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HomeIlanomicsHow India's informal economy is shrinking, and why that's good news in...

How India’s informal economy is shrinking, and why that’s good news in the long term

Greater formalisation will see a shift from low-paying, labour-intensive jobs in informal sector to more productive, formal-sector jobs. This could lead to disruption in short term.

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A report issued by the State Bank of India (SBI) last month estimated that India’s informal economy has shrunk to 15-20 per cent of the GDP in 2020-21 from 52 per cent in 2017-18. The report uses employment and digitisation to assess the extent of formalisation in the economy. The report finds that Rs 13 lakh crore has come under the formal economy through various channels over the last few years. 

This raises the important question of what the formal sector is. Formalisation has alternatively been understood to be a move to formal finance such as banks or digital payment systems, an increase in the share of output produced by firms in the tax net, an increase in the number of employees in registered enterprises, or an increase in GDP produced in enterprises that are part of the tax net. 

  • ‘Formal’ measured by financial transactions 

In the SBI report, the measure used appears to be the use of digital channels or formal finance. 

Use of digital payments, formalisation of agricultural credit through Kisan Credit Cards and increase in online purchases during the last three years have contributed to increasing the share of transactions made using formal finance. 

A combination of demonetisation and implementation of GST set the pace for cashless transactions in business and reduced the cash intensity of the economy. These reforms triggered a process of transformation of the economy from one that is typically dominated by cash to one in which the formal finance or banks and payment banks have a larger role. 

Though these laid the foundations, it was the Covid-19 pandemic that provided a further opportunity to accelerate the process of digitalisation. Formalisation got a boost during this time through greater proliferation of digital transactions. Concerns over contracting infection propelled people not only in metros but also in small towns to shift to digital payments. Digital payments touched a record high from all channels from the United Payments Interface (UPI) and the Aadhaar-enabled Payment System (AePS).

Also Read: Why India must change rules after COP26, let rich nations pay it to hit climate change targets

  • ‘Formal’ measured by presence in the tax net

The provisions under the GST discourage registered businesses to deal with unregistered entities in the informal sector. Consequently, the informal sector is encouraged to get itself registered to remain in the supply chain. When GST was introduced, firms that were competing with the informal sector saw a rise in sales while firms in the informal sector suffered from compliance costs. This led to an increase in the formal economy as measured by output produced by firms in the tax net. 

  • ‘Formal’ measured by employment in registered enterprises

A third way to define formal is by the share of employees working in registered units.

Informal economy represents enterprises that are not registered, where employers do not provide social security to employees. In India, the Annual Survey of Industries (ASI) conducted by the Central Statistics Office (CSO) gathers information on “registered” or formal sector firms. These are firms that typically hire more than 10 workers. Unorganised or informal sector firms are not covered by the ASI. These are covered through the surveys on unincorporated non-agricultural enterprises conducted by the National Sample Survey Office (NSSO). 

One of the sources to analyse the extent of formalisation is the monthly EPFO payroll report. This report provides data on establishments remitting first ECR (Electronic Challan-cum-Return), an electronic monthly return. It has member-wise details of the wages and contributions in a particular month. Based on this data, the SBI report estimates that from 2017-18, almost 36.6 lakh jobs had been formalised till 21 July. 

The second source of “formalisation” is the e-Shram portal, India’s first national database of unorganised workers. It facilitates extending benefits of social sector schemes to the workers in the unorganised sector. More than 5.3 crore workers had registered until 30 October. Based on monthly incomes of the registered workers, the report estimates that roughly half of the Rs 13 lakh crore formalisation is through the e-Shram portal. In this case, the worker is “registered”. 

The government took a number of measures to formalise the economy through incentivising formal employment generation and through bringing informal entities into the formal economy. A scheme was launched to incentivise establishments under the EPFO to hire more workers along with social security benefits. As part of the scheme, the government is crediting, for a period of two years, the employees’ and the employers’ share of contribution payable depending on the employment strength of the EPFO-registered establishments.

  • ‘Formal’ measured by share of output produced by registered enterprises

An alternative way to assess the informality in the economy is to look at the total universe of India’s non-agricultural enterprises and their contribution to GDP. Based on the latest survey, India has 6.36 crore enterprises, informal and formal taken together. As many as 99.7 per cent of the enterprises are in the unorganised sector and this share was constant between 2011-12 and 2015-16. The registered or formal sector firms are only 0.3 per cent or 1.7 lakh in numbers. A large fraction of these unorganised firms belong to the “micro” category of the MSME sector. According to the annual report on MSMEs, they contribute more than 30 per cent to India’s GDP.  

A useful proxy to assess the size of the formal sector could be to look at the share of the private corporate sector in total Gross Value Added (GVA). The share of the private corporate sector in total GVA has remained stable at around 37 per cent from 2016-17 to 2019-20. 

The government launched a new process of registration of small businesses on 1 July 2020. The “Udyam” registration will play an important part in formalisation of this sector. It will help the government collect data on this sector, and, at the same time, it will help small businesses (MSMEs) access the various schemes offered by the government. More than 50 lakh MSMEs have registered on the new platform.

There are many degrees of overlap in the definitions above. 

For example, a firm that may be registered is likely to be in the tax net, pay its employees social security contributions, and use the banking system. The 15 to 20 per cent share of informal sector appears to be those who use the banking system. This should match with the share of GDP produced by unregistered firms. We still expect a large share of firms remain unregistered and out of the tax net even after demonetisation, GST and Covid. Thus the share measured by other measures may be smaller.

Impact of formalisation on MNREGA 

While the informal sector has gone through transition challenges, the real benefits of formalisation will manifest through higher productivity, formal jobs and improved competitiveness in the economy. 

Greater formalisation will see a shift from the low-paying, labour-intensive jobs in the informal sector to more productive, formal-sector jobs. This could lead to disruption in the short term as formal jobs are relatively more capital-intensive than those in the informal sector. So, as the transition to greater formalisation propels the move towards more productive and capital-intensive jobs, unemployment is bound to increase. We see this impact in higher number of jobs being demanded under the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA).

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Radhika Pandey is a consultant at NIPFP.

Views are personal.

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