Channelizing Afghanistan to Pakistan Informal Trade into Formal Channels

Despite enforcement measures, smuggling continues due to the arbitrage opportunity provided by the differences in applied tariffs and taxes between the two countries. Informal traders import goods into Afghanistan and then route those goods back to Pakistan through informal channels to take advantage of the price differentials. A basic model and illustrative example are presented to assess the possibility of bringing informal trade from Afghanistan to Pakistan into the legal channels by reducing tariff and tax differentials between the two countries. The analysis is applied to case studies for LCD TVs and tea, both of which have been identified as smuggling-prone items. For LCD TVs, at existing tariff and tax rates, there are substantial incentives for informal trade through Afghanistan. Very significant reductions are required in the tariff or taxes to eliminate the incentives and make informal trade unprofitable. The effects of price discounting of informally traded products in the Pakistan market and possible under-invoicing by traders are also taken into consideration. Under-invoicing exacerbates the challenge, but a more substantial effect comes if there is price discounting by the informal traders. With a 20 percent discount, informal trading becomes unprofitable with tariff or tax reductions of as little as 8 percentage points. For tea, sold without discounting, a reduction of the sales tax by 12 percentage points, holding the tariff and income tax rates constant, or an equivalent combination of tariff and tax reductions, would be needed to eliminate profits from smuggling. Trade facilitation measures that enhance the efficiency of the APTTA could make it more competitive with trade into Afghanistan through Iran but may modestly add to the profits of informal traders. Additionally, there is limited scope for a Preferential Trade Agreement (PTA) between Afghanistan and Pakistan to channelize informal trade based on utilizing the APTTA and a formal channel coming back into Pakistan. The analysis suggests that reducing tariff and tax differentials between Pakistan and Afghanistan is essential to bring informal trade into the legal channels. This can be achieved through a combination of tariff and tax reductions, as well as trade facilitation measures. However, the effectiveness of these measures will depend on the specific circumstances of the trade and the level of cooperation between the two countries.