Context: Despite efforts by the government, formalisation of economy still eludes us. This article talks about the prevalence of the informal sector in India’s economy and the challenges associated with the formalization of the sector.
Key Scenario

• In the last few years, the Government of India has made several efforts to formalize the Indian economy via the introduction of the Goods and Services Tax (GST), digitalisation of financial transactions and enrolment of informal sector workers on government portals such as E-Shram.
• Despite these well-intentioned efforts at formalization, the challenge of informality looms large for India. The novel coronavirus pandemic has only exacerbated this challenge.
• Lack of job security, absence of social security benefits, tax evasion, all point towards the need for the formalization of the informal sector at a faster yet sustainable pace. 
• Policy interventions, fiscal support, education and upskilling have a major role to play in the formalization of the economy.

Prevalence of informality in India

• In many parts of the developing world, including India, informality has reduced at a very sluggish pace, manifesting itself most visibly in urban squalor, poverty and unemployment.
• Despite witnessing rapid economic growth over the last two decades, 90% of workers in India have remained informally employed, producing about half of GDP.

Official Periodic Labor Force Survey data shows that 75% of informal workers are self-employed and casual wage workers with average earnings lower than regular salaried workers.

Combining the ILO’s widely agreed upon definition with India’s official definition (of formal jobs as those providing at least one social security benefit — such as EPF), the share of formal workers in India stood at only 9.7% (47.5 million).

• About half of informal workers are engaged in non-agriculture sectors which spread across urban and rural areas.
• Industries thriving without paying taxes are only the tip of the informal sector’s iceberg.

What remains hidden are the large swathes of low productivity informal establishments working as household and self-employment units which represent “petty production”.

• To conflate the two distinct segments of the informal sector would be a serious conceptual error.

Formal-Informal Linkage: The fiscal perspective has a long lineage in India going back to tax reforms initiated in the mid-1980s.

• Early on, in an attempt to promote employment, the Government of India protected small enterprises engaged in labor intensive manufacturing by providing them with fiscal concessions and regulating large-scale industry by licensing.
• However, such measures led to many labor-intensive industries getting diffused into the informal/unorganized sectors.

Need of Formalization

• The formal sector is more productive than the informal sector, and formal workers have access to social security benefits.
• The persistence of a high share of informal employment in total employment represents a lack of adequate growth or continuation of underdevelopment.
• According to Oxfam’s latest global report, out of the total 122 million people who lost their jobs in 2020, 75% were lost in the informal sector. This raises the need to provide social protection to the vulnerable informal sector.
• As the businesses of the informal economy are not directly regulated, they usually avoid one or more taxes by hiding incomes and expenses from the regulatory framework.
• This poses a challenge for the government as a major chunk of the economy remains out of the tax net.
• Hence, it is believed that simplifying registration processes, easing rules for business conduct, and lowering the standards of protection of formal sector workers will bring informal enterprises and their workers into the fold of formality.

Issues with fiscal perspective

• Early on, in an attempt to promote employment, India protected small enterprises engaged in labour intensive manufacturing by providing them with fiscal concessions and regulating large-scale industry by licensing.
• Such measures led to many labour-intensive industries getting diffused into the informal/unorganised sectors.
• Further, they led to the formation of dense output and labour market inter-linkages between the informal and formal sectors via sub-contracting and outsourcing arrangements (quite like in labour abundant Asian economies).
• While such policy initiatives may have encouraged employment, bringing the enterprises which benefited from the policy into the tax net has been a challenge.
• Political and economic reasons operating at the regional/local level in a competitive electoral democracy are responsible for this phenomenon, too.

Role of underdevelopment

• Global evidence suggests that the view that legal and regulatory hurdles alone are mainly responsible for holding back formalisation does not hold much water.
• A well-regarded study, ‘Informality and Development’ argues that the persistence of informality is, in fact, a sign of underdevelopment.
• The finding suggests that informality decreases with economic growth, albeit slowly.
• A similar association is also evident across major States in India, based on official PLFS data.
• Hence, the persistence of a high share of informal employment in total employment seems nothing but a lack of adequate growth or continuation of underdevelopment.

Impact of pandemic

• Research by the State Bank of India recently reported the economy formalised rapidly during the pandemic year of 2020-21, with the informal sector’s GDP share shrinking to less than 20%, from about 50% a few years ago — close to the figure for developed countries.
• These findings of a sharp contraction of the informal sector during the pandemic year (2020-21) do not represent a sustained structural transformation.
• They are a temporary (and unfortunate) outcome of the pandemic and severe lockdowns imposed in 2020 and 2021.

Key Suggestion

• Policy efforts directed at bringing the informal sector into the fold of formality fail to appreciate that the bulk of the informal units and their workers are essentially petty producers eking their subsistence out of minimal resources.
• Education, Investment and Skilling: The continued dominance of informality defines under-development. The economy will get formalized and the nation will develop when informal enterprises become more productive through greater capital investment and increased education and when the skills are imparted to the workers.
• Strengthening MSME: Nearly 40% of the informal workforce is employed with MSMEs. Therefore, it is natural that the strengthening of MSME will lead to economic recovery, employment generation, and formalization of the economy.
• Financial Support for Formalisationx: Giving financial support to help small-scale industries stand on their own is a crucial step in bringing them to the organized sector. Schemes like MUDRA loans and Start-up India are helping the youth carve a niche in the organized sector.

Road Ahead

• The economy will get formalised when informal enterprises become more productive through greater capital investment and increased education and skills are imparted to its workers. Therefore,  the need of the hour is formalization of the informal sector and the steps that can be taken for a smoother structural transformation of informal to formal economy.