Why India needs a formal economy

Informal workers who migrate and send remittances allow families to eke out a living. However, forced isolation will see them struggling to survive as the economy staggers to a standstill

The Covid-19-induced lockdown has resulted in lost jobs and the closure of informal businesses everywhere. Entrepreneurs are facing cash flow issues and workers in casual and informal employment are undergoing liquidity stress, causing them to migrate back to their families. 

While small and medium enterprises that constitute a part of the informal sector are a characteristic of fast-growing economies, it is a mistake to think that they are an important engine of economic growth. Small firms do not offer stable employment and non-wage benefits. Nor do they offer a greater quantity of employment.

Much of the focus in policy circles has been on costs imposed by enforcement of labour laws regarding layoffs and retrenchment as a cause of and motivation for informality and the growth in casual employment. What has not been emphasised enough is how financial constraints and State regulations and laws, specifically those related to taxation, promote informality and poor job growth. 

Informality is a choice in relation to regulation by the State, and financial development affects the decision to operate formally. Firms require external funds to grow, which they obtain from financial intermediaries (FIs). In turn, they must reveal details about their assets, which serve as a signal of indemnity and allow FIs to disburse loans at rates that reflect the appropriability of the assets as collateral. Once a firm accesses the financial sector, it leaves a paper trail that facilitates tax enforcement. 

Firms will use the formal financial system only if it makes possible considerable value addition that exceeds the costs of accessing the FIs and the losses from being part of the tax net. Costs of accessing FIs include the time and money needed for acquiring financial literacy or relying on intermediaries. For a FI, institutions of governance that enable enforcement of loan contracts and recovery of dues when a borrower reneges are important determinants of funding the creditworthy. Thus, informality in terms of its characteristics (small size, nature of employment contracts and benefits provided) is a result of choices made by firms and FIs to institutions of governance. 

Many entrepreneurs are engaged in activities where social value is destroyed. There is value in upgrading organisations so that they do not provide low pay, hazardous jobs, or excessive hours of work. Weeding out entrepreneurs who are either avoiders (with potential to grow, but decide to stay small to avoid the costs of compliance) or evaders (those non-compliant with healthy regulations) requires institutions of governance that can align the incentives of entrepreneurs with growth that enhances social value.

Sometimes it is rent-seeking officials who impose entry costs and regulations to create opportunities for corruption. At times it is misaligned policies and regulations that result in enterprises turning avoiders or evaders. In India, faulty input price policies (such as low electricity tariffs for agriculture and domestic sectors, cross-subsidised by industrial and commercial users; or the excessive costs of land acquisition due to holding out and rent-seeking), for instance, push business margins low and induce evasion. 

It takes an economy-wide crisis to bring out the social and economic costs of informality and the importance of formalisation. Informality is double-edged. Informal workers who migrate and send remittances allow families to scrape through with a living. However, if their meagre income comes from casual employment, such as hawking roadside goods, then forced isolation will see them struggling to survive as the economy staggers to a standstill.

An extended lockdown is only effective to the extent that an economy has testing capacity and responsive health systems. And in the intervening period it requires income support and functioning supply chains. Otherwise a lockdown is an unfair tax on the vast majority in the informal sector.

The litmus test for how policymakers handle Covid-19’s economic fallout will be how much support can be provided for withstanding the income shock. Formalisation supports policy in this endeavour, as it provides for good risk-sharing institutions. A good example is Switzerland’s package of emergency loans to small business, unveiled on March 25. The application was a one-page form and the money was credited into accounts within a day, enabling businesses to protect and pay their staff. The backbone to this was formal institutions. It was a fellowship of the political and business elite (cronies, to use the word in its positive sense) that got the programme quickly up and running. 

Cronyism as a word is discredited today. But there is no getting away from the fact that unless policymakers and entrepreneurs are cronies in promoting and attributing high value to institutions of governance, we will not see formalisation, and the associated entrepreneurship that pursues growth opportunities instead of survival. The precarious circumstances in which large sections of the population live in the informal sector will only then be mitigated. Until then, malfunctioning input and labour markets will exhaust the welfare State and families, and produce dysfunctional inequality. 

D’Souza is director, IIM- Ahmedabad, and Agarwalla is associate professor, Adani Institute of Infrastructure Management.

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