One of the main functions of any government is to collect revenue and then to prudently spend it on the well-being of citizens. Government is also bound to provide public goods and a conducive environment for businesses to promote economic activities.

Generally, the process of revenue collection and spending speaks volume about the economic acumen of a government, the power of a state and the commitment of a business to the well-being of a territory.

In order to facilitate its function, economic entities, big and small alike, are supposed to work in the legal sphere and contribute to the economic development of a country by in time payments of taxes. Government machinery efficiently runs in countries where individual and economic entities pay their taxes.

However, globally there is no dearth of firms, individuals and economic entities that avoid paying taxes and working in underground or shadow economy. Such entities and individuals hide their economic activities from officials for monetary, regulatory or institutional reasons and thus render a government unable to collect taxes and spend the revenues on the well-being of citizens.

Meagre revenue generations also hinder a government to facilitate businesses. Moreover, shadow economy not only retard revenue collections, it also misleads investment, deteriorate income inequality, mis-allocate resources, and facilitate money laundering. Thus, shadow economy is a direct threat to sustainable economic development.

Shadow economy is not limited to the developing world. It can be traced in the developed world as well but with disproportionate distribution.

A cursory look at the size of shadow economy across regions shows that underground economic activities are three times bigger in developing countries (35 percent of GDP on average) compared to its size in developed countries (12 percent of GDP on average).

Some studies report that the size of shadow economy in Pakistan is far bigger than 35 percent, but for the sake of some necessary calculation, we keep the figure of 35 percent intact.

Now take a break and look at the size of Pakistan’s GDP; let us say in 2025 it was USD 411 billion.

Now take another break and calculate 35 percent of USD 411 billion, which comes to USD 144 billion. This is the size of shadow economy in Pakistan in 2025. This means that Pakistan could collect USD 7 billion more taxes in 2025 if USD 143 billion of activities were legalized and taxed at a rate of 5 percent. This prudent act could relieve Pakistan from knocking on every door for a few billion dollars. It could also have given breathing space to the government and could have relieved pressure on taxpaying entities.

At the same time, it could expand tax base and help avoid imposition of regressive super taxes.

However, bringing shadow economy to legal sphere is not an easy task for any government whose priorities are anything but improving the well-being of people.

The question that needs a plausible answer is why isn’t the government of Pakistan bringing shadow economic activities into the legal sphere? Perhaps, an answer could be that successive governments in Pakistan wanted to tread the easiest paths. They avoid tough measures such as tightening regulatory system, curtailing size of the government, introducing efficient level of taxation, using tax money on public welfare, strengthening of democracy, and improving quality of institutional and judicial system in order to incentivize economic activities to work in the legal sphere.

Similarly, it is difficult to justify taxes if they are not spent on public projects, nor are they spent on provision of basic infrastructure. Therefore, a huge number of economic entities avoid paying their due share when government imposes or increases tax.

Some entities also avoid paying taxes because once they are in the tax net, they have to take the disproportionate burden. That’s why the size of shadow economy usually swells with increase in taxes in Pakistan.

Successive governments have used deterrence measures to increase revenue; however, deterrence is theoretically appealing while empirically it has produced mixed results.

On the other hand, curative and commitment measures such as enforceability of contracts, efficient judicial system, spending money on public projects, access to finance and good governance along with justifiable tax rates can play a crucial role in bringing shadow economic activities into a legitimate system.

Firms will never work in shadow economy if their cost of not using particularly services, such as access to finance and quality public goods, increases.

Therefore, the government in Pakistan can use access to finances and provision of other services as a way to bring underground businesses back to legal sphere. Financial inclusion and access to finance is one of the effective ways to discourage shadow economic activities, especially those who are focused on the long run.

Economic stability, policy consistency, and ease of doing business are some other important factors that can incentivize working in the legal sphere by reducing the cost of doing business. Unfortunately, lack of finance and economic instability are the two perennial problems of Pakistan’s economy.

Addressing these two problems along with improving quality of institution and provision of public goods will bring shadow economic activities back to the legal sphere and will increase revenue collections at local level.

Tackling the issue of shadow economy will not only enable government to collect more revenue, it will also help Pakistan avoid frequently kneeling at the doors of IMF and brotherly countries.

Copyright Business Recorder, 2026

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