Rather than tax dodgers, the informal sector consists mainly of struggling businesses. For the informal sector to become formal, it will require a structural transformation. A pandemic-related shock caused the informal economy to contract recently.

The Indian economy has been formalizing since 2016. In this direction, it has been a priority for the government to implement demonetization, the Goods and Services Tax (GST), digitalization of financial transactions, and enrollment of informal workers on various websites. The Economic Survey 2017-18 illustrated a clear message by including monthly EPF enrollments as the official job creation metric.

From about 50% just two years ago, the informal sector’s share in GDP would have dropped to about 15% to 20% during the first year of the pandemic (2020-21), according to a recent SBI report. According to the report, the government’s initiatives were responsible for the formalization of an unprecedented number of informal workers.

Economists and the general public have been baffled by this finding. Considering that informal employment and GDP ratios remained unchanged for decades, how could the informal or unorganized sector shrink (30 percentage points in the case of GDP) so dramatically in just two years? Is this formalization part of a structural transformation, or is it simply the result of an economic contraction brought on by the Ebola pandemic? Formalization is explained in this article, with definitions and evidence, and it also explores the SBI report’s claims.

Perspectives on theory and policy

According to Arthur Lewis, a labour surplus economy would be composed of two distinct sectors-the traditional and the modern-each operating under different behavioural principles and endowments.

Asia’s successful economies followed the Lewisian path of economic growth throughout the 20th century. During rapid state-led industrialization, industrialization brought surplus labour from traditional (and primarily agricultural) sectors into the modern industry. However, the development outcomes for the rest of the ‘Third World’ differed.

The current non-agricultural sector has been unable to provide adequate productive employment opportunities for its surplus-labour involved in the traditional sector despite moderate economic growth. Thus, the labour market diversified and layered with a large informal sector (unorganized) coexisting alongside the formal sector (organized), even in non-agricultural sectors.

With a rapidly growing labour force, urban areas in poverty and squalor saw rising unemployment (open and disguised). A lucid analysis of the informal sector can be found in Debraj Ray’s (1998) Chapter 10, where he discusses coexistence between Lewisian sectors as a relatively permanent feature of developing countries.

Today, with a market-oriented approach the only way to develop, informality is increasingly viewed as the primary constraint on growth due to policy-induced rigidity. Well-functioning markets unlock the essence of economic growth with the primacy of the rule of law and fair property rights and simplified bureaucratic procedures (De Soto, 1989). It is argued that less regulation of labour and enterprises would thus reduce informality.

According to another theory, the informal sector became associated with illegal activities and an unaccounted economy after the collapse of socialist-style economies in Eastern Europe. Consequently, it was argued that an improved market environment and a solid rule of law would lead to the disappearance of the informal sector with a rising formal sector. 

Global definitions

• Labour market perspective

The International Labour Organization (ILO) provides a global template for defining informality. A private unincorporated enterprise is an unincorporated enterprise owned by an individual or household that is not separate from its legal entity, without which complete accounts are not available.

There are many different types of informal employment, including jobs within informal enterprises and careers outside of informal enterprises. People who work in formal enterprises but do not have social protection are categorized as informal workers. Additionally, casual workers and family workers who do not receive social security benefits from their employers are excluded from coverage.

Several country-specific features are incorporated into these definitional templates in practice. Employees are considered in informal jobs in this template if their employment relationship is not, legally or practically, subject to national labour laws, income taxation, social protection, or entitlement to certain employment benefits such as sick leave or paid time off.

The Indian government defines a formal job as providing access to at least one social security benefit, as per the Task Force Report on Employment Statistics (Ministry of Labour and Employment, 2017).

• Fiscal perspective on formalisation

In principle, the ILO-defined informal economy appears to be accepted by international financial institutions, including the International Monetary Fund (IMF) and the World Bank. Despite its strengths, this framework is considered inadequate for measuring the informal economy’s contribution to output, an issue of particular significance when one considers that the informal economy encompasses “activities that are marketable and would contribute to tax collection” (IMF, 2020).

The IMF recently published a report that noted there is no international statistical framework for measuring the informal economy despite the International Labour Organization developing an analytical definition. Therefore, different criteria have been used to define and estimate the informal economy, depending on the motivations of researchers and policymakers” (IMF, 2021).

Evidence in the global community

An analysis of cross-sectional data from high-income and low-income countries revealed that income per capita is negatively related to the share of self-employment in total employment, as explored by La Porta and Shleifer (2014). As a measure of informality, they use the latter.

The argument is based on the idea that informality decreases as countries grow, and Underdevelopment is therefore characterized by informality. According to the authors, informality declines with development, although slowly.

According to them, the informal and formal sectors are segregated. In the informal (traditional) sector, most people engage in subsistence activities to make ends meet. Most families earn their living through intensive work on meagre, low-productivity capital with great labour at little or no cost. The high burden of surplus labour means informal sector wages remain at or near the subsistence level, with a slight possibility for surpluses to be reinvested for productivity improvement.

Formal sector firms pay taxes and adhere to regulations, which is often cited as a reason for the persistence of informality in fiscal policy literature. Although government taxes and regulations may contribute to demarcating formal from informal economies, these factors are not deemed fundamental for this separation in the development literature. In contrast, economic growth is often viewed as the cure for informality (ibid.).

India’s informal economy’s size

• Output

The organized or formal sector of India’s National Accounts Statistics (NAS) includes the entire public sector, private corporations, factory sector, and educational and medical institutions receiving government grants. The output of the organized industry remains an approximation because these categories overlap.

In 1980-1981, it contributed about 30% to GDP, but in 2017-18 it contributed about 52%. The GDP grew at a rate of 6–7% annually during this period; agriculture (which is almost entirely informal) accounted for 15% of domestic output in 2017-18, down from 35.7% in 1980-81.

A factory is an enterprise with ten or more workers who regularly use power or 20 workers without power. That is the definition of the formal sector of the labour market. Workers in the organized sector, such as those employed in the NAS, make up between 10 to 20 per cent of the labour force. Formal and informal sectors are asymmetrically distributed in terms of employment and output.

The main reasons are that the organized sector requires a high level of capital. The informal sector is burdened with disguised unemployment; roughly half of the workers are independent contractors.

• Estimating informality in India: Employment

To demonstrate the impact of informality on formal employment, Table 1 uses ILO’s definitions. From 88.0% in 1999-2000 to 81.1% in 2017-18, the share of informal employment in total employment has decreased very slowly, mainly due to the declining role of agriculture in total employment. The decline in the formal employment rate is offset by an increase in informal employment, from 4.2 to 9.5 per cent.

Cumulatively, informal employment has remained at over 90% even as India witnessed rapid growth over the past three decades. In contrast, if we consider the changing work patterns in the agricultural to non-agricultural sectors, employment has been mainly shifted to the unorganized or informal sector in industry and services, perhaps evenly distributed between urban and rural areas.

How does informality affect the level of development in India? 

The share of regular formal employment (defined as regular salaried employees who have access to at least one social security benefit) correlates with per capita Net State Domestic Product (per capita income) among significant states.

It is also noteworthy that there is a negative correlation between the proportion of individuals on their accounts and self-employed individuals in total employment and per capita income. A prosperous state would have a lower informality rate, whereas poor conditions would have a higher informality rate as a share of total employment. A similar association is found across countries by La Porta and Shleifer.

Almost 10% (or 47.5 million) of the workforce had formal employment and had access to social security. Many others were employed informally, and many workers are in formal employment, even in the legal sector. The vast majority of workers (347.4 million or three-fourths of all) are self-employed or casual wage workers.

When viewed through the ILO’s informal sector lens, informality has increasingly become differentiated and multi-layered rather than the Lewis model’s undifferentiated low-productivity traditional sector.

In India, formalization is a contentious issue.

India’s current policy on formalization is based on the evidence that informality and Underdevelopment are so severe. Why does this matter? It is evident from the focus on the formal and informal by the IMF that the fiscal perspective dominates.

For a long time, Indian policies promoted employment by prioritizing labour-intensive industries among consumer goods (“cottage industries”). The scope of industrial policy later expanded to include promoting subcontracting by capital goods companies, eliminating labour-intensive activities among small firms, and encouraging entrepreneurship.

Cotton textiles are an excellent example of government effort and its results. Economic planning restricted the expansion of composite (spinning and weaving) mills at the time of Independence, affecting the cotton textile industry. Although modern composite (spinning and weaving) mills dominated the cotton textile industry in Independence, handloom weaving was encouraged.

Unfortunately, the policy decimated both the composite mills and handlooms during the same period. Powerlooms, with access to (more productive) second-hand looms from organized mills and low wages compared to the handloom sector, emerged as the real winners. Scale economies in production made cotton spinning a booming industry that provided yarn for handlooms and power looms (Omkar Goswami, 1985).

A host of factors contributed to the increase in labour-intensive industries (or parts thereof) in the unorganized or informal sector, including the expansion of electricity, infrastructure (encouraging spatial decentralization), the dissemination of skills, tax concessions, and state-led advertising (Nagaraj, 2015). Nevertheless, large producers and trading companies discovered that informal sector businesses were sources of labour-intensive products and services.

Contrary to La Porta and Shleifer’s observation of developing economies, casual and formal sectors are increasingly interconnected in India via labour and product markets with dense sub-contracting relationships that reach low-income settlements in urban and peri-urban areas involving women and children. Even if you could estimate the size and composition of such transactions, it would still be difficult to map them.

A better understanding of what formalization means for such enterprises and the economy requires a recognition of the enormous heterogeneity in the informal sector.

In the fiscal discourse, such industries are often contended to dodge the tax net in specific locations. They might benefit from subsidized power (or worse, power theft), evade taxation and business and labour regulations, and generate unaccounted income and output (black money). The position of the IMF is similar. The author of Sukhamoy Chakravarty (1987) alluded to the “financial crisis of the state” by arguing that tax and labour laws had seldom been obeyed by unorganized industries that benefited from government assistance.

Such activities need to be fully integrated into official national accounts and taxes. The government’s inability to tax or enforce labour regulations is partially administrative. Regional and local economic and political factors may account for a more significant part of the reasons. A rising democratic decentralization, facilitated by the electoral process, has intensified the administrative constraints of such industries due to their use of local politics and bureaucracy, which crosses party lines and cleavages of social identity.

When labour and enterprise laws are enforced, however, the nature of such firms — their footloose nature — makes them well suited to circumventing regulations in a variety of ways: by shifting locations (from urban to rural), reappearing under different forms of organization, or relocating under other legal names (say becoming a household business with family and child labour).

For over three or four decades, household manufacturing employment has hovered around 30% over three to four decades now (Chakbraborty and Nagaraj, 2019). During their comparable stage of development, advanced economies have not experienced the same degree of persistence of the household non-agriculture sector.

Various tax reforms since 1985 have aimed to tax the informal or unorganized sector, especially the most recent and most stringent reform of GST in 2017. The results of these reforms, however, have been disappointing. According to Chakravarty, the tax-GDP ratio for 1984-85 was 18.5 per cent. In 2019-20, the ratio remained unchanged even after three and half decades, standing at 17.4% of GDP.

Depending on where they are located, such thriving industries may represent just a tiny part of the informal economy, especially employment. 

What remains unrecognized is the large number of low-productivity informal establishments, which operate as households and self-employment units (to use a classical economic definition). 

Surplus labour is intensively used on meagre resources to maintain their subsistence. Most informal sector workers are self-employed or work in their own business, with earnings levels significantly lower than regular salaried workers. To describe them as entrepreneurs is misleading. Lacking the financial ability or commercial knowledge to borrow capital and hire labour, they cannot take on “business risks”. These workers and their families face the biggest challenge of survival, and their existence is defined by precarity.

SBI’s assertion that the informal sector will lose more than half its GDP share by 2020-21 is bizarre.

Some of these production units and their workers may operate illegally and evade taxes. Although they might be below the floor for GST compliance in urban areas, they might also be violating local regulations such as compliance with the Shops and Establishments Act. Because they do not adhere to formal rules, do not pay taxes, and do not avoid other “legal” costs of production, such informal enterprises may not pose unfair competition to traditional enterprises.

The casual market for credit often requires them to borrow at usurious interest rates. Generally speaking, the earnings of such workers are lower than those of regular salaried employees. Due to poverty and illiteracy, many of these workers can’t even complete the required legal paperwork or pay taxes.

Although these establishments can be formalized (registered under relevant laws), banks typically do not consider them due to their inability to collect mortgages. (Likely, the urban poor does not even possess permanent addresses because of the precarious nature of their lives.)

Recent initiatives of financial inclusion (JanDhan Yojana, Mudra scheme) have not even scratched the surface of the urban poor’s needs. As a result, these workers and companies fare better performing “job work”, that is, labour-intensive tasks using raw materials obtained from traders or manufacturers for a predetermined “labour charge”.

Non-household enterprises (seemingly capitalist enterprises) employing hired labour often make limited profits and investments over time. To understand what formalization means to these enterprises and the economy, one must understand the enormous heterogeneity present in the informal sector, from relatively high-productivity clusters of industries such as power looms to subsistence household units.

A study of the productivity differentials of the informal sector is presented, which shows a comparison of Gross Value Added per enterprise and worker for enterprises operating on their account (OAEs) and establishments (i.e., enterprises that hire employees). Within the sector, there are significant differences in productivity. 

Despite government efforts to register informal workers under social security regulations, only a tiny percentage of workers receive social security benefits. It is estimated that 9.6% of the total workforce is eligible for at least one social security benefit in 2018-19, according to PLFS data.

When formal employment criteria are adhered to more rigorously (e.g., access multiple social security benefits), the proportion drops to 4.2% (Kapoor, 2020), and most of these individuals are likely to be employed by the federal government.

Puzzling evidence from the SBI report

According to the State Bank of India‘s research, the informal sector’s output share in 2020-21 will be between 15-20% the year of the pandemic. Despite a return to pre-pandemic levels in the formal sector, the informal sector has experienced significant output contractions.

It claims there has been a successful transformation to formality as the legal sector’s share of GDP has increased (while GDP itself has contracted). Since Bhattacharya (2021) has demonstrated, the report’s estimate of informal sector output contraction is factually incorrect.

Based on the most recent data, formal and informal sectors break down output, and the informal sector’s share of GDP has barely decreased over the last six years. Thus, the SBI report’s prediction that the percentage of the informal sector in GDP will be reduced dramatically by 2020-21 is confounding, or, putting it simply, near impossible! 

A large number of informal workers have been formalized thanks to government efforts, according to the SBI report. This is contrary to data from the Population Labor Force Survey. The change in informal employment between 2017-18 and 2019-20 when looking at employment in both formal and informal enterprises (non-agriculture non-agriculture employment).

Rural areas have seen the most significant increase in informal employment. This information, coupled with the fact that the share of agriculture employment (almost entirely relaxed as noted above) increased by three percentage points between 2018-19 and 2019-20 (not reported here), does not demonstrate any progress towards formalization on the labour market. 

SBI considers formalization to only register in online portals (rather than accessing social security as accepted in India) and not claiming social security. Registering employees on online portals without ensuring compliance with social security provisions do not constitute formalization. India has a reputation for aspirational labour laws, with innumerable loopholes and inconsistent implementation (as found in many developing countries).

Conclusions

Despite the health pandemic and severe lockdowns in 2020 and 2021, the informal sector’s output share in India is expected to decrease in 2020 and 2021, as noted in the SBI research report. It is temporary, though. When the economy has recovered from the health shock, perforce gets reversed. To survive, the informal sector will do whatever it can to get back to work.

There is little evidence that the economy’s contraction has resulted in the sustainable movement of low-productivity workers from the informal and traditional sectors to the formal, higher-productivity sector. Simply registering on one of the many official websites does not reduce informality if labour laws and codes are not enforced.

Due to India’s employment promotion policy, several labour-intensive industries and activities have subsequently been dispersed into the informal or unorganized sector.

It appears that the IMF’s focus on fiscal matters explains much of the ongoing drive for formalization in India. Under this view, tax evaders and arbitrageurs are classified as part of the informal sector. There is a theory that tax-compliance incentives could expand the tax base and increase formality by reducing evasion and providing a level playing field. Despite this evidence, the argument that legal and regulatory barriers prevent formalization does not hold much water in the global context.

The government of India has been promoting employment through a policy that has led to a diffusion of labour-intensive industries and activities into the unorganized or informal economy. While its policy aims to tax (rightly) the “creamy layer” (the tip of the iceberg of informal sector industries), it seems to miss that the majority of the informal units and their workers are essentially petty producers (self-employed and casual workers) who need a minimum amount of resources to survive.

Underdevelopment and not structural rigidities are to blame for their continuing dominance in the labour market and enterprise landscape. Informal enterprises will become more productive by investing in capital and educating and empowering workers, and formalization will follow.