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There are many different definitions of formality/informality. The most common ones are: (a) whether a worker has a formal contract; (b) whether a worker is a regular/salaried worker (as opposed to self-employed or casual); (c) whether a firm is registered with any branch of the government; (d) whether the firm pays taxes; and (e) whether a worker receives social security. GST data throw up new data that allows a better re-examination of the extent of formality/informality in the Indian economy. Informality or rather formality can be defined in at least two senses. First, when firms are providing some kind of social security to employees. In India, government provides this for its employees, and the Employees’ Provident Fund Organization (EPFO) provides it to private sector employees in respect of pensions and provident funds; and the Employees’ State Insurance Corporation (ESIC) in respect of medical benefits. The EPFO contribution is mandatory for industries employing greater than 20 workers, and whose monthly wage/salary is below Rs. 15,000. Above that level, contributions are voluntary. Of the total active members (for whom the monthly contribution is deposited by the employer), 86 percent earn less than Rs 15,000, and about 98 percent have opted for a combination of the ‘provident fund-pension’ option. The ESIC contribution is mandatory for certain firms, employing greater than 10 workers, and for workers in these firms whose monthly wage/salary is below Rs. 21,000. A second definition of formality is when firms are part of the tax net. Since new data on the GST is available, one can define tax formality as firms having registered under the GST. Based on these definitions, the magnitude of formal sector firms, turnover, tax liabilities, tax paid, exports, and payroll can be estimated. The following are the key findings. • About 0.6 percent of firms, accounting for 38 percent of total turnover, 87 percent of exports, and 63 percent of GST liability are what might be called in the “hard core” formal sector in the sense of being both in the tax and social security net. • At the other end, 87 percent of firms, representing 21 percent of total turnover, are purely informal, outside both the tax and social security nets. • Around 12 percent of firms, accounting for 41 percent of turnover, 13 percent of exports, and 37 percent of tax liabilities are in the tax net but not the social security net. These firms are relatively smaller than those in both nets, since they have a lower average turnover and average tax rate, 7 percent compared with 16.3 percent. • Finally, less than 0.1 percent of firms accounting for about 14 percent of turnover are in the social security net but not in the GST net. These are mostly firms that are in GST-exempted sectors (such as education, health, electricity), although there are many firms that appear to be outside the GST even though they are in the GST-included sectors. One possible reason is that they fall below the GST threshold, but there might be others.
There are a few important policy puzzles here.
First, is the high degree of informality in India the result of the lack of job opportunities in the formal economy or has the growth in the formal sector been thwarted by the presence of informal sector enterprises that do not pay taxes? The causal link can be difficult to untangle.
Second, the rapid shift away from cash as well as the need of an audit trail to claim tax credits under the new goods and services tax (GST) regime could push a lot of firms into the tax net. The question is whether there will be disruption along the way as the implicit tax subsidy to informal firms withers away.
Third, the shift in balance towards formal enterprises will push up labour productivity but also perhaps reduce job creation, assuming that economic growth remains the same. Many informal enterprises use family labour far in excess of their needs. Large enterprises have no reason to do so (other than the jobs reserved at the top for promoter families, that is).
Fourth, can easier access to credit or more direct forms of support help tiny informal enterprises compete with larger firms even after paying taxes? Or can they become part of larger supply chains? One useful global comparison is the Central European Mittelstand, or the small and medium firms that account for nearly 99% of the enterprises registered in countries such as Germany, Switzerland and Austria.
The question is not just about informality. Tax evasion also allows low productivity firms to attract capital away from high productivity firms. There are also tax structures that create distortions between small and large firms. Economists Diego Restuccia of the University of Toronto and Richard Rogerson of the University of Arizona have shown that there are three types of distortions that hinder productivity. First, laws that distinguish between firms based on their size or location or products. Second, discretionary decisions that favour specific firms based on their political influence. Third, market imperfections such as monopoly or incomplete financial markets.
Much has been written in recent weeks about the need for greater formalization in the Indian economy. The high prevalence of tiny enterprises in the informal sector is a drag on productivity on the one hand, but is also a source of distress employment to millions on the other. Managing to balance these two issues is a complicated political economy challenge.
By: Abhishek Sharma ProfileResourcesReport error
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