India’s informal economy does not need restructuring

India’s informal economy has recently received a lot of attention from policymakers, especially the Finance Minister, who has made it his raison d’etre to push for the integration of the informal economy into a more formal structure to allow for more accessible tax collection.

The irony is that while the Indian government is pulling out all stops to force people out of the informal economy, the rest of the developed world is rapidly moving towards one. A salient feature of a formal economy is a full-time job with health and retirement benefits. But, slowly this form of employment is being replaced with what is called the ‘gig’ economy, in which full-time workers are being replaced by self-employed contractors. Companies like Uber, Airbnb, CrowdFlower are among the thousands of companies that operate almost exclusively with contractual workers.

This move towards an informal structure of employment is a global phenomenon with the informal sector now accounting for almost 50 per cent of the total employment in the US. Recent studies on employment patterns in the US and Europe show that for every one job created in the formal economy, two new ones are being created in the informal economy.  

India’s gig economy is the largest informal economy in the world. It consists of people engaged in either small contractual jobs or involved in micro-level entrepreneurship. Based on the government’s rather bizarre definition ( Factories Act 1948) of the informal sector as being any enterprise that uses electric power but employs less than 10 people, or one that employs less than 20 people and doesn’t use electric power, the informal sector provides sustenance to over 350 million people. If instead, we use a more useful definition of informal employment as being one without a contract or the provision of a pension, the number of people in the informal sector increases to almost 92 per cent of the total workforce or roughly about 450 million people.  

This huge informal economy produces almost $1 trillion in goods and services annually or nearly half of the country’s GDP. If it were a country this economic system would be the 15th largest economy in the world. To put it bluntly, India’s informal sector is an enormous wealth-producing ecosystem that the government should not attempt to restructure.

India’s informal economy is not some giant tax evasion scheme. Instead, it is partly the result of weak employment opportunities in the formal economy, and rigid labour laws and stifling business regulations imposed by the government. India lacks the mass producing large-scale manufacturing industries that can provide employment in the formal sector. As a result, almost 87 per cent of employment in India’s manufacturing sector is in firms with fewer than 10 employees, compared with only 5 per cent in China. Less than 10 per cent of Indian businesses employ more than 200 employees while in China that number is close to 50 per cent.

Antiquated labour laws also continue to hold back the emergence of large enterprises in India. For example, companies with more than 100 employees cannot dismiss an employee without the government’s permission. As a result, the vast majority of businesses in high-employment sectors like textile and leather prefer to hire labour on an informal contractual basis.

There is also no evidence to support the claim that a large informal sector hurts the Indian economy. And while it might be less productive compared to larger manufacturing units that can extract economies of scale, the informal sector performs a vital role in India’s economic ecosystem. It is a textbook market economy of individuals engaging in commerce with each other, and keeping money in circulation. This entire system performs without direction from a central planner and is an excellent example of free markets at work. The informal economy is also counter-cyclical, that is, it expands during economic downturns and provides a secure economic and social buffer for millions during sharp economic slowdowns. This is especially important in a country like India with its nonexistent social security net and limited unemployment benefits.

And where India is today is where the rest of the world is heading — an economy in which people are engaged in informal contracts with each other. This structure provides flexibility and reduces the fixed costs of full-time employment. Many economists believe this informal arrangement powered by millions of micro-entrepreneurs rather than a small number of giant corporations, will result in a reduction in the concentration of capital and create more equality.

Any attempts, therefore, by the Indian government to coercively push the informal economy towards a formal structure mainly to extract tax revenues will be extremely unwise and will result in massive economic and social disruption. Government intervention against “informal” activities can do a lot of harm to the vast majority, who are just trying to make a legitimate living. Any evolution towards a more formalised economy, if and when it happens, will happen spontaneously as skill levels change, employment opportunities improve and labour laws become more favourable to large-scale employment.  

The author is Founder, contractwithindia.com.Views expressed are personal.