Formalization of the economy is a form of coercion
What India needs, as economists have advocated time and again, is a simpler regulatory framework
One of the biggest challenges facing the Indian economy is the size of the informal sector. The present government, more than any other, has taken upon itself to punish those in the informal economy. Their logic is simple: Informal operations are unproductive and pose many challenges to the government, like the inability to raise tax revenue, collect data, and regulate firms and firms operating in the shadows will be punished until they step into the light.
The problem is that the government has missed the fundamental reason for the nature and size of the informal sector in India, and “remedies” like demonetization and the goods and services tax (GST) are making the problem worse.
It begins with a misguided assumption—that firms in India have a preference to operate informally. But the truth is that most businesses have no choice but to hide from the regulatory system, which imposes too high a burden. If firms actually comply with all the regulation, their costs are too high to offer competitive prices to the customers. Customers look elsewhere (usually imports or the informal economy) and the firms go out of business. This is the short version of the tragic tale of most firms in India.
The worst affected are the micro, small and medium enterprises (MSME). According to a 2015 study by Amit Chandra and Vrinda Pareek for the Centre for Civil Society, starting an MSME requires 12 licences, a relatively high barrier to entry. Add to these 27 construction permits and seven property registration requirements; many are dead on arrival. The MSMEs that are launched are flouting more than a few rules of this extensive regulatory burden. The worst are the labour laws—44 Central statutes and over 150 state statutes are in place governing every aspect of the employer-employee relationship. On average, firms spent 243 hours a year filing and paying taxes and the total tax payment is 61.7% of profit. GST has definitely not reduced, and possibly increased, these compliance costs. It is a wonder that even a fraction of businesses formalize.
There are very few businesses that have a preference for the informal or the underground economy. In a world where all businesses are legal, perhaps those afraid of social shaming will be the only firms that remain underground. Indian firms remain in the shadows because that is the only way to exist and operate competitively. In a world with a simple and reasonable regulatory and tax system, most businesses would prefer to be legal, above board, and profitable. The problem is of costs imposed by regulatory compliance. And punishing firms by adding to these costs will not solve the problem.
The punishment imposed by demonetization and GST are not likely to incentivise most of the small businesses to formalize—because if they do, they will probably go out of business. Demonetization was a double whammy for the informal sector. It resulted in a very large demand side shock, where customers could not pay in the short run for these informal goods and services using cash. And the cash balances of entrepreneurs were also called into question overnight. Demonetization killed small firms, put informal workers out of jobs, and destroyed entire supply chains. GST is imposing even higher costs because it is recurring and long term. It imposes a whole new system of compliance that requires frequent filing, navigating an impossible classification system, and a dysfunctional receipt matching mechanism under the GST network. Complying with GST crippled the economy immediately after its introduction, the consequences of which will be felt for a while to come. Most businesses in India cannot function if they operated in the harsh light of the regulatory state. After all, too much exposure to the sun can also cause cancer.
Indian businesses lose the productivity, economies of scale, and gains from trade that come with formalization because the regulatory environment is impossible to navigate. Remaining informal allows them to buck most of the regulatory and tax system, a survival tactic without which India would be poorer. However, to survive, firms must give up any hope of growth. Productivity gains remain unrealized, because these firms are forced to remain informal, trapping Indians in poverty.
Why does the government punish the lack of formality instead of fixing the regulatory system and easing the compliance burden? Probably because fixing the regulatory system is very difficult, and it prefers having control over the economy instead of fostering growth. The real reason to favour formalization is to help individuals and firms grow and achieve scale and productivity, both of which are difficult to attain in informal businesses. But the government wants to formalize the economy to increase revenue, data and surveillance. Informal businesses are a problem because the government can’t keep track of them. And therefore, it is willing to give up growth for formality.
What India needs, as economists have advocated time and again, is a simpler regulatory framework. But a simpler regulatory framework reduces the power of the state and increases the freedom of the people. On the other hand, employing more coercive means to “force” firms to formalize helps the state keep up the pretence of fixing the problem, while, in fact, increasing its own power and scope, and coercing more Indians than ever before. This government has just used new rhetoric of modernization and formalization to develop increasingly coercive instruments to control and harass Indians. It is time to call the bluff, and demand genuine reform that transfers power back to the individual.
Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.
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