Moving towards a larger formal economy

One-time initiatives like currency swap might signal intent, but increasing the size of India’s formal economy will require a sustained effort

Credit: Jayachandran/Mint
Credit: Jayachandran/Mint

According to conventional wisdom, the currency swap initiative was supposed to have been the Narendra Modi government’s political epitaph. The assembly poll results have turned that on its head. The economic effects of the initiative will likely continue to be debated for a while yet. But the voting public has shown that at worst, it didn’t consider any immediate economic pain arising from currency swap sufficient reason to vote against the Bharatiya Janata Party—and at best, the initiative was an electoral positive, seen by voters as proof that the Prime Minister intends to follow through with difficult reforms. This creates a unique opportunity for Modi.

As NITI Aayog chairman Arvind Panagariya put it, the initiative was seen as a “move towards formal economy” with the need “to bring workers and activity into the formal sector”. This is an economic and social imperative. Providing employment for India’s youth bulge is the state’s greatest challenge, and will remain so for the next few decades. Unorganized sector jobs are a suboptimal solution, much less productive than formal jobs; apparel firms in the latter are 15 times more productive than those in the former, as an example. There are numerous other concerns as well, from a lack of security for the worker to lopsided growth and inefficient capital allocation.

Economic logic dictates that as a country climbs the development ladder, its economy will shift towards the formal. However, this has not been the case with India. National Sample Survey Office (NSSO) statistics show that in the 1989 to 2010 period, informal firms have accounted for the maximum number of jobs created and the vast majority of new establishments. Little wonder that 80-91%—depending on the criteria used—of the non-agricultural workforce is in the unorganized sector.

Modi now has the political space to consider the policy measures needed to increase formalization of the economy; currency swap may have been pitched as a first step, but the changes that are truly needed are structural in nature. The common sense trio of labour—there are currently 200 labour laws on the books—land and tax reforms top that list. They are distortionary on multiple levels, from making it difficult for firms to expand to incentivizing them to stay small in order to avoid higher regulatory compliance costs. Tinkering around the edges will be of little use here. For instance, multiple studies have shown that raising the number of workers beyond which a firm must seek government permission for retrenchment merely changes the threshold at which inefficiency sets in.

But a granular look makes it clear that this is no silver bullet. As Ravi Kanbur points out in Informality: Causes, Consequences and Policy Responses, disaggregating NSSO and Annual Survey of Industries statistics throws up some interesting facts about the informal sector. Firms that should comply with the Factories Act, 1948, but do not do so—the institutionalised corruption that arises from evading regulation is another cost of regulatory cholesterol—and firms that adjust out of regulation make up a minority of the sector. The majority of the country’s informal sector, by far, is made up of enterprises whose natural size falls below the regulatory threshold.

Addressing this necessitates a much broader approach on multiple fronts. Improving transport infrastructure and connectivity is one of them. Spatial mismatches between enterprises and workers are a major barrier to growth and formalization: the relatively high cost of urban living makes labour-intensive firms uncompetitive in cities while poor connectivity undercuts hub and spoke arrangements that could get around the problem. Setting up enterprises in smaller towns with lower costs is another option—but here again, improved infrastructure is a necessity. Improving access to formal credit is another front.

The Modi government is laying the foundation via its banking inclusion drive, but this is a multi-faceted problem; it will require, for instance, overhauling property rights systems to better allow assets to be used as collateral. A third front—a crucial one—is improving the quality of human capital by boosting education and skill levels.

One-time initiatives like currency swap might signal intent, but increasing the size of India’s formal economy will take a sustained effort that works on the systems that underlie the Indian economy and society. The interlinked nature of these systems where improvement on one front will necessitate working on another—as access to credit and property rights show—makes it that much more difficult. So does the fact that in multiple areas such as labour and land reforms, state governments will have as much of a role to play as the centre. Here, given that the BJP now controls a large number of states, Modi must push their governments to take these reforms forward.

Modi has shown that he has the appetite—and the aptitude—for the necessary risk-taking. But the setbacks his government has faced in its quest to simplify labour regulations point to the magnitude of the challenge. Now, it remains to be seen just how far his appetite and aptitude extend.

Will Prime Minister Narendra Modi undertake the tough reforms needed to increase the size of India’s formal economy? Tell us at

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