How Informal Sector Affects the Formal Economy in Pakistan? A Lesson for Developing Countries

• Published in: South Asian journal of macroeconomics and public finance Vol. 9; no. 1; pp. 7 - 21
• Main Authors: Mughal, Khurrum S., Schneider, Friedrich G.
• Format: Journal Article
• Language: English
• Published: New Delhi, India SAGE Publications 01.06.2020; Sage Publications, New Delhi India
• Subjects: Bureaucracy; Classification; Corruption; Developing countries; Estimation; Informal economy; LDCs; Statistics; Transition economies; Pakistan; shadow economy; Informal sector
• ISSN: 2277-9787; 2321-0273
• DOI: 10.1177/2277978719898975

We explore the interaction of the informal sector with the formal economy for a developing economy, that is, Pakistan. Estimation results are obtained via autoregressive distributed lag (ARDL) bounds testing approach, which show a significantly positive effect of the informal sector in the long run whereas a negative impact of informal sector is found in the short run. We also present dynamic simulations to show the effect/contribution in terms of revised GDP per capita if the informal sector is accounted for in official statistics. The novelty of results is the varying effects of the informal sector across two time horizons that can have serious policy implications for developing and transition economies with large informal sectors. Although, the findings of this article enrich our understanding on the behaviour of the informal sector, they further fuel the debate associated with eradication of the informal sector. Efforts to curb informal activities may burden the low-skilled workforce in this sector and increase corruption opportunities in bureaucracy in the absence of institutional reforms. On the contrary, it makes the formal sector policy design and implementation a challenging task. JEL Classification: E26, H26, K42, O17