Intensity of Regulations as a Cause of the Informal Sector

It is argued in the literature that the intensity of regulations and control in an economy is a determinant of the informal sector which however is ignored in most of its estimates. This article uses a new variant of the currency demand approach where ‘unemployment’ and ‘intensity of government control’ are used to estimate a shadow economy, alongside a the traditional tax variable. We choose Pakistan since it has a significant share of its activities in the informal sector along with the history of various political and dictatorial regimes. Further, there are examples of bureaucratic control leading to corruption in the economy. It provides an opportunity to study the nexus between regulation intensity and informal economy and present a case study for other developing countries exercising control over the economy through the large size of its public sector. The results show that the intensity of the control variable has statistically and economically significant role in increasing the shadow economy, almost equivalent to the tax coefficient. Once the yearly variation in our estimates is mapped with various political regimes, it seems that the validity of estimates is reinforced considering policy inconsistencies and prominent events of each regime.