Forced formalisation is not healthy

The large informal sector is a consequence - not a cause - of the low level of development

For decades, one of the central aims of economic policy in India has been to create conditions for workers to move from low- to high-income employment. This has usually implied a shift from the informal sector where productivity is low, to the formal sector where productivity is high. This process of “formalisation” has been excruciatingly slow.
 
The pace is now quickening.
 
Demonetisation, which led to financialisation of savings and then to the government-ordained acceleration of digitalisation, was one driving force. So, too, the introduction of the goods and services tax (GST). Formalisation was not the original objective of either; it has turned out to be an ex-post official rationalisation for both. The “forced” formalisation that has been set in motion is, however, not good for working people.
 
The appreciation in government and international agencies of this kind of formalisation is based on a surprisingly inadequate understanding of the informal sector. So, first a primer:
 
Informal, unorganised, tiny or whatever you call it, this part of the economy has been defined in different ways. At its core, the informal sector contains small establishments with up to 5-10 workers (family, self-employed, or with hired workers) producing products often of low price and quality. Productivity is usually low, and so too are incomes and wages. The informal sector enterprises are to be found in manufacturing (from handloom to metal-fabrication) and services (small retail, eateries, repair establishments, and the like). It is in essence a very heterogeneous sector in terms of what it makes, how it functions, and where it sells its products.
 

Illustration: Ajay Mohanty

The self-employed and the wage workers stay in the informal sector or drift to it essentially because they cannot find jobs in the formal sector. In other words, the informal sector is a “sink” where people work because they have to earn whatever is possible. This sink of an informal sector is a reflection of a low level of development and not its cause. Estimates of the size of the informal sector in India vary depending on the definition one uses. The general view is that it contributes to up to 45-50 per cent of gross domestic product (GDP) and provides work to over 75 per cent of the labour force, if one includes non-plantation agriculture as part of the informal sector.
 
The informal and formal sectors function side by side, and, hence, the longstanding characterisation of such economies, including the Indian, as a dual economy.
 
The links between the informal and formal sectors — in terms of the flow of goods and services — are now deeper than before, but overall they remain shallow. The products and services of the informal sector are often (not always) purchased by consumers who themselves may be low-income earning members of the informal sector.
 
The informal sector does not pay income tax of any kind because the self-employed and hired labourers earn incomes well below the threshold. Most of the products and services they produce are also exempt from indirect taxes. Functioning as they do on the margin, the enterprises (if one can call them that) do not pay minimum wages either. (The self-employed themselves can on occasion find themselves earning less than the minimum wage.) On the whole, therefore, the informal sector does not enjoy any kind of advantage whether on account of non-payment of taxes or non-adherence to labour and other regulations.
 
Yet it seems as if official policy now sees the informal sector as one largely made up of tax evaders and arbitrage operators.
 
Yes, there are enterprises which operate under the tax and regulatory scanner in order to get the better of the formal sector. There are manufacturing enterprises which are split up into smaller “name plate” firms to work under the threshold of labour regulations. There are the larger service establishments in, say, retail, which again operate mainly through cash operations to evade payment of taxes. Then there are the civil contractors who neither pay minimum wages nor pay income tax. No one has an idea of the size of this “illegal” informal sector. But given that the larger informal sector functions as a sink for the labour force, it is difficult to see these “evading” enterprises as accounting for a very large share of aggregate output.
 
It is these enterprises which are now sought to be formalised through the push to digital payment and by integrating them into the GST chain. They will first try and function as part of the formal sector. If they cannot succeed they will fold up. Going by press reports, it appears that the latter process is already happening. Large firms producing consumer goods seem to expanding their markets at the expense of the informal firms which are being driven out of business.
 
As a consequence, yes, tax revenue should be going up. But as far as employment is concerned, in the first round of adjustment, workers in these informal sector firms will lose their jobs, and the number of jobs lost here will not be compensated by those created in the high-productivity formal sector.
 
 It is not as if the rest of the informal sector, which has many more enterprises and many more workers will remain untouched by forced formalisation. They too will be affected negatively in different ways by this process.
 
The push to digitalisation of transactions will have a negative impact on household enterprises which are not ready for this switch and which are also not familiar with this mode of payment. So, too, the introduction of the GST. As many media reports have pointed out, GST exemption is not an unmixed blessing for small enterprises. The firms in the formal sector do not want to deal with those outside the GST because they cannot claim any tax credit. This then has another negative impact on the small enterprises in the informal sector.
 
The ongoing forced formalisation is based on the belief that the informal sector is the cause of a low level of development, when it is actually a consequence. There is no disagreement on the need for labour to shift from low productivity to high productivity jobs. However, the growth of the formal sector should not happen with a closure by government fiat of the informal. Tax evasion and regulatory arbitrage must end, but not by simultaneously shutting down a much larger number of household enterprises, which are not flouting any laws and where people are struggling to earn a livelihood.
 
The writer is a former editor of The Economic and Political Weekly, and the author of Demonetisation and Black Money