‘Table 1, A Taxonomy’ f Underground Economic Activities NUST Journal of Business and Economics ‘Monetary Transactions Mlegai Activities smuggling and fraud, ‘Trade in stolen goods; drug dealing and manufacturing; prostitution; gambling; Non-monetary Transactions Barter: drugs, stolen goods, smuggling etc., Cultivation of drugs for self-use, Thett salaries, and assets from unreported work related to legal activities. Tax Evasion ‘Tax Avoidance ‘Tax Evasion Tax Avoidance Tegal Activities Unreported income from | Employee discounts, | Barter of legal services | All do it yourself and self-employment; wages, fringe benefits and goods neighbor help activities (Original Source: Micus and Smith (1970, pS), with minor changes in some of the calls. Recognizing the seriousness of the topic, the present study rekindles the debate on the underground economic activities to understand the difference between the recorded and the hidden components of the economy. A critical review of the empirical work is undertaken 10 clarify the ambiguity about the size of the underground economy in Pakistan and the inferences drawn for the economy in general and the fiscal policy in particular What Constitutes UGE? Before proceeding further, it may be relevant to identify UGE. The underground activities can be either legal or illegal, and can involve pecuniary or non-pecuniary transactions. Out of these four distinct possibilities, attention is generally restricted to legal activities involving, monetary and non-monetary transactions. Thus, the empirical work relatcd to UGE concentrates mainly on incomes generated through legal activities that are somehow concealed from tax authorities. This explanation necessitates a further distinetion between (ax evasion and tax avoidance as these concepts are interconnected with the hidden economy. Whereas the former refers 0 concealment and/or misrepresentation of the size and source of income, tax avoidance relates to taking advantage of the tax code by exploring the loopholes. Usually, tax evasion is nothing short of delinquency, but the same is not true for tax avoidance, ethical considerations notwithstanding. Based on this elaboration, the taxonomy of underground activities is summarized in ‘Table 1. which is extracted from Schneider and Enste (2000, page 79), “Measurement” of UGE By its peculiar nature, the size of UGE is difficult to measure. Nonetheless, numerous efforts have been made during the past three decades to “estimate” the unrecorded component of GDP. This process is continuing unabated and there is no end in sight” According to Feinstein (1999), “as long as eriminal activity in all ts mnysiad forms remains an important social problem there is « need for For a comprehansive survey ofthese eons, see Schnoider and Ente (2000) op ct andthe Spail Suploment of the Economic Journal, 1299, 1n the Gonoversyon Hidden economy, See eso Lope. O. and M Waker (1907 some means of assessing the nature, incidence and magnitude of this activity, both for general education and for policy formulation. ‘The four approaches commonly used to comprehend the nature and the size of UGE are: (a) direct estimation, either through detection-controlled methodology whereby tax non-compliance data are used to measure the degree of tax evasion, or through the use of tax surveys; (b) indirect estimation based either on one of the many different variants of monetary approach or alternatively through discrepancy analysis on the basis of national income and expenditure statistics or actual and official labor force data. The difference between the two in ether of the two cases is regarded as an indicator of UGE; (c) physical input (electricity consumption) method which results into proxy measurement of the overall economy and its difference from official GDP yields estimates of UGE; and finally (4) dynamic multiple-indicators multiple-causes model where unobserved variables are linked with observed indicators UGE being one of the unobserved variables ina simultaneous equation system is designed 10 have structural dependence on observable variables, which help in predicting the movement and size of UGE in the foture How Reliable are the UGE Estimates? Despite this large array of estimation techniques, it is still not clear what is being measured, Apart from definitional vagueness and weak theoretical foundations, the quantitative estimates also suffer from vulnerable Lnderpinnings. To add insult to injury, heroic assumptions fare made to justify manipulation of certain numbers [Thomas (1999) It s amazing to see that no two estimates, of the empirical research, even in the case of developed economies, match with each other. Keeping in view the sensitivity of the UGE estimates to estimation techniques, the information in Table 2 rately restricted 10 OECD countries for the simple underlying belief that the “official” GDP statistics of these countries are comparatively more reliable than those for the developing countries ‘A cursory look at the information indicates that the estimates of gray economy for most of the OECD countries are as murky as the shadow component of the economy itself. It appears that the general observation regarding‘Underground Economy in Pakistan: How Credible are the ‘Table 2, Estimates of UGE as % of GDP for Selected OBCD Countries imates? - ther Magsood Aled 3 comtey Currency Demand Approach Physical Input Method 1930 1939-90 1990.93 1990 ‘Austria 3d 5 61 155 Belgium 16.4 193 208 198 Canada 107 128. Bs ua Denmark 86 108 15 169 France 69 9 Bs 123 Germany 108 los. 12s 146 Ireland 8 " 142 206 Tay 167 28 24 196 Netherlands 94 19 127 1B Norway 106 148. 167 93 Spain Na 16.1 173 29 Sweden 122 ase 7 u Switzerland 65 67 69 102 UK 84 96 m2 Bt USA 5 67 82 105 Average 95 122 4 148 Source: Schneider (1997) and Schneider and Enste (2000) ever-growing nature of the hidden economy stands vindicated — the average share of UGE in GDP has increased from 9.5% in 1980 to 14% in 1990-93. However, the surprising element is the speed at which this share has grown in some of the economics, especially in the Scandinavian countries, as compared to others. ‘The discomfort intensifies further when these “estimates” are compared across estimation techniques. To emphasize this point, the UGE estimates for Switzerland are picked as an example. The evidence confirms that based on the currency demand approach, the share of gray economy was less than 7% in 1990; the physical input method inflates this share to ‘more than 10% —a difference of nearly 48%. A similar but contrasting distortion is present for other countries especially Austria, Norway, and Sweden, Extending the argument further, itis rather surprising to note that the discrepancy in UGE estimates is increasing overtime despite the fine-tuning of the estimation techniques. Schneider and Enste (2000) have exposed the divergence in the size of UGE relative to GDP in five of the OECD countries. The study shows that, based on nine estimation techniques covering a time horizon of 1986-90, the relative size of UGE ranged between 1.4% and 21.2% in Canada, 11.3% and 31.4% in Germany, 6.2% and 19.4% in the USA, 9.79% and 13.2% in the UK, and 9.3% and 21.3% in Italy. This conspicuous difference clearly puts a big question mark on the reliability of UGE estimates and their literal obedience by practitioners to draw implications. for various segments of the economy including the fiscal sector Evidence from Pakistan Similar to other countries, the measurement of UG continues to be a favorite pastime of researchers in Pakistan as well. A number of studies have been completed since 1990 not only to quantify the size of UGE in relation to GDP, but also to estimate the extent of tax evasion in the country.” However, unlike elsewhere, these studies have concentrated on the monetary approach — originally put forward by Cagan (1958) and later on extended by Tanzi (1980, 1983), which assumes that transactions in the UGE are largely funded by cash in order to reduce the chances of detection. This, in turn, requires a larger than reasonable level of circulation of currency in the cconomy. Without going into finer details, Tanzi's approach is briefly explained in the following, as a starting point for the later discussion, ‘The monetary approuch develops a_ relationship between currency (relative to a suitable scale factor such as “These nous Shabsigh,G. (1995). Ahmed, Mand. A. Abed, (1995), Igoe, Z. Qureshi. K, and F. Mehmood (1895), Ata, & (1998), At ‘ema (2003) Busha ar Rau! (2004, Ane and Hussain (2006), and ‘At Kemal 2007)