since raw or intermediate goods are available at cheaper rates from the informal market than formal sector. Almost all the studies done on the wage differentials between informal and formal sector came out with significant differences in wages in the two sectors. Either it could be labour market regulation problems or exploitation or lack of trade unions. We can start debating on any of the above mentioned important issues, for example, how to regularise the informal economy or should we document the informal economy. I believe debate is an indispensable part of development, which should not be ignored. Moreover, since the last comprehensive survey on the informal sector was done in 1990s by PIDE-FES, it would be good to conduct another comprehensive survey on the informal sector, which highlights the problems of informal sector and workers working in the informal sector.

Playing with the Data

The article in published on Feb 25, 2013 in the Money Matters

 Playing with data 
 By M. Ali Kemal 
There are countless ways to interpret data and researchers can put their own spin on statistics. Consider the State Bank of Pakistan’s Handbook of Statistics (SBHS) 2010. The following is my analysis using data from the above mentioned source.

According to one researcher, total tax cuts to big business and wealthy individuals that were introduced by Nawaz Sharif’s government in 1990 led to a decline in tax collection by one percentage of GDP from FY90 to FY93. Additionally, other bad policies led to a decrease by 1.1 percent of total tax revenues as percentage of GDP from FY97 to FY99.

That was a period of reforms and tax reforms in particular were top of the list. Tariff rationalisation was initiated in 1987-88 and that process continued in the 1990s. In 1990 total tax revenues were 12.18 percent. The ratio declined to 11.83 percent in 1993 (Table 3.1 SBHS 2010).

Tax revenues declined during Sharif’s first term in power but as this was the era of tariff rationalization, we need to look at the revenues from custom duties. If the revenues from custom duties have declined then can we say that decline in revenues was due to decline in custom duties. Further analysing along these lines, if we subtract custom duties from tax revenues, we find that revenues increased during 1990-93.

Secondly, in the same era, there was an effort to increase the collection of direct taxes, which includes income taxes. The share of income taxes was increased by one percent of GDP from 1990 to 1993. By looking at the two scenarios (i) decline in custom duties which is a tariff rationalisation policy, and (ii) increase in the direct tax share, I would not call Nawaz Sharif’s first term in power was replete with bad policies. We should keep in mind that direct tax is a progressive tax and indirect taxes are known to be regressive in nature. Evidence in Pakistan’s case is not significant but definitely not progressive.

Analysing the second term of Sharif’s tenure makes for an interesting exercise. Sharif’s government came to power in 1997. Thus if we analyse his performance using a base period from 1996 (last government) and end period 1999, then we will see a sharp decline in tax revenues as presented by another writer.

Sharif’s government took charge of the PM office in February 1997, which means that eight months of that fiscal year had already gone. Thus it is not correct to analyse his performance comparing FY96. Interestingly, from 1997 to 1999 tax revenues as a percentage of GDP, declined by 1.12 percent. This decline too was largely associated with the decline in custom duties due to international tariff rationalisation.

Revenues from custom duties decline by 1.37 percent in the same term. Given the above analysis of tax structure, it is incorrect to deduce that tax cuts for the rich, if there were any, led to a decline in tax collection in the 1990s. In fact it is the tariff rationalisation of international trade taxes which led to a decline in total tax revenues. However, we can say that, apart from increase in the share of direct taxes, the overall tax efforts in the Sharif era would have been better.

One researcher suggests that the Sharif government’s economic performance was the worst amongst all the civilian and military governments in Pakistan. He talks about “average 3.1 percent growth” during his second term in power. The said writer neglects to mention that during Sharif’s first term GDP growth rate was 5.16 percent (compound growth rate).

Moreover, while criticising his performance in the second era, the said researcher used 1996 as a base period for comparison and blamed all the problems of FY97 on Sharif. As mentioned earlier, eight months had already passed by the time he took charge. His cabinet could only pray for bumper agriculture crops and wait for some miracle to lift economic growth from 1.7 percent.

However, during FY98 growth rate increased to 3.5 percent. After the nuclear detonation in May 1998, sanctions were imposed but still the government managed to get 4.5 percent of growth in FY99, which indicates that some good policy measures were taken at that time. In 1999 the military overthrew the democratic government and democracy was again derailed. In the second term, even if we exclude the first year, the average growth rate was four percent, which is lower as compared to other governments however still not as bad as it has been made out to be by the researcher in question.

The beauty of research lies in exploring different questions which instigate further research questions – thus debate continues. I believe I was unbiased in this data analysis. However, someone else may find my analysis wanting and come up with additional findings. The purpose of writing this article is to demonstrate proper use of data – examining the data in depth instead of simply showing the apparent picture.

My advice for new researchers is that while writing a research article you need to be very careful if you are not using data. If you want your arguments to be concrete then data is necessary however some precautions also need to be exercised while using the data. It is important then to go into the depth of things to see the real picture.

Mapping the Unrecorded

The article was published in Money Matters on March 4, 2013
Mapping the unrecorded 
 With a new figure for the size of the unrecorded economy, the terms used in academic circles are now being hotly debated 
 By M. Ali Kemal 
Researchers and writers have been using the word “informal” for the unrecorded economy quite frequently for the last many years. Some other terms are also used in this regard such as ‘hidden,’ ‘shadow,’ ‘underground,’ ‘black’ and ‘undocumented’. Each term has its own meanings and can be interpreted in different ways. When I started working on this issue, I used the term ‘underground economy’ since my predecessors and colleagues were using it.

Bruce Weigand at the University of Wisconsin, Whitewater wrote in his book that the underground economy can be defined as unmeasured and untaxed sectors. Furthermore, it classifies activities based on unreported cash transaction to evade or avoid taxes. According to this definition, cash is the sole medium of exchange in underground economic activities. 

The shadow economy entails the same concept as the underground economy, which in literal terms represents smaller activities supporting medium and large enterprises. However, if the activity is micro then it might be supporting the small, medium and large enterprises. Therefore, all those activities which are flourishing due to large, small or small and medium enterprises are part of the shadow economy.

The hidden economy is, as the word suggests, hidden. But from what? Tax authorities or the law enforcement authorities? Whether or not it is legal, whoever is estimating the hidden economy is measuring all the activities which are hidden from the authorities. Thus, by definition, it may cover aspects other than the shadow economy. However, while measuring its size, it is difficult to say whether it is a shadow economy or hidden economy.

The black economy is a different concept than the underground, hidden or shadow economy. It refers specifically to the illegal activities which lie outside the formal market. Smuggling, drug trafficking, prostitution and all other activities which are not permitted by the law are part of the black economy. We can say that the black economy is part of the hidden economy but not all of the hidden economy is the black economy.

The above mentioned definitions are important because all of these terms are often used synonymously. Researchers are still unsure whether or not the underground economy includes unpaid housework such as self-gardening, self-plumbing or not.

The example of self gardening is significant since it is hidden from the national accounts but is certainly not part of the black economy or shadow economy. Moreover, it is not conclusively said whether money generated from crimes is part of the underground economy or not. Where should we put money from rent or revenue seeking in these definitions since both are bad but not illegal?

In a nutshell, the above mentioned definitions portray different things but when it comes to data, we do not distinguish between them. In general, we use the same methodology and call it different names. The bottom line is that all those economic activities and the income which evades or avoids government regulation and/or taxation is part of the underground or hidden economy. The major component is undeclared work, which refers to the wages that workers and businesses don’t declare to avoid/evade taxes or documentation. The rest is represented by business underreporting profits to avoid/evade tax regulation. Thus all these activities are not recorded in the national accounts.

A study I participated in calculated the informal economy to be 91.4 percent of the formal Gross Domestic Product (GDP). But the figure does not represent the entire informal economy. It is the unrecorded economy – which is not recorded by the national accounts. The national account records formal activities and tries to incorporate informal activities as well. This leads one to ask: which activities represent informal activities in the national accounts?

While studying the methodology of national accounts, we can see how these estimated figures are computed. GDP can be measured by three different techniques (i) expenditure approach (ii) output approach and (iii) income approach. Any of the techniques can be used to compute the total GDP. In Pakistan, GDP is computed using the output approach, which is the value added of manufacturing, agriculture and livestock, other industries, services and the rest of the sectors. The data on the value added of agriculture and large scale manufacturing is readily available but it is mostly not readily available for every variable. For example, value added of small scale manufacturing is projected by using some constant growth rate. In this estimation procedure of other variables, some of the informal sector is also covered such as wholesale and retail trade. Thus national accounts do cover some part of the informal sectors.

Why is wholesale and retail trade part of the informal and not the formal sector? To answer that, let’s consider the definition of the formal and informal sector. The formal sector is a taxed sector which is under all the obligations/rules of the government. It follows all the regulations and being part of the formal sector, if it does not report any activity, then that activity becomes part of the underground economy. On the other hand, the informal sector does not report its activities to the formal system and remains out of the tax net. Consequently, workers in the informal sector are not working under the laws made by the government. It therefore does not also enjoy the favours given by the government to the formal sector.

There are various approaches to measure the hidden/underground/informal/undocumented/unrecorded/ black economy. Among many approaches, such as the fiscal approach, labour market approach, monetary approach, the MIMIC approach and electricity approach, most of the studies have adopted the monetary approach. More recently studies have used the MIMIC and electricity approaches. The biggest problem with the monetary and MMIC approaches is that they are based on indicators. An indicator, which suggests that there is a possibility that the underground economy exists, is selected and regressed econometrically on different explanatory variables. The final estimates which are basically the estimates of the indicators are then interpreted to predict whether the underground economy is going up, down or staying stagnant. The electricity approach is a better approach in terms of getting the actual estimates of the underground economy but since electricity is not used by all the sectors, the approach underestimates the actual size of the underground economy.

Coming back to the estimate of the informal economy that Ahmed Waqar Qasim and I placed at 91.4 percent and which has been quoted on various occasions. Initially, we labeled this figure an estimate of the informal economy. However, after discussing the matter with several people including Omer Siddique, a research fellow at PIDE, and Rashid Amjad, former vice chancellor of PIDE, we have changed the name of the paper to ‘unrecorded economy estimates’ from ‘informal economy estimates’.

Our methodology is very straight-forward. Since consumption is computed as a residual of GDP and saving and we know that the formal sector underreports production and computations for the other sectors are done by using formulas, also underreported, thus overall GDP is under reported.

We computed overall consumption from the household survey thus it gives us the total private consumption of households. We also adjusted mis-invoicing of imports and exports using a paper by Dr Zafar Mahmood. However, for the time being we have not adjusted investment (which is also underreported) and government expenditures.

The GDP computed from this methodology is then subtracted from the GDP figure available in the economic survey – the remaining is 91.4 percent.

Should you call it the ‘informal economy’? My answer would be, no. If we call it the underground economy, we may be wrong too since some of the untaxed sector is covered by the national accounts. Similarly we will avoid calling it the ‘hidden’ or ‘shadow economy’. We can safely call it the ‘unrecorded economy’.

Why Pay Taxes?

Article was Published in the Money Matter on April 1, 2013 
 Why pay taxes 
 By M. Ali Kemal 
Poor tax collection translates into poor living conditions. This is a point that has been brought home time and again by numerous researchers. Only recently, Sayem Ali wrote in this magazine about health indicators which suggest that Pakistan’s infant mortality rate is worse than that of many African countries. He also cited the embarrassing information that 67 percent of parliamentarians and senators did not file their tax returns in Pakistan. Most interestingly, one senator paid only Rs 82 in tax.

The main idea he raised was that we don’t collect enough taxes nor do we have a strict inspection and punishment system for those who are evading taxes. Due to the low level of tax collection, we cannot finance our basic needs. It is important for any developing country to provide basic education and health services to everyone. In this article I have attempted to identify other problems which emerge when taxes are not paid.

Since I started studying economics I have been listening to four major problems Pakistan’s economy has been facing: (i) exchange rate depreciation (ii) high inflation (iii) balance of payments crisis, and (iv) high fiscal deficit. Since the scope of this article is taxation, which is a fiscal variable, this analysis is restricted to the fourth problem.

Budget deficit is the difference between taxes and revenues. It is commonly argued that to reduce the deficit, we should increase taxes or decrease expenses. However, when asked how this should be done and which taxes should be increased, the answer is, usually along the lines of “tax the rich and give relief to the poor.” As for the how part, the most common answer to this is: “I don’t know; it’s the government’s job.” Those who know about taxes are likely to say, “Increase direct taxes and not indirect taxes.” Since direct taxes can be more progressive and indirect taxes are regressive by nature, the answer is correct.

Certainly, if everyone pays their share of taxes, we may have a lower budget deficit than we do at present. The most important consequence of having greater revenues and a lower budget deficit is lower borrowing and a sustainable deficit. Sustainable deficit means GDP growth rate is higher than the deficit, which implies that the government may not need to ask the SBP to roll over debt and may not need to borrow from scheduled banks. Moreover, chances of bankruptcy and solvency will be reduced and both government and banking sector credibility will improve. This may attract private and foreign investment in the country. Nevertheless, other measures should also be taken to attract investment.

Informal activities are mostly outside the tax net. Recent estimates show that the unrecorded economy is 91.4 percent of GDP. This implies that tax revenues can be doubled if measures are taken to document unrecorded activities in the recorded economy. If this is done then, we may not need to pay higher taxes. Since the government needs revenue to spend on public goods such as parks, roads, interest payments and debt repayments, the required amount of revenues are collected by taxing us at a lower rate instead of higher rates. Permanent reduction in tax rates would have a beneficial impact on the economy through increase in consumption and savings. Decrease in overall tax rates increases the profitability of investors and may boost investment.

Managing tax collection is a difficult task when we have deductions and exemptions in the tax system. The purpose of deductions is to legally decrease the taxable income of a taxpayer. The rule of calculating taxable income is to deduct all those expenses that are incurred to generate income. Thus a retailer will deduct transportation cost, rent of a shop, utility expenses, and investment before calculating his taxable income.

Tax exemptions, which also reduce taxable income of taxpayers, however are entirely different from tax deductions. Exemptions are usually given to grant relief to specific type of organisations, activities or persons. New industries were exempted from paying taxes during the first half of the 1990s, which promoted industrialisation in Pakistan.

Similarly, money given to charities is also exempted from taxation. Moreover, teachers and researchers pay 25 percent as taxes. Taxpayers often avoid paying taxes by hiding their income behind these deductions and exemptions which reduce the overall tax revenues. Consequently, the rest of the population pays the cost incurred.

Since income from agriculture has zero income tax, passing off income as agricultural income is an easy way to evade tax. Even the amnesty scheme, which is probably going to be implemented soon, includes all the sectors but income from agriculture is again exempted. Thus people who still want to evade taxes therefore have the option of showing their income as agricultural income.

Thus from the above discussion we can summarize that what is the real cost of not paying taxes? (1) higher taxes (2) higher borrowings (3) higher public debt (4) higher inflation (3) higher interest rate (5) lower investment (6) solvency and bankruptcy issues and (7) inadequate public facilities.

We have discussed several loopholes in the tax systems which explain lower tax revenues. Apart of these problems Dr Faiz Bilqees, in her paper, wrote that we have lower direct taxes because overall average income is lower. Some researchers argue that if we have lower overall average income then can’t we live modesty? Why do we need to collect 15 percent of tax revenues? On the other hand, it is also argued that policies are not implemented in developing countries, which is the main reason why we don’t benefit from them.

According to the chairman FBR, with Nadra’s help, 3.2 million potential tax payers have been identified. These are people who travel frequently, having multiple bank accounts, live in affluent areas, possess weapons and send their children abroad to study but do not pay taxes. Further details can be gleaned from information such as whether the children attend private or public schools/universities of these non-filers and how much they pay in utility bills each month.

Since it is not obligatory for everyone to file tax returns in Pakistan, people can get away with it quite easily. There is no punishment for non-filers/non-taxpayers. As a result, people are not afraid of being caught by the authorities. As a reform process, I believe that it should be mandatory for everyone to file tax return. This may unleash a new set of complications altogether because a majority of the population does not come under the tax net.

Moreover, literacy rate is just 58 percent. Of this, very few can understand the taxation system and fill the tax returns form. Thus it would be better to make it mandatory for all those potential taxpayers who live in or near urban areas. Furthermore, provinces should be asked to collect agriculture income tax from large landholders and use it for the development of their province. Simultaneously Federal government should cut their funding by some percentage so that provinces make as much efforts to collect revenues from agriculture income tax.

To increase our revenues, non filers should be brought into the tax net. Instead of inventing new taxes to increase tax revenues, we need reforms. We may need a new policy but implementation of policies, rather than changing policies frequently, is what matters. Renowned economist and former governor State Bank of Pakistan, Shahid Kardar, once said that we need to abolish exemptions if we want our tax system to work better.Why 

Towards Revival

Towards revivalArticle was Published in the Money Matter on may 6, 2013 
 By M. Ali Kemal 
According to a recent report issued by the Asian Development Bank (ADB), chances of economic recovery in Pakistan are bleak. The report also said that the chances for immediate recovery are nil. In such a scenario, the first two years will be very difficult for whichever party comes into power in the upcoming elections. Interestingly, if they are ousted in the third year, they will not have much in hand to show to the people and ask for them to vote again. Despite all the challenges, all the parties are vigorously participating in the elections.

The economy desperately needs stronger actions, which will fix things in the short to medium run. Meanwhile, in the long run certain reforms are needed that will stabilise the growth process.

Investment is crucial for growth. To achieve high growth rates, high levels of investment are necessary. In the last five years, investment in Pakistan declined to 12 percent from 22.5 percent in 2007. The decline in investment is associated with rise in extremism/terrorism, energy crisis, decline in profitability and lack of demand, which is also linked with the first two problems.

The previous government is getting ready for the next elections and so are the other parties. Everyone is all geared up to come into power. All the parties have published their manifestos, which cover various issues pertaining to the country, to inform the people about their agenda.

I have selected four major national parties, which are expected to form government in the centre or a coalition with the so-called regional parties or smaller parties. The four parties that have been analysed in the article include Pakistan Muslim League-Quaid e Azam Group (PML-Q), Pakistan People’s Party Parliamentarians (PPPP), Pakistan Tehreek-e-Insaf (PTI) and Pakistan Muslim League- Nawaz ( PML-N).

All the four parties have talked about economic revival. The PML-Q said that they will achieve six percent growth in their first term. The PPPP expects a six percent growth till 2016 and eight percent afterwards. On the other hand, the PTI does not mention their growth target but they expect to achieve 22.5 percent investment as percentage of GDP by 2018. The PML-N has a modest growth target of six percent till 2018 with 20 percent investment by 2018.

Investment, which kick starts the growth process, is common in all the manifestos. Due to terrorism, private as well as foreign investors are reluctant to invest in Pakistan as there is a high cost of security, which reduces profitability. Moreover, energy crisis is one of the major determinants of low investment in the country as most of the firms are unable to produce even to their installed capacity (due to unavailability of electricity and gas). Therefore, they do not want to invest more in physical capital.

By the same token, new investors are not investing in the country due to the prevailing energy shortages. One of the main reasons for low investment is the government’s bank borrowing, which crowds out private investment. It is pivotal to mention here a new growth theory, as said by Dr Nadeem-ul-Haque,  that the lack of private investment is due to lack of entrepreneurship. Do we have such policies that allow new entrepreneurs to experiment their ideas? Moreover, do we have policies that welcome new entrepreneurs into the market?

Despite the differences among political parties, they have agreed on a single point: terrorism is a deep-rooted problem and cannot be handled with force. However, the PPPP said that they will use force to eradicate terrorism where it is necessary. Apart from awareness programmes, education and employment opportunities, none of the parties has a tangible policy to eradicate terrorism.

Similarly, everyone talks about energy issues and all the four parties have their own way of solving this issue. A few days ago, Sartaj Aziz in an article, blamed the IPPs for high fiscal deficit. The article further stated that when the IPPs were asked to produce electricity, the price of oil was $18 per barrel, while today it stands at more than $100 per barrel. Hence, the cost of electricity production has increased significantly, especially in the last five years. Moreover, Aziz further said that the ratio of thermal to hydel was 40 to 60 in 1994 and it has now increased to 80 to 20. Thus, we are relying more on thermal electricity in the presence of high oil prices. This raises the issue of circular debt since the government needs to give more money to the IPPs.

The PML-Q thinks that the issue of circular debt will be abolished with a one-time settlement, whereas, the PPPP is thinking long term, i.e., building dams and renewable energy options. However, the PPPP’s manifesto includes an important point that has been missed by everyone and that is the policy of energy conservation, which can take place through different awareness programmes. Nevertheless, these awareness programmes should not involve huge costs. The PTI wants to wipe this problem out by moving towards lower cost of production. Nonetheless, their manifesto does not mention how they would go about it in the short run. They are keen to divert all resources to maximise energy production.  The PML-N, on the other hand, understands the problem of circular debt very well and their policy of mitigating power outages sounds better than all the other parties. According to the PML-N, they will find ways to reduce the cost of production by better management, and by replacing the use of furnace oil with coal in the short run. In the long run, they seek to introduce reforms in distribution and generation companies by corporatising and privatising both the institutions, decreasing line losses by less than 10 percent and introducing a pre-paid billing system to avoid non-bill payment problems.

In addition to terrorism and energy crisis, private investment crowding out due to massive government borrowing from scheduled banks in the last few years attributed to the high fiscal deficit. Thus, to counter the problem all the parties have vowed to reduce the fiscal deficit by increasing revenue as well as reducing wasteful spending, including untargeted subsidies. All the parties’ revenue targets are quite ambitious and seem impossible to achieve without structural reforms.

Moreover, cities are the engines for growth. All the manifestos incorporate urban land records as their main policy, which help in securing property rights. However, only the PPPP embraces the policy of expansion of markets in inner cities, promotion of cluster development and energy-efficient buildings. These policies are a significant part of the new growth framework of the Planning Commission, which enhances growth.

Other than the above mentioned challenges and their possible solutions provided by the four parties, certain reforms are necessary that involve ease in the process of service delivery, less paperwork, and lower bureaucracy restrictions, which help in reducing the cost of doing business and increases profitability. All the manifestos have touched upon these issues but the entire policy framework has not been shared and certain loopholes are prominent in each policy.

Besides a few reforms mentioned in the manifestos, various reforms are needed, including civil service reforms to achieve higher growth. The current bureaucratic system gives too many discretionary powers to the person sitting in the seat, who does not allow for new entrepreneurs to enter the market. The Planning Commission’s new growth framework tells us to implement various reforms that allow equal opportunities to everyone.

I would congratulate all the political parties who came up with different strategies for economic revival. It is now necessary that whoever comes to power, they involve other political parties and think tanks, e.g., the Pakistan Institute of Development Economics, to help them in implementing these policies in line of research.

The writer is a research economist at PIDE.

Informal Economy

INFORMAL ECONOMYThe article was published in the money matter on june 10, 2013 
 Debunking myths 
 By Ali Kemal 
The informal sector is considered the backbone of the economy since it provides basic intermediate goods to the formal sector. For the most part, it features small scale industries while large and medium enterprises are part of the formal sector. In 1990, Kibria wrote, based on the findings of a survey, that there are about 20,000 engineering units in the informal/unorganised sector, which provide 37 types of machine tools and 30 different types of chemical and acid plants. Approximately 500 small units provide components which are used in assembling tractors.

Among several misconceptions, two important ones related to the informal sector beg clarification. First, a study carried out at PIDE by Kemal and Qasim in 2012 estimated the undocumented economy stood at 91.4 percent in 2007-08. It includes part of the informal activities and the rest of them are included in the documented economy in the economic survey (such as small scale industries, transport, wholesale and retail trade, private sector construction, and social and personal services).

The second misconception is related to tax payments by the informal sector. A study by Kemal and Mahmood at PIDE in 1993 says that it is sales tax exempt but people working in the informal sector pay income tax. Moreover, goods they buy to produce further goods already include sales tax which is paid in the process of purchasing those products. Thus the notion that informal activity is entirely outside the tax net is false.

The fact that people operating within the informal sector do not pay sales tax does not imply that the informal sector is a bad thing. Informal activities begin with little investment and are usually smaller in scale. Thus paying taxes and being subject to several regulations increases the cost of doing business, which eliminates the competitive advantage they otherwise enjoy. Moreover, if the informal sector is also documented and comes under the tax net and regulations then downstream industry will acquire intermediate goods at higher prices.

For various reasons, labour in the informal sector receives lower wages. The lower wages also help the informal sector remain competitive by bringing down the cost of production. It is generally believed that the informal sector provides a better way to distribute wealth in the community because it does not ask for subsidies or other extra benefits. One of the strongest points in favour of the informal economy is that entrepreneurs have their own ideas and they take risks by investing their own money into the business.

The formal sector has limited capacity to absorb labour due to regulation and need for more skilled labour. However, this may not be the case with the informal sector. For this reason, migrants who move from rural to urban areas in search of work are easily absorbed within the informal sector as opposed to the formal economy. The informal sector creates opportunities to enhance self employment and labour.

Another important aspect of the informal sector is informal training transferred by way of the traditional ustad-shagird relationship, which in the absence of vocational training institutes helps train people. However, workers are paid very little till they are fully trained or receive their ustad’s approval. Most importantly, those trained in this manner, can only work in the informal sector for the most part. This is because the skills they learn usually relate to obsolete tools which are not technically efficient or prevalent in mainstream use.

There are big question marks surrounding the growth of the informal sector – will it grow at the same rate as the formal economy or even faster? What makes us think the informal sector is growing?

Employment share is increasing over time in the informal sector. This shows more absorption of labour in the informal sector than the formal sector. Another reason why we think the informal economy is growing is an increase in urbanisation, which leads to an increase in rural urban migration. People from rural areas usually do not have skills required in the formal sector. This propels them to begin working in the labour intensive informal sector.

Small industries have been hit hard by an energy crisis since FY08. Moreover, some other informal activities must have suffered as well. However, we have been continuing to project the same growth in relation to small scale industries, which may mean overstating actual growth. Miscalculations and inflated figures are expected in the documented GDP for FY11 and FY12. Figures for the undocumented economy may decline however this is not reflected in data as data for the documented economy is overestimated. It emerges that g rowing documented GDP is just an overestimation of data for the last few years. This may be attributed to faulty data calculation. Nevertheless, it does not mean that informal activities are controlled and that controlling informal activities is not good for the economy.

The writer is a research economist at the PIDE