The formal push

Formalisation by itself will not drive growth

A number of initiatives of the government and the impact of the pandemic are said to have increased the level of formalisation in the Indian economy. Demonetisation in 2016 and the subsequent cash shortage pushed many to adopt digital modes of payment. The implementation of goods and services tax brought a large number of firms into the formal system. It became necessary for businesses to deal with other businesses in the formal system to be able to claim input tax credit. However, it is likely that small businesses that could not get into the formal system and comply with rules lost out. Further, the pandemic affected the informal sector disproportionately. As a result, economic activity seems to have moved towards large firms. In this context, a new study by economists at the State Bank of India (SBI) shows that the share of the informal economy in gross value added (GVA) declined sharply from 52.4 per cent in 2017-18 to 15-20 per cent 2020-21.

This is a sharp shift in activity to the formal sector. According to the data presented, the share of the informal economy in agriculture and allied activities is estimated to have declined from over 97 per cent in 2017-18 to 70-75 per cent in 2020-21. Similarly, informal activity in the construction sector declined from 74.5 per cent to 35-40 per cent during the same period. The government’s new initiative to register workers through the e-Shram portal is also helping in this context. At a broader level, as the study notes, there is no globally accepted framework to gauge informal activity. Accounting for goods and services produced by entities that are not registered in the system is an issue. These entities could be out of the system because either they are too small or are trying to avoid taxes. Although increased digital transactions and other government interventions seem to have made the economy more formal, determining the extent of formalisation would need more investigation. The SBI study could be a good starting point.
 

Greater formalisation of economic activities has its benefits. For instance, it will give a better sense as to how the economy is performing without a considerable lag, enabling policymakers to make more informed decisions. At the micro level, it will facilitate small businesses to have a digital presence, which would help in accessing formal credit. A number of new-age fintech firms are helping small businesses in accessing credit more efficiently. Since the extent of formalisation may be difficult to measure, improvement in the tax-to-gross domestic product (GDP) ratio over the years could be a good indicator.

India’s tax-to-GDP ratio has remained low and a significant improvement in the medium term could give a big boost to economic growth. Besides, formalisation can also be gauged by the level and nature of employment being created in the economy. As things stand today, the government’s rural job guarantee programme has run out of money, which shows the state of the job market. The ongoing recovery from the pandemic and greater formalisation of the economy do not seem to be benefiting a large part of the labour force. This suggests that the government will have to continuously focus on attaining higher economic growth. Digitisation and formalisation can help push up the momentum, but will not be the primary drivers of economic growth.