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Prelims Capsule


Is Indian economy getting formalised? Informal sector shrinking says SBI report

Is Indian economy getting formalised? Informal sector shrinking says SBI report


  • GS 3 || Economy || Structure of the Indian Economy || Labour & Unemployment

Why in the news?

According to SBI, the may have reduced to no more than 20% of economic output after the pandemic, down from around 52 percent in 2017-18.

Present context:

  • From around 52 percent in 2017-18, the informal economy may have decreased to around 20% of total economic production.
  • It’s been dubbed a “good development” in the midst of the pandemic.
  • Furthermore, according to an IMF policy paper published earlier this year, India’s informal economy contributed 53.9 percent of Gross Value Added (GVA) in 2011-12 and improved just little to 52.4 percent in 2017-18.
  • According to a 2014 National Sample Survey (NSS), 93 percent of the workforce earned their living as informal workers.

What is formalization of economy?

  • The term “formalisation of the economy” refers to putting businesses under the government’s regulatory structure and subjecting them to manufacturing and income tax rules. According to the 2018 Economic Survey, formalisation occurs when businesses provide some sort of social protection to their employees and when they are taxed.

The Importance of the Informal Sector

  • India’s massive informal sector, which employs over 80% of the workforce and generates about half of the country’s GDP.
  • The informal sector employs 384 million people, half of whom work in agriculture and live primarily in rural India, and the other half work in non-agricultural sectors.
  • About half of them live in rural India, while the rest dwell in cities.
  • Ignoring difficulties in the informal sector can be costly, as it can result in job losses and pay increases, as well as putting migrant workers’ livelihoods at danger.

Advantages of formal sector:

  • Social spending: As the government’s revenue grows, so does its investment in the social sector. Increased money allows the government to invest in areas such as education, health, and skill development.
  • Reduce black money: As transparency improves, it becomes more difficult to engage in money laundering and criminal operations. Companies are required to show balance sheets and follow laws and regulations as a result of formalization.
  • Increased tax revenue: Informal operations present the government with numerous obstacles, including the inability to gather tax money, collect data, and regulate businesses. With a higher tax-to-GDP ratio, formalization generates more tax income. Formalization creates a level playing field for tax-compliant firms by broadening the tax base and distributing the tax burden more fairly among all players rather than just a few.
  • Scale and productivity: Formal businesses can more easily increase output and employment, allowing them to expand to a bigger, more efficient scale of operation, potentially bringing in more income and profits. It enables businesses to obtain formal credit, comply with the law, and avoid paying penalties.
  • Labor welfare: Transitioning the economy toward formality benefits businesses and workers by creating the rule of law and providing advantages of labour laws. It mandates that employers pay minimum salaries and keep accurate records of employee benefits. Formal jobs also ensure the dignity of labour, allow for productivity gains, and provide access to formal training.
  • Formalisation helps doing business and enhances the investment climate, resulting in growth and development. This promotes a country’s growth and development.

The Consequences of Formalization:

  • Red-Tapism: According to a 2015 study by the Centre for Civil Society, beginning an MSME necessitates the acquisition of 12 licences, 27 building permits, and seven property registrations. Every facet of the employee-employer relationship is governed by 44 federal statutes and over 150 state statutes. For small businesses to remain competitive, the formalisation process is too time-consuming and costly.
  • Demonetization: For the informal sector, demonetization proved to be a double-edged sword. It drew clients away from the cash-based informal sector on the one hand, and generated a negative demand-side shock for the informal sector on the other. It also drove away workers in the informal sector, with daily wage earners being the hardest hit. Demonetization spurred a rush for distressed labour under MGNREGA, according to the Economic Survey 2016-17.
  • GST: The Goods and Services Tax (GST) have added to the miseries of small business owners. According to the aforementioned survey, MSMEs pay over 61.7 percent of their profits in taxes, which is far more than they can afford. It’s quite complicated, and adhering to it comes at a tremendous price. Small firms fall into the trap of intermediaries and face additional expenditures due to the required computational abilities, frequent filing, and negotiating an impossible classification system.
  • Compromise on labour rights: The concentration on formalising the economy has led to charges of compromising on labour rights, inhibiting unionisation, and favouring the wealthy at the expense of the poor. At the same time, the informal sector frequently employs people on a contract basis with little pay, and the employer is not obligated to offer any sort of social protection to the workers. As a result, outright formalisation is not a viable option for both workers and employers in the informal sector.

Future strategy for smooth transition in formalization:

  • Simpler regulatory framework: The informal sector can only move to the formal sector if it is relieved of the weight of regulatory compliance and given sufficient time to acclimate to the modern, digitised formal system.
  • Skilling the labour force: Unless the labour force is skilled and educated, they will not be able to work in the formal sector, and formalisation initiatives will result in unemployment.
  • Investing in social security schemes like the Atal Pension Yojana, PM JeevanJyotiYojana, and RashtriyaSwasthyaYojana. AamAadmiBimaYojana, BimaYojana, and AamAadmiBimaYojana can all contribute to enhancing the working conditions of people. The inclusion of Universal Basic Income in the 2016-17 Economic Survey is a step in the right direction.
  • Financial assistance: Providing financial assistance to small-scale industries to help them stand on their own is an important step toward bringing them into the organised sector. MUDRA loans and Start-up India are two programmes that are assisting the youth in carving out a place in the organised sector.
  • Policy reforms: Formalization policies should be implemented with discretion, with the goal of encouraging formalisation rather than expressly forbidding informal behaviour.
  • Reforms to labour laws: The old labour rules must be rewritten to make them more flexible. This should be done while both protecting the rights of workers and preventing their exploitation.

Mains oriented question:

Analyze the recent trend of the informal sector declining and the essential safeguards to be made in response to this new trend.