Thursday, 11 July 2013

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’.

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