India’s economy and the challenge of informality

News: This article says that fiscal policy efforts to formalize the economy are not enough in the case of India. There is a need for a coherent approach that focuses on the productivity of workers, efficiency, and overall economic growth.

 What is the fiscal perspective of formalization?

One, according to international financial institutions such as the International Monetary Fund, the informal sector exists due to excessive state regulation. It drives genuine economic activity outside the regulatory ambit.

Second, it believes that simplifying registration processes, easing rules for business conduct, and lowering the standards of protection of formal sector workers will increase formality.

How the efforts in India are based on the fiscal perspective of formalisation?

First, small enterprises engaged in labour-intensive manufacturing were protected by providing fiscal concessions, and large-scale industries were regulated by licensing. Hence, the fiscal perspective has a long history in India. For example, tax reforms in the mid-1980s.

Second, the Government has made several efforts to formalise the economy. For example, Currency demonetisation, introduction of the Goods and Services Tax (GST), digitalisation of financial transactions, etc

What is the impact of fiscal perspective?

One, it reduced efficiency and led to many labor-intensive industries getting distributed into the unorganised sectors.

Two, sub-contracting and outsourcing arrangements have increased. For example, the rise of power looms at the expense of mills in the organized sector.

Three, this has helped enterprises in staying out of tax nets even after getting benefited from the policy.

Why informality is not reducing even after steps taken by the government?

First, economic development is a movement of low-productivity informal sector workers to the formal. It is also known as structural transformation. India witnessed rapid economic growth over the last two decades but still, 90% of workers are informally employed and produce about half of GDP.

For example, East Asia rapidly industrialized in the mid-20^th century by drawing labor from traditional agriculture.

Second, a well-regarded study, ‘Informality and Development’, argues that informality is a sign of underdevelopment. The finding suggests that informality decreases with economic growth. Hence, the existence of informal employment is due to a lack of adequate growth or continuation of underdevelopment.

Third, informality in India is many-layered. As per International Labour Organization’s and India’s definition, the share of formal workers in India stood at 9.7%. Also, PLFS data shows that 75% of informal workers are self-employed and casual wage workers. About half of informal workers are engaged in non-agriculture sectors.

Four, there are industries that are growing without paying taxes and there are numerous low productive informal establishments that work as household and self-employment units. These establishments are not identifiable, thus very difficult to be formalised.

Five, State Bank of India recently reported that the economy formalized rapidly during the pandemic year of 2020-21, but this was not due to structural transformation rather due to shock due to lockdown.

What is the way forward?

The economy will get formalised when informal enterprises, like household and self-employment units, become more productive through greater capital investment and increased education and skills are imparted to its workers.

Source: This post is based on the article “India’s economy and the challenge of informality” published in The Hindu on 28^th Jan 2022.