The Extent and Causes of Tax Evasion in Pakistan

Molar and woodland (2004) investigated the efficiency of tax through tax optimality index. In their paper they measured the difference between the current tax structure and an optimal tax structure. They used the methodology was based on a small open economy and they constructed an equation on economy’s equilibrium to construct their tax optimality index including public goods. The model used to calculate the total optimality index had four variables – three private and one public good.

The tax optimality index came out to be 0.7972 which showed that the taxes where 79.7% efficient compared to the optimal tax index. The advantages of the tax were that it immediately told how efficient where the current taxes of a country with reference to an optimal model.

Kemal (2007) discussed the extent of underground economy and tax evasion in Pakistan. He analyzed the main causes of increase in underground economy citing reasons such as intensity of regulations burden of tax and social transfers etc. The methodology he used was that he collected many micro and macro variables such as total number of bank deposits, interest rates, GDP, GNP, inflation etc in order to construct his equations to measure the extent of increase in underground economy. Years were ranging from 1973 to 2003. The equation developed was a regression equation, first legal money is calculated, and after that velocity of money is calculated by dividing the national income with legal money, lastly multiplying the velocity of money with illegal money gives the underground economy. Multiplying underground economy with total tax to GDP ratio gives tax evasion.

Empirical results showed that both the size of underground economy and tax evasion increased significantly during these years. The increase was most predominant in 1990’s. He also concluded that raise in underground economy poses many problems for policy makers. He also concluded that had there been no tax evasion budget balance could have been positive.

Aslam (1998) measured the size of underground economy and tax evasion in Pakistan. His paper used Tanzi’s methodology with few changes made to the model. The range of the years was from 1960 to 1998. The modified model was of log to log specification with demand of currency assumed to me the main determinant of tax rate. The paper reinforced the presence of a large underground economy and huge tax evasion in Pakistan. Results showed the variation in underground economy is very sensitive and has significant impact on GDP. Further it showed that the Dollarization of economy is major problem because of significant involvement of underground foreign exchange. The limitation of this paper was that this paper could not be concluded as completely accurate and it does not tell about a remedy plan.

Jayasinghe (2007) evaluated the components and sources of tax gap in Pakistan.

Presence of significant tax gap forces a country to impose higher marginal tax rates of tax payers in order to collect additional revenue required to overcome a potential budget deficit.

The model assumes that tax evasion in the economy is represented by a fully established hidden economy. Tax evasion is estimated through estimating the size of shadow economy through 1984-2004. A regression analysis is conducted in two specifications for comparisons. One specification is run by using total values of GDP while the other using per capita values for GDP.

The size of the shadow economy estimated through both specifications, GDP and per capita GDP show an increasing trend. Results showed that size of underground economy has increased from 23% to 84% till 2004.

Increasing trend in underground economy is followed by an increasing tax gap. Lastly, the paper argues that the source of declining government, revenue is growing tax gap.

Hibbs and Piculescu (2005) proposed a model of how taxation and government regulations affect the productivity of private institution.

The model proposed considers private firm with fixed capital (K) and variable labor requirements: Lo, labor in official while Lu labor employed in unofficial production. Wage is identical at (w) but wage cost varies: regarding the public sector, it is demand as potentially corruptible and markets for corruption would arise giving firms opportunity for evading taxes.

The model also assumes that incentive to evade taxation depend on statuary tax rates.

Regression equation is developed and regression tests are run to arrive at the conclusion. Empirical results in this paper are that markets for corruption arise due to perception of figures taxes as not “worth paying”.

Dependency on how many and to what extent firms within a country have incentive to produce underground economy and evade taxation policies regarding taxation and employment conditions of enforcement bureaucrats may create tradeoffs between containment of tax evasion and overall level of economic activity.

Goerke (2003) investigated the relationship between tax progressivity and the tax evasion. In this paper, the consequences of tax evasion upon employment opportunities are investigated. It relates that an increase in tax progressivity has no employment effect in the absence of evasion opportunities. The model has a fixed number of workers whose only source of income are wages (w) and who can evade income taxes a regression test is run and conclusion are drawn.

The results are that employment effects more of progressive taxes in an efficiency wage economy has no employment consequences in the absence of tax evasion. The analysis has presumed a constant level of statuary tax payments at the initial wage level.

Niepelt (2003) explored the dynamic of tax evasion. He analyzed the dynamics of tax evasion using a model in a continuous time. He developed an equation using the model and his assumptions based on the households in that model.

The conclusion drawn in his paper is that risk aversion and endogenous detection probability play a central role in static theories of tax evasion. It concludes that in the presence of tax evasion, the statuary tax rate is an important policy instrument but an unpredictable indicator of the effective stance of fiscal policy.

Ahmed and Ahmed (1995) estimated the extent and level of black economy in Pakistan through monetary approach. Researchers have termed the underground economy in various names such as (i) illegal economy (ii) unreported economy (iii) unrecorded economy (iv) informal economy. The method adopted for quantification of the black economy is that of Tanzi, with some modifications. The equation is of double Log specification. Tax – GDP ratio sign is positive. Relationship between interest rate on time deposits and currency ratio is said to be negative. After estimation of equations through least square method results are obtained.

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It has been found that the black economy as a percentage of GDP has shown a fluctuating trend. Black economy and level of tax evasion have increased over the number of years, but black economy as a percentage of GDP has experienced a decline. The sizeable magnitude loss of revenue indicates that substantial revenue can be realized by reducing the extent of tax evasion in the economy.

Crane and Nourzad (1985) analyzed the effect of inflation on aggregate tax evasion in the US over the period of 1947- 81.

The methodology used is to construct an equation using major determination of evasion. The major determinants are derived with the following implicit evasion function Z= f(O, f, TR, V, P). Z is a measure of tax evasion, D is probability of detection, F is fine rate, TR is tax rate, Y is real true income and P is inflation rate.

The equation derived comes out to be a logarithmic equation in Z. the most difficult variables to quantify is dependent variable itself, Z, measuring tax evasion. Probability of detection an independent variable is measure using moving averages over the period of 2 years. Tax rate is calculated using weighted average marginal tax rate. Inflation is calculated using CPI.

Empirical results show that aggregate income tax evasion in both absolute and relative taxes is positively related to inflation rate. Aggregate evasion is risen in absolute terms but has fallen in relative terms when real true income has risen.