Integrating India's Informal Economy into the Formal One

Thu, 27 Apr Pre-Open

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India is now a test case for whether a high rate of economic growth is enough to alleviate poverty. With the fastest rate of growth among the world's biggest economies, India has an opportunity to overcome its historic difficulty in distributing equitably the benefits of its growth.

However, the transition from farm to factory has been hindered in India because of regulatory policies that have made it difficult for firms to grow.

As per an article in The Livemint, the 58.5 million enterprises counted in the sixth economic census, that was released last year, employed just 131.29 million people. That gives us an average of 2.24 workers per enterprise. What is even more baffling is the that the average employment per economic establishment has been coming down since the advent of economic reforms in 1991.

For example, the average enterprise in urban India had 3.77 people working in 1990. The number had come down to 2.68 in 2014. The proportion of enterprises employing more than 10 people has come down from 37.11% in 1990 to 21.15% in 2014.

Formalisation of the economy received a boost after Prime Minister Narendra Modi scrapped the Rs 500 and Rs 1,000 denomination notes in last year's notebandi exercise.

So how does informality affect tax revenue on the one hand and productivity growth on the other?

Informal companies evade fiscal and regulatory obligations, including value-added taxes, income taxes, labor market obligations such as social-security taxes and minimum-wage requirements as well as product market regulations.

Avoidance of regulation and taxes gives these firms an advantage over firms in the formal economy, who are unable to increase their market share despite being far more productive and efficient. Also, value added in Indian informal firms is nearly a fifth of the value added by formal firms.

But it is not as straightforward as this. As economist Jim Walker of Asianomics wrote in a research note: "There is nothing intrinsic that says that the informal economy is a less effective or beneficial source of activity than the formal economy."

The informal sector accounts for 40% of India's GDP and employs about to 75% of the labor force. The point is that the informal sector is a significant part of India's economy. There are other estimates which say that the informal sector employs more than 75% of India's workforce.

So, the shift in balance towards formal enterprises will push up labor productivity but also perhaps reduce job creation. Many informal enterprises use family labor far more than their needs.

Also, a rapid shift away from cash as well as the need of an audit trail to claim tax credits under the new goods and services tax (GST) regime could push a lot of firms into the tax net. The question is whether there will be disruption along the way as the implicit tax subsidy to informal firms withers away. Tax evasion also allows low productivity firms to attract capital away from high productivity firms.

The high prevalence of tiny enterprises in the informal sector is a drag on productivity on the one hand, but is also a source of distress employment to millions on the other.

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