data/Tackling_Informal_Economy/Tackling Informal Economy.txt

The informal sector's contribution to Pakistan's economy is remarkable, as it adds a handsome volume of approximately $661 billion, tantamount to 35.5 percent of GDP. The growing size of the informal economy in Pakistan is a major cause for much consternation for our policymakers who are trying to boost tax revenues and widen documentation, primarily through administrative measures.

Informality is also associated with higher income inequality, poverty, and less progress toward Sustainable Development Goals (SDGs). The informal sector is, on average, less productive than the formal sector because it tends to employ more low-skilled workers, has more restricted access to funding, services, and markets, and lacks economies of scale.

A recent joint study by the Small and Medium Enterprises Development Authority (SMEDA) and the International Labor Organization provides fresh, and disturbing, evidence of the informal economy's continuing growth. The total size of the informal sector, growing over time, is currently projected to be an enormous $457 billion, in sharp contrast to the size of the formal economy, which was officially estimated at $340 billion in 2023.

The informal economy, also known as the "shadow economy," "underground economy," or "unregistered economy," refers to economic activities that are not regulated by the government and are typically not subject to standard labor laws or tax codes. The size and characteristics of the informal economy vary widely across countries and regions, but it is estimated that around 61% of the world's workforce is employed in the informal sector of the economy. It is contributing to employment, income generation, and overall economic growth.

The informal economy is a critical source of employment in many developing countries, particularly in areas with limited formal job opportunities. It provides a safety net for people facing unemployment or those not having access to formal-sector jobs. In fact, in many regions, especially in sub-Saharan Africa, Asia, and Latin America, the informal economy represents a significant portion of the labor force. Nearly 75% of the total labor force in Pakistan is engaged in informal sector employment.

The ILO estimates that the informal sector employs about 60–70% of the workforce in low-income countries, and in some parts of the world, it accounts for up to 90% of total employment in rural areas. In India, it is estimated that the informal sector accounts for 50% of GDP, while in countries like Mexico and Brazil, the informal economy represents about 30–40% of total economic output. Pakistan's informal economy has a significant impact on the country's economic growth. As recently documented in a study by the Pakistan Business Council (PBC), informality in the wholesale and retail trade (WRT) sector has significant fiscal implications, especially when compared to the more formalized manufacturing sector. The share of the manufacturing sector in direct taxes amounts to 34.5%, a full 22% greater than its share in GDP. On the other hand, WRT contributes a paltry 2.9% towards direct taxes, 15% less than its share in GDP.

Using FBR data from 2018–19, in rupee terms, a proportionate revenue obligation on the wholesale and retail sector would amount to a minimum of PKR 277 billion, or at least PKR 234 billion greater than its current contribution.

A similar imbalance emerges in the domain of domestic sales tax collection. Estimates of WRT drawing on non-manufacturing, non-importing business sales tax returns from the Association of Persons (AOPs) and individuals show that the overall percentage contribution to domestic sales tax collection amounts to a negligible 1.65%. In contrast, the manufacturing sector's contribution exceeds 75%.

A major hitch of the informal economy is the loss of tax revenue. Informal businesses and workers typically do not pay taxes, which creates significant gaps in government fiscal income. The OECD (2024) estimates that in many countries, especially developing nations, the informal economy contributes to tax evasion and reduces the tax-to-GDP ratio. For example, in South Africa, the informal sector is responsible for an estimated 5–10% of lost tax revenue annually. Similarly, in Kenya, the government loses up to 8% of GDP due to informality. This lack of taxation limits the government's ability to provide public services and infrastructure and hampers overall development.

At present, only 300,000 of an estimated 3.5 million retailers are actively filing tax returns. The newly proposed scheme aims to bring the remaining 3.2 million retailers, primarily located in major cities, into the tax net. This initiative represents a significant step towards expanding the tax base and enhancing revenue collection.

The Federal Board of Revenue (FBR) introduced a special procedure to levy tax on small traders and shopkeepers, known as the "Tajir Dost (Special) Procedure, 2024." In this context, shopkeepers include wholesalers, dealers, retailers, manufacturer-cum-retailers, importer-cum-retailers, or such persons who combine the activity of retail and wholesale with any other business activity or other person in the supply chain of goods. Advance tax is to be paid on a monthly basis through a computerized payment process. The first installment was to be paid on 15 July 2024, and additional installments were to be due on the 15th day of each month thereafter. The formula calculating advance tax will be prescribed; however, every person shall be liable to pay a minimum advance tax of PKR 1,200 per year.

A person’s advance tax payment can be reduced by 25% of the total amount if the person:

Pays the whole or the remaining balance of the advance tax for the applicable tax year in a lump sum before any due dates.

Files the income tax return for the tax year 2023, if the return has not yet been filed, before the due date for the first monthly installment.

The FBR point of sale (POS) system refers to a specific initiative in Pakistan aimed at integrating retail sales with the tax system. This system is part of the government’s efforts to enhance tax compliance and reduce tax evasion by directly linking retail transactions to the tax authority.

Tier-1 retailers are required to integrate all their POS with FBR’s computerized system. Tier-1 POS is defined in section 2(43A) of the Sales Tax Act, 1990, to be a person who falls in any of the following categories:

A retailer operating as a unit of a national or international chain of stores;
A retailer operating in an air-conditioned shopping mall, plaza, or center, excluding kiosks;
A retailer whose cumulative electricity bill during the immediately preceding twelve consecutive months exceeds Rs. 12,00,000;
A wholesaler-cum-retailer engaged in the bulk import and supply of consumer goods on a wholesale basis to the retailers as well as on retail basis to the general body of the consumers;
A retailer whose shop measures 1000 square feet or more in area.
Key Features of FBR POS include:
Real-time Data Transmission: The FBR POS system transmits sales data in real-time to the FBR, allowing for better monitoring of retail transactions.
Tax Identification: Retailers using the system must register and obtain a unique tax identification number, which links their sales to their tax records.
Benefits of POS systems:
Compliance: It helps ensure that retailers comply with tax regulations by making it harder to underreport sales.
Incentives for Retailers: In some cases, retailers using the FBR POS system may benefit from tax rebates or incentives for compliance.
User-friendly Interface: Many FBR-compliant POS systems are designed to be user-friendly, helping retailers manage transactions easily.
Improved Tax Collection: Helps increase the tax base by capturing data from previously unregistered businesses.
Enhanced Transparency: Reduces the chances of tax evasion and enhances accountability.
Better Business Insights: Retailers can gain insights into their sales patterns and inventory management.
FBR has registered 5,026 businesses under the Tier-1 category. The registered companies have 31,119 POS and 22,657 branches. Pakistan has over 3.5 million traders; only 58,802 are registered for Tier-1, below 0.5 million of them have submitted tax returns during the past two financial years. The majority of businesses have not yet registered for the sales or income tax. Businesses in the informal economy remain outside the tax net and other regulations.

According to the FBR Year Book 2018-19, a major contributor in direct taxes is the manufacturing sector, with around 34.5% share, services sector about 24.2%, and share of WRT is "2.9% and 2.3%, respectively," which is, in fact, very low as against the existing potential in the country. Wholesale and retail trade sectors together paid Rs. 48.2 billion: Large Retail Trade (7.9 billion), Small Retail Trade (9.7 billion), and Wholesale Trade (25.1 billion). The government needs to present a simple and low-rate tax scheme to tap the real tax potential of the retail sector.

According to estimates, Pakistan’s retail market size in 2023 was $300 billion. By applying a market size tax of 4% and an income tax of 1% on gross turnover, total collection from the retail sector alone comes to US$15 billion. To keep that in perspective, the FBR collected total net sales tax on goods of Rs. 2,591 billion in 2022–23 and managed a total tax collection of Rs. 7,164 billion. Pakistan is struggling hard to overcome a monstrous fiscal deficit, which may reach a record high at over 9% of GDP in this fiscal year.