Measuring the Underground Economy and its Impact on the Economy of Pakistan

Abstract

This study focuses on the measurement of the underground economy (UGE) through tax evasion in Pakistan over the time period 1974-2002. The monetary approach is applied in order to estimate the underground economy. First, the currency demand equation is estimated and then an attempt is made to deduce the size of the underground economy and tax evasion. Finally, an Ordinary Least Square (OLS) Model is applied in order to estimate the impact of the underground economy on Gross Domestic Product of Pakistan for a selected time period. The results demonstrated that the underground economy has increased enormously from Rs. 12 billion in 1974 to Rs. 1085 billion in 2002. The findings suggest that the existence of such a large UGE can decrease tax revenues, depress GDP, and raise socio-economic problems. Frequent tax audits and heavier penalties for tax evasion may minimise the size of the underground economy with its ill effects.