India’s economy and the challenge of informality

Since 2016, the government has made several efforts to formalize the economy. Currency demonetisation, introduction of the Goods and Services Tax (GST), digitization of financial transactions and enrollment of informal sector workers on several government internet portals are all meant to encourage formalization of the economy. But why the incentive for formality? The formal sector is more productive than the informal sector, and formal workers have access to Social Security benefits.

The above efforts are based on the “fiscal perspective” of formalism. This perspective appears to draw from a strand of ideas developed by some international financial institutions, such as the International Monetary Fund, which foreground the persistence of the informal sector to excessive state regulation of enterprises and labor that drive real economic activity outside regulatory realm. does. It highlights informality as a result of structural and historical factors of economic backwardness. Arguably, excessive regulation and taxation ensure the endurance of informal activities. Therefore, it is believed that by simplifying the registration procedures, easing the rules of business conduct and reducing the standards of safety of formal sector workers, informal enterprises and their workers will be brought under the ambit of formalisation.

The fiscal perspective in India has a long lineage in the tax reforms introduced in the mid-1980s. Initially, in an effort to promote employment, India protected small enterprises engaged in labor intensive manufacturing by providing financial concessions and regulating large-scale industry by licensing. Due to such measures, many labor intensive industries spread to the informal/unorganized sectors, except in the question of efficiency.

In addition, they created dense production and labor market interrelationships between the informal and formal sectors through sub-contracting and outsourcing arrangements (much like the labor-abundant Asian economies). In the textile industry, the emergence of powerlooms at the expense of mixed mills in the organized sector and handlooms in the unorganized sector best illustrates the policy outcome. While such policy initiatives may have encouraged employment, bringing the enterprises benefiting from the policy into the tax net has been a challenge. The challenge is only partly administrative. Political and economic factors operating at the regional/local level in a competitive electoral democracy are also responsible for this phenomenon.

sign of underdevelopment

Undoubtedly, it is necessary to widen the tax net and reduce tax evasion. However, global evidence suggests that the idea that legal and regulatory barriers are primarily responsible for the withdrawal of formality does not hold much water. A well-known study, ‘Informality and Development’ (https://bit.ly/3KOBEVx), argues that the persistence of informality is, in fact, a sign of underdevelopment. In all countries, the paper finds a negative relationship between informality (as measured by the share of the self-employed in total workers) and per capita income. The findings suggest that informality decreases with economic growth, albeit more slowly. A similar association is evident in the major states of India based on official PLFS data. Therefore, the persistence of a high share of informal employment in total employment seems to be nothing more than a lack of adequate growth or a continuation of underdevelopment.

change in asia

The defining characteristic of economic growth is a movement of workers in the informal (traditional) sector with low productivity to the formal or modern (or organized) sector – a process known as structural change. The second half of the 20th century saw rapid structural change in East Asia as poor agricultural economies rapidly industrialized, with labor derived from traditional agriculture. However, in many parts of the developing world, including India, informality has decreased at a much slower pace, manifested most clearly in urban filth, poverty and (open and disguised) unemployment.

Despite witnessing rapid economic growth over the past two decades, 90% of workers in India are informally employed, producing almost half of the GDP. Combining the International Labor Organization’s widely agreed template with India’s official definition (in the form of formal jobs providing at least one social security benefit – eg EPF), the share of formal workers in India is 9.7% (47.5 million). Was. Official data from PLFS shows that 75% of informal workers are self-employed and casual salaried workers whose average income is lower than that of regular salaried workers. It is worth noting that the prevalence of informal employment is also widespread in the non-farm sector. About half of the informal workers are engaged in non-agricultural sectors which are spread over urban and rural areas.

it has many layers

It needs to be understood that informality has now become differentiated and multi-layered. Industries thriving without paying taxes are just the tip of the iceberg in the informal sector. There are hidden large clusters of low-productivity informal establishments operating as domestic and self-employed units that represent “small production”. It would be a grave conceptual error to mix the two disparate parts of the informal sector. Survival is perhaps the biggest challenge for most informal workers (and their enterprises), and uncertainty defines their existence.

In spite of the (deliberate) efforts to formalize, the challenge of informality remains great for India. The novel coronavirus pandemic has added to this challenge. State Bank of India research recently reported that the economy has been increasingly formalized during the pandemic year of 2020-21, with the informal sector’s GDP share falling from around 50% a few years ago to less than 20%. Developed countries close to this figure. As we have argued elsewhere (https://bit.ly/3G6JtST), these findings of rapid contraction of the informal sector during the pandemic year (2020-21) do not represent a sustained structural transformation of the low productive informal sector . A more productive formal sector. They are a temporary (and unfortunate) consequence of the pandemic and severe lockdowns imposed in 2020 and 2021. The informal sector will soon be forced to come back to life, using its abundant labor and scarce resources, to produce whatever it can.

essential element

The policy efforts directed towards formalizing the tip of the informal sector iceberg by removing legal and regulatory hurdles are laudable. However, these initiatives fail to appreciate that the bulk of informal units and their workers are essentially small producers (self-employed and casual workers) who are subsistence with minimal resources. Therefore, these efforts will yield limited results. The continued dominance of informality defines underdevelopment. Policy-driven restrictions are minor irritants, at best. The economy will be formalized when informal enterprises become more productive through greater capital investment and enhanced education and skills provided to their workers. Given the poor record of implementation of labor laws, mere registration under several official portals will not ensure access to social security.

R Nagaraj is with the Center for Development Studies, Thiruvananthapuram. Radhika Kapoor is with the International Council for Research on International Economic Relations, New Delhi