Owing to its importance at various fronts, international trade is one of the key policy concerns, especially for developing countries. However, as with all other policies, the effective formulation of trade policies requires correct information about the relevant factors and possible consequences concerning changes in various instruments at the hands of policy makers. In case such pre-requisites are not met, the policy changes may fail to achieve the desired goals or may result in unintended consequences.
Smuggling or illegal trade, being unidentified and unrecorded in official accounts, is one of the examples of the situations that can cause informational gap for designers of trade policies, putting certain side-effects of the use of policy tools into oblivion. Defined formally, smuggling is the “conveyance of things by stealth, particularly the clandestine movement of goods to evade custom duties or import or export restrictions.”1 In general, smuggling involves the employment of illegal means not only to circumvent the trade taxes but it can also make available certain goods that are lawfully banned in a country. Evasion of tariff can partly proceed under the cover of authorized means, such as, through trade under-invoicing, misdeclaration of goods or under/over weighing the products; while the trade of contraband involves the use of unauthorized means through clandestine entry points from where the goods go unchecked in/out of the country. In addition to its socially Pakistan Journal of Applied Economics, Vol.25 No.2, (135-159), Winter 2015 * Staff Economist, Pakistan Institute of Development Economics, Islamabad, Pakistan. **Vice Chancellor, Quaidi-Azam University and Professor, Department of Economics, Quaid-i-Azam University, Islamabad, Pakistan. 1 Encyclopedia Britannica. harmful role in being immoral, it involves violation of law, and smuggling which harms the economy, as well. By evading trade restrictions, it does not let a government exploit the revenue opportunities as per potential, which in turn may lead to compromising on public expenditures meant for social welfare. Moreover, as far as trade restrictions are imposed to protect local industries, smuggling does not let the achievement of this objective possible. It is even more harmful when done in response to a complete ban on a product because the government prohibits trading such goods on certain moral, religious or economic grounds. Thus, smuggling harms the socio-economic framework of a country on various accounts.
Smuggling has been classified as an illegal Directly Unproductive Profit-Seeking (DUP) activity of category-1, in Bhagwati (1982), i.e., an activity which arises in initially distorted situation and leaves the final situation distorted too. It is theoretically seen that as an exploitation of a profit opportunity; smuggling emerges when a price wedge is drawn between domestic and foreign prices owing generally to trade regimes, exchange rate regimes or market intervention by government, such that there is an incentive to buy from the cheaper market and sell in the expensive, till the price differential decreases to equal the costs of such transaction. The major factors that are held responsible for promoting smuggling can be categorized into two types; those that stress the benefits of illegal trade and those that highlight the problems with formal trade (Table 1). The former includes trade restrictions, such as, tariffs, quotas, license requirements, embargo, etc., distortionary domestic policies e.g., market interventions that artificially drive prices too low or too high, lax administration, poor law and order situation, mild penalties, and corruption; while the latter refers to phenomenon, such as red- tapism, complex procedural requirements, poor infrastructural arrangements, and high transport costs on formal routes. The reasons, however, may vary from country to country depending on the geographical locations, trade regimes and preferences of people.
Illegal trade is one of the important components of underground or informal economy, the latter being defined to consist all activities that are not recorded in formal national accounts [Schneider and Enste (2002)], in addition to smuggling, tax evasion, gambling, drug trafficking, moonlighting, etc. According to one of the latest studies on underground economy in Pakistan, it has been found that on an average, between 2000 and 2008, the informal economy has remained about 23 percent; as a percentage of Gross Domestic Product (GDP) per cent declining from 26 per cent in 2000 to 19.6 per cent in 2008 [Arbk, et al. (2010)]. Despite declining in recent years, it is still an alarming figure because all such activities go untaxed and the correct macroeconomic performance of the economy cannot be gauged without these activities taken into account. However, the share of smuggling in the underground economy of Pakistan has not been calculated