Impact of Modi govt’s campaign against cash on informal economy

The government’s war on black money now seems to have morphed into a campaign for a cashless economy. The media focus has understandably been on the pain inflicted on people due to the shortage of cash. But what will be its long-term effects?

It is now abundantly clear that, among businesses, it is the informal sector that has been the worst affected by demonetisation. Firms in the informal sector operate in a cash economy—they buy their raw materials, pay their workers and sell their products in cash. It’s no wonder that when access to cash is a problem these businesses will suffer.

But the cash shortage will ease sooner or later. Does that mean it’s just a matter of short-term pain before it’s business as usual? Not really, not if the government is serious about pushing through its ‘less cash’ pro-digital payments agenda and ensuring that every transaction has an audit trail.

It’s not just a matter of the lack of connectivity for digital payments—there are more fundamental issues involved. The informal sector operates under the radar of the authorities. As a 2004 McKinsey report titled The Hidden Dangers of the Informal Economy put it pithily, “Informal companies evade fiscal and regulatory obligations, including value-added taxes, income taxes, labor market obligations (such as social-security taxes and minimum-wage requirements) and product market regulations (including quality standards, copyrights, and intellectual-property laws).” So far, governments in India have turned a blind eye to these illegalities, not least because they were worried about the consequences on employment and on the economy if they decided to enforce the rules. But it seems the present government not only wants to change that policy, but also wants to force the pace of change.

It is, of course, a laudable objective and the decision to force it through is a bold move. The big question though is: will it work? The McKinsey report is very critical of the informal sector, because its avoidance of regulation and taxes gives it an unfair advantage over firms in the formal economy, who are unable to increase their market share despite being far more productive and efficient. The report wants governments to start enforcing the rules against the informal firms, so that the formal sector benefits.

Significantly, it says value-added tax is a good place to start, since it enables the government to gain information about the informal firms and then go after them. It’s no surprise then that the government is trying to push through a comprehensive goods & services tax (GST). And that’s not the only place where the government seems to be heeding McKinsey’s advice—the report also says, “Another way of improving enforcement is for governments to partner with payments providers such as banks and credit card companies to increase the number of monetary transactions accurately recorded by the collections system and thus to raise the quality of the data available to tax enforcers.” The government’s push to a digital economy is precisely on these lines.

The expectation is that the short-term pain will lead to long-term gain. The benefits are expected to come from more tax revenue collected, which can then be used by the government to provide sops for the masses. The coming budget, for instance, is expected to echo this approach. The benefits are also expected as more firms join the formal economy, with access to funds and technology. The hope is that informal businesses will transform themselves from being the dirty underbelly of Indian capitalism into respectable, tax-paying, suited and booted members of a sleek, productive and bourgeois modern India.

Will the audacious gamble succeed? The McKinsey report didn’t think that informal firms could change so easily. It pointed out that informal businesses tend to structure their supplier and customer relationships in ways that make it difficult to go above board later, that customers of an informal firm come to expect very low prices, and many would go elsewhere if it transformed itself into a formal company and had to raise them. Indeed, the report said, “The idea that informal businesses might grow and join the formal economy is therefore a myth.”

Many firms in the informal economy would cease to be competitive if they are exposed to the full brunt of taxation and regulations of the formal economy. A 2014 paper by Rafael Porta of the Tuck School of Business and Andrei Shleifer of Harvard University, published in the Journal of Economic Perspectives, concluded thus: “we are skeptical of all policies that might tax or regulate informal firms. Rather than encourage informal firms to become formal, such policies may have the effect of driving them out of business, leading to poverty and destitution of informal workers and entrepreneurs. The recognition of the fundamental fact that informal firms are extremely inefficient recommends extreme caution with policies that impose on them any kind of additional costs.”

In other words, shock therapy such as demonetisation could very well turn out to be counter-productive. Instead, Porta and Shleifer say the cure for informality is economic growth. The evidence shows that informality declines, albeit slowly, with development. An 2009 OECD paper on Informality and Informal Employment also came to the conclusion that policies that make it more difficult for informal firms to carry out their activities and stricter enforcement of laws and regulations “have contributed to increased poverty and vulnerability by pushing already vulnerable groups of people into even more difficult situations.” What the government should instead aim for is expanding the formal sector, by making it easier for firms to operate there. But that is easier said than done and the record of the formal sector in creating jobs has been dismal.

The saving grace is that much of the talk about a transition to a cashless economy will remain just rhetoric. It’s also likely the government will soon realise that forcing the pace of change on the informal economy carries with it huge costs and it will opt instead for less ambitious, less intrusive methods.