Don’t believe everything they tell you about dangerous formality

The SBI report examines the potential loss of output or Gross Domestic Product (GDP) across all sectors in the pandemic year (Financial 2020-21), assumes that this GDP loss is concentrated in the informal sector, and comes from that assumption . The share of the informal sector in India’s GDP has come down to a “maximum of 15-20%” of GDP from about 52% three years ago.

There are four major problems with this analysis. First, the assumption that the loss to the overall GDP in 2020-21 represents just the loss of the informal sector is too simplistic. The informal sector was undoubtedly the hardest hit. But given the extensive evidence of revenue loss to the formal sector, it is difficult to justify the assumption of zero loss in the formal sector. The report acknowledges the possibility that the formal sector was affected, but justifies its extreme assumption on the grounds that it harbors a “downward bias” in its findings. There is no water in this justification. A simple example can show how this perception actually holds up for the extraordinarily small part of the informal sector to which the report comes.

Consider a hypothetical economy with a pre-pandemic GDP ₹2,000. It is called Dream Land. Now, let’s assume that the structure of Dream Land is similar to that of the Indian economy, accounting for the formal sector. ₹1,000 (50%) of GDP and the informal sector accounts for an equal share. Now, suppose the formal sector declined by 20% during the pandemic, while the informal sector decreased by 50%. In other words, while the formal sector is now producing value ₹800, the informal sector generates production value ₹500 and total GDP . is on ₹1,300. This means GDP has declined by 35% [(1300-2000)/2000], and the share of the informal sector has now come down to 38% (100X500/1300).

Now consider an economist from Dream Land, Doc Stats, who does not have data on the divide between the formal and informal sector, but knows that the overall economy has shrunk by 35% due to the pandemic. It assumes that the entire production loss (amount ₹700) is due to the informal sector. reduce ₹700 from the size of the pre-pandemic informal sector ( ₹1,000), she comes to the estimate of ₹300 for the informal sector. The estimated informal sector share in this case would be 23% (100X300/1300). Note that due to his (wrong) assumption, Doctor Stats arrive at a figure that is 15 percentage points lower than the actual share of the informal sector (38%) in Dream Land. The SBI report also has the same flaw.

The second problem with SBI’s analysis is that it uses an exceptional reference point (pandemic year) to make claims about structural changes in the economy. Imagine a dry year where half of India’s agricultural production and employment are lost. This will reduce the share of agricultural jobs in the economy, but will increase again next year as the agriculture sector recovers. It would be absurd for anyone to claim that the structure of the Indian economy has changed just after the drought. Similarly, it would make no sense to claim that the informal sector has disappeared as many informal enterprises shut shop during the pandemic. Small enterprises turn easily when faced with external shocks, be they pandemics or droughts. Compared to larger firms, they are also easier to resume once the blow has subsided.

The third issue with the SBI report is its underlying assumption that the reported GDP figures accurately capture the contribution of the informal sector. Unlike Dream Land, none register annual growth in the informal sector in India. During the process of revision of GDP and change in base-year, a benchmark survey of informal sector firms is carried out to find out their contribution to the GDP. But these surveys are not repeated every year. To calculate informal sector growth, national accounting statisticians use available data on formal-sector indicators for each sub-sector of the economy (with a few exceptions, such as agriculture). Thus, a significant portion of India’s GDP ‘grows’ every year by mere estimates. Over assumptions over such a weak statistical framework are unlikely to yield strong estimates of the informal sector. To arrive at the truth, we need a well designed survey.

Finally, in addition to the share of production, the share of workers with formal contracts (and social security benefits) is also considered to measure the extent of formality worldwide. In India, thanks to the Periodic Labor Force Survey (PLFS), such data is now available annually. The story they are telling is very different from the SBI report. Most of the workers in India do not have regular employment. According to the last pre-pandemic PLFS survey conducted in 2018-19, a majority of the small minority who have regular jobs do not have written contracts or paid leave. We know very little about the true size of the informal sector, but we do know that the labor market has yet to be formalised.