Few policies focus on what causes informality and so most ignore the cost of trying to make the economy more formal.
The move to formalise the Indian economy through demonetisation and goods and services tax (GST) system is largely viewed as a positive development. This is because an efficient and productive formal sector is perceived as the main driver of growth. Formalisation is understood happening through two shifts—informal to formal as unregulated firms enter mainstream, and market share expansion of formal firms as some informal businesses exit. These structural processes are accepted as given—no one really questions formalisation may not accelerate as anticipated. However, the cross-country evidence on reducing informality through explicit efforts is quite discouraging! Then too, scant policy attention has focused on what the costs of shrinking informality might be, if any offsetting measures are required to combat adverse income-employment effects.
Scepticism and caution is urged on both counts: Expectations of formalisation and related growth benefits need tempering, while prudence is needed for recognising the additional costs imposed upon a segment that is already extremely inefficient segment and could tip over the edge without support.
Formalisation accompanies development, rising incomes
Two important insights are drawn from collated findings of La Porta and Shleifer (henceforth LPS) who consider the critical question of how the informal economy shrinks (“Informality and Development”, Journal of Economic Perspectives, 28-3, 2014). In sum, LPS conclude the informal sector rarely, if ever, transits to formal. The formal sector is essentially demand-driven, i.e. consumers’ preferences for high-quality, higher-priced products. Formalisation of an economy accompanies the level of development as the informal sector gradually dies out with rising per capita incomes.
Now, this need not fully apply to India, but may do so in parts. Five critical facts about the informal economy that LPS distil from numerous studies and two decades of World Bank Enterprise Surveys imply this might be so.
Critical features of informality: Not tax evasion, but poor human capital quality
1. Informal economy is huge in developing countries—a typical 30–40% share in total economic activity and high employment shares amongst the poorest countries in a 185-country sample; this share falls to 15-20% in the richest quartile countries. India is above the median share—455 of GVA originates from the unorganised sector.
2. Informal firms are small, unproductive, stagnant—but the main reason is not size, but human capital. For India, 89% of formal firms were headed by college-educated managers against none in informal ones as per Enterprise Survey data! Given a chance, many informal entrepreneurs would happily shut their businesses and work as formal sector employees, pay income tax. But few have this opportunity. The median productivity difference between informal and formal firms is 15%; for India, it is 18%. Similarly sized informal firms added just 21% of the value per employee of formal ones. Low productivity reflects very low quality products sold at low prices to low-income customers.
3. Regulation is not what keeps them down—lack of access to finance is the biggest obstacle; informal entrepreneurs lack skills, business and accounting systems that banks value. Land is another, partly because of illegal occupation and fear of eviction. Regulation, taxes are distant concerns, way below corruption, electricity, licence-permits and crime. Informal firms consider the biggest benefit of registering is financial access!
4. Informal firms rarely become formal—almost never. They start out and die in informality. They are not ‘reservoirs of entrepreneurial energy’ but ‘swamps of backwardness” (LPS). But they allow their owners to survive. Majority of registered firms started off as registered. A small percentage of informal firms, 14%, sell their output to formal firms (Enterprise Survey).
5. As countries develop, informality becomes less important—the informal economy, captured by the degree of self-employment shrinks as per capita income rises. It is intuitive seeing the association between consumer incomes and demand for better quality, higher priced goods produced by the modern, organised sector.
Policy focus fiscal, overlooks lack of managerial skills, formalisation costs
The above basic facts suffice to inform that framing concerns about informal activities entirely in terms of negative consequences for competitiveness and growth and fiscal losses from undeclared economic activity is one-sided. Both demand and supply matter: low incomes and low demand for modern goods and services; job opportunities relative to the supply of unskilled labour force, education and managerial skills of entrepreneurs, etc.
It is for governments to work out what matters how much, especially before structural policies are drafted to hasten formalisation to spur productivity and growth. Joining the formal sector significantly raises costs for informal firms—far more than they can recoup from raising volumes and prices given market constraints or which they can’t dream of lowering with their existing managerial skills, inputs, etc.
GST timing compounds informal sector’s burden, costs
Glimpses of all of above can be observed in the almost one year after demonetisation and more recently, the GST reform. Scattered reports abound about small business closures and failures, import substitution, rising default rates of small finance banks, rising unemployment, farmers’ unrests, and much more. The inability to adapt is variously manifest in either strong resistance or pleas for fiscal support, e.g., reversion to cash from digital transactions (costs, computer knowledge and access, etc.), online compliance aversion under GST by textile, construction, transport, trade and other segments marked by large informality (lack of managerial, IT skills, accounting systems, additional costs threatening viability, loss of business from formal buyers, etc).
There is likely much more that remains hidden or uncovered and unknown. In December 2016, we speculated if demonetisation’s debilitating impact could open fault lines for a (goo.gl/sqnS8N) structural slowdown, arguing for a quick survey to assess damages to the informal economy. Much water has flown under the bridge since. But now, the institution of GST reform so closely after demonetisation, the facts and evidence on why the informal sector is what it is and how it shrinks, the surfacing responses juxtaposed with India’s own structural characteristics call for focusing upon the constraints on transition to formality that are more to do with supply side factors than mere evasion of taxes and regulation. As LPS note, recognising that informal firms are extremely inefficient, extreme caution with policies that impose on them any kind of additional costs is recommended.
Where’s the backup?
It is overlooked that most other GST countries had much smaller informal sectors, e.g., 10-12% in Malaysia and lower informal employment shares, e.g., 33% in China as per ILO against India’s 82%. The focus upon formalisation not only misses supply-side constraints to transition but also fails to incorporate safety nets for those who could be casualties in the process.
We can only finish with LPS who find evidence is consistent that informality declines, although slowly, with development. Therefore, structural policies designed to promote formality should be introduced with caution; their wisdom depends in part, whether they encourage formalisation, or discourage informal activity. They are sceptical of all policies that might tax or regulate informal firms; rather than encourage them to become formal, these could instead drive them out of business, leading to poverty and destitution of informal workers and entrepreneurs—despite all their benefits of avoiding taxes and regulations, they simply cannot compete with formal firms. Growth that kills the informal sector is driven by the formation and expansion of formal firms managed by educated entrepreneurs.
Taking into account the subsistence dimension of informality in India suggests a combination of following outcomes: fierce resistance to formalisation for preserving livelihoods, which would only thwart formalisation; or substantial income and employment losses surfacing as a drop in aggregate demand. Possibly, a mix of both. Perhaps expectations of accelerated formalisation need moderation, especially in the light of steadily decelerating growth. The prism of viewing the informal sector as merely unproductive and tax-evading needs broadening too with greater attention to the bottleneck—the supply of educated entrepreneurs who can run productive businesses—and mitigating the costs.