Nepal’s already tarnished financial reputation suffered another blow this year, as a new report by Ernst & Young (EY), one of the biggest global accounting firms, revealed that more than half of the country’s economic activities remain off the books. Released a few months after the Financial Action Task Force (FATF) placed Nepal on its grey list for deficiencies in financial transparency and anti-money laundering efforts, EY’s Global Shadow Economy Report 2025 found that 51% of Nepal’s gross domestic product (GDP) comes from unregistered and untaxed activities.

Globally, Nepal ranks third in terms of the relative size of its shadow economy, behind only Sierra Leone (65%) and Niger (56%). Nepal is the only non-African country among the world’s 10 most informal economies.

Based on the International Monetary Fund’s estimate of Nepal’s 2023 GDP at $40.9 billion, this implies that around $20.9 billion worth of economic activities take place outside formal

oversight—through informal labour, small-scale enterprises, under-the-table wages and cash-only transactions.

“The shadow economy distorts competition, reduces the quantity and quality of public services, hinders investment and economic growth, and weakens economic institutions and social perspectives,” the report warns.

Structural Gaps and Policy Shortfalls

According to Nara Bahadur Thapa, former Executive Director of Nepal Rastra Bank (NRB), the government has long recognized the weight of the informal economy. The 16th Plan identifies four indicators to gauge informal activity, including business registration status and accounting practices. Alarmingly, 50% of businesses are not officially registered, and 48% do not maintain regular books of account.

“The large size of the informal economy has several adverse effects,” Thapa said. “Unregistered businesses are ineligible for government incentives, which undermines fiscal and monetary policies. These enterprises also operate at high cost and small scale, missing out on economies of scale essential for national growth.”

He further noted that such enterprises are generally resistant to innovation. “They tend to rely on traditional methods and are slow to adopt technology. Without innovation, sustained economic growth becomes difficult,” he added.

Moreover, these businesses are generally not bankable. “They lack access to formal credit markets and are left out of financial sector expansion. This means monetary policy cannot be transmitted effectively, as only a slice of the economy can access formal financing,” Thapa added.

On the fiscal side, poor tax compliance is persistent. “Informal businesses do not pay taxes, and their transactions go unrecorded. This leads to low public

revenue and constrains the state’s ability to invest in infrastructure development,” he explained.’

A Shrinking Shadow—But Slowly

Despite the scale of the problem, Nepal has made modest gains in formalizing its economy. According to the EY, Nepal’s shadow economy shrank from 59.9% in 2000 to 51% in 2023—a decline of 8.9 percentage points over two decades. However, progress is slowing. Between 2013 and 2023, the drop was only 3.3 percentage points; while it was mere 0.6 percentage points between 2019 and 2023.

This slow progress contrasts with the progress seen in 19 countries that reduced informality by an average of 6.75 percentage points since 2000. Notably, many low-income countries made significant improvements, highlighting the potential of political will and structural reforms —even in difficult contexts.

According to the EY report, the shadow economy has been on a downward trend across countries from all income groups. “The most significant reductions were estimated in low–income countries, while high–income countries displayed the least change, due to a smaller room for improvement in shadow economy drivers and relatively stable socioeconomic conditions. EY analysis indicates that the pandemic–induced economic crisis has been accompanied by a temporary upswing in shadow economy activity, especially in lower–middle and low–income countries,” the report said.

Local Research Confirms Scale of Informality

Findings from Tribhuvan University’s Central Department of Economics align with the EY report. Using the National Accounting Method, the TU study estimates that Nepal’s informal sector averaged 42.66% of GDP between 2010/11 and 2020/21. It spiked during periods of instability—most recently in 2020/21 when it reached 43%.

The study highlights two sectors where the informal economy is most concentrated: real estate and agriculture. According to the study, 99.97% of real estate activities and 96.48% of activities in agriculture, forestry and fisheries operate informally.

Only South Asian Outlier in a Mostly African List

What makes Nepal’s ranking in the EY report more stark is its regional context. All other countries in the top 10—Ethiopia, Burundi, Mali, Tanzania, Burkina Faso, the Democratic Republic of Congo and Mozambique—are sub-Saharan African nations grappling

with weak institutions and limited market development. Nepal’s inclusion in the list indicates that its informal economy is a structural and policy failure, not just a consequence of poverty.

“The dominance of the informal economy reflects deep-seated structural constraints—regulatory weakness, lack of capacity and policy incoherence. It is not just an economic issue but a governance challenge,” Thapa said.

Lessons from the Middle East and Asia

The EY report also includes countries with highly formal economies. The United Arab Emirates leads globally, with just 2.1% of GDP generated from informal activity. Other top performers include Qatar (2.2%), Bahrain (2.5%), Singapore (3.4%) and Kuwait (4%).

These nations share certain structural strengths: robust digital payment ecosystems, simplified tax regimes, strong regulatory institutions and high financial inclusion. The gap underscores what Nepal could gain from bold, institution-led reforms.

How EY Measured Informality

EY's estimates are based on a refined Currency Demand Approach (CDA), which correlates high cash usage with informal activity. The methodology incorporates multiple variables, such as tax coverage, regulatory complexity and institutional quality, to produce more accurate estimates of the shadow economy.

Globally, EY found that the shadow economy represents an average of 19.35 percent of GDP. In total, informal activity accounts for 11.8% of the global GDP. Unsurprisingly, developing countries, especially low-income ones, tend to have significantly higher levels of informality.

Nepal’s informal economy poses a serious risk to its development aspirations. Insights from both EY’s global benchmarking and local experts like Thapa make one thing clear: addressing informality is not just a matter of enforcement. It requires building systems, creating incentives and strengthening institutions that make formalization attractive, accessible and viable.

(This article was originally publihsed in  July 2025 issue  of New Business Age Magazine.)