The consequences of revenue gap in Pakistan: Unveiling the reality

The purpose of this study is to investigate the major macroeconomic factors that enhance revenue gap for Pakistan through the co-integration and error correction model over a 36-year time period, i.e. between 1975 and 2010. The study employed the bounds testing approach of cointegration to estimate the long-run relationship between the variables, while an error correction model was used to determine the short-run dynamics of the system. The study was limited to a few variables, including economic growth, imports, unemployment rate, external debt and consumer price index, in order to manage robust data analysis. These variables are selected because of their vital importance to an emerging economy like Pakistan. Both short and long-run results confirm that except consumer price index, all other explanatory variables are positively associated with the revenue gap in Pakistan. The results suggest that changes in price level decrease the revenue gap in the short-run which indicates the “Patinkin effect” but these results disappear in the short-run. The results further point out that the speed of adjustment is rather slow for equations to return to their equilibrium level, once it has been shocked. The result of Granger causality test shows that there is a bidirectional causality relationship between revenue gap and imports on one hand, and between revenue gap and underground economy on the other hand. Moreover, unidirectional causality runs from debt, unemployment and inflation towards imports. There is a bidirectional causality runs between debt and imports, between unemployment and imports and between inflation and imports in Pakistan.