The flip side to a formalised economy

Following the twin strikes of demonetisation and GST, commentaries on India’s economic outlook have frequently highlighted the two emerging trends of financialisation of savings and formalisation of the economy as factors set to hasten growth in the coming years.

Financialisation of savings — the shift towards formal channels of savings — is indeed an unmixed blessing for the economy.

Recent months have seen a surge of money flowing into the banking system and into mutual funds, insurance, etc. That has helped lower interest rates and brightened prospects of more lending by banks. The rush of money into the equity markets will make it easier for entrepreneurs to raise funds from the capital markets.

Besides, the persistent attraction of gold as a form of savings will likely fade, which is good for India’s balance of trade.

However, when it comes to formalisation of the economy — the shift of output and employment from the unorganised, informal to the organised, formal sector — the picture is clouded.

Informality and development

Formalisation comes with significant transition pains that can have serious political ramifications, if not managed well. While we dismiss the informal sector for not paying taxes, the fact is, it accounts for 40 per cent of the Indian economy and provides employment to 75 per cent of its labour force. Any attempt to squeeze the sector is fraught with unwelcome consequences because this is where the bulk of our low skilled workers find employment. A 2014 paper, “Informality and Development”, by Rafael La Porta and Andrei Shleifer (academicians affiliated respectively to the Tuck School of Business and Harvard University), is notable for the ground it covers in furthering our understanding how informality and development relate to each other.

They examined the two contrasting assessments of the informal sector: one which holds informal firms “as an untapped reservoir of entrepreneurial energy held back by government regulations”; and the other which holds them to be “parasites competing unfairly with law abiding formal firms” and therefore to be held down.

However, they conclude in favour of a third perspective which sees informality as a by-product of poverty with formal and informal firms being fundamentally different from each other.

Productive formal entrepreneurs are usually educated, pay taxes and obey government regulations. Informal entrepreneurs are mostly uneducated and unproductive, producing low-quality stuff and adding negligible value. From this perspective, development comes about when formal firms expand as the economy grows, to eventually displace informal players.

Among their key findings are that while the informal economy is huge accounting for 30-40 per cent of economic activity in the poorest countries, informal firms typically add only a fraction of the value per employee of formal firms (about 15 per cent in the median sample country).

This huge productivity gap is largely to do with the low level of human capital of the entrepreneurs who run them (education level of workers being less consequential). Other interesting findings are that it is not government regulations that keep informal firms down (low productivity does) and that informal firms rarely become formal, as they subsist in an economic space of their own.

Further, the universal experience is that informality shrinks of its own as development occurs, suggesting that it is a characteristic of underdevelopment, not the cause. Indeed, in an underdeveloped economy with working age population increasing faster than the organised sector’s capacity to absorb, the informal sector functions as a safety net offering a hand-to-mouth existence but enough to keep the wolf at bay.

Particularly relevant to India today is the overall conclusion they arrive at, that structural policies designed to promote formality should be implemented with caution, aimed at encouraging formalisation rather than explicitly discouraging informal activity. They are sceptical about policies that would tax, regulate or impose any additional costs on informal firms because that would drive them out of business and increase poverty and destitution.

While La Porta and Schleifer’s study recommends abundant caution, it is equally true that growing informalisation undermines sustainable businesses and diminishes opportunities for decent jobs and is therefore harmful to the interests of both employers and workers.

In this context, there are three important objectives to be attained by promoting formalisation: to increase workers’ welfare and the opportunities for decent jobs; to reduce unfair competition between formal and informal enterprises arising from tax or regulatory arbitrage; and to expand tax revenues that can support social safety nets.

Labour reforms

But then, even as the outcome is desirable, the government of the day that follows through in this direction will step into a veritable political landmine.

Since formalisation cannot be about handholding and upgrading the informal sector (given the inherent limitations discussed above) and instead involves laying the groundwork for the formal sector to ultimately displace the informal players, it becomes vulnerable to emotive accusations about favouring the rich at the cost of the poor.

These concerns are amplified in a scenario where formalisation is pursued as an objective in itself leading to initial widespread job losses in the informal sector. For the formal sector to pick up the slack with increased hiring, the Government will then have to bite the bullet and get moving with labour law reforms to reduce the regulatory cost of employment. In practice, this means turning its back on the ever-expanding ambit of labour welfare regulations and allowing flexibility in hire and fire.

Data dilemmas

The other challenge is that as the economy formalises, statistics about GDP and its growth rate will show an uptick that may not represent the true state of affairs in the economy. It is easy to capture data from the formal sector, not so much from the informal, whose output figures are mostly guesswork.

As formalisation increases, official statistics will effortlessly capture the full shift in activity to the formal sector but will, in all probability, underplay the destruction of output in the informal sector. This has the potential to lull the government into complacency and set it up for another ‘India Shining’ moment, as in 2004.

That’s why, even as formalisation and all remains a worthy objective, let’s not lose sight of the label it comes attached with. Quite simply, it says “handle with care”.

The writer is MD & CEO of Manappuram Finance Ltd, an NBFC predominantly dealing in gold loans that cater mostly to customers from the unorganised sector

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