The average Indian enterprise is more an act of desperation than a burst of entrepreneurship. The lack of viable job opportunities elsewhere has led to the creation of millions of tiny enterprises that offer families dignity but not much of an income. The transition from farm to factory that drove rapid development in many Asian countries has been stymied in India because of regulatory policies that have made it difficult for firms to grow in size.

Let us look at the numbers. The 58.5 million enterprises counted in the sixth economic census that was released last year employed just 131.29 million people. That gives us an average of 2.24 workers per enterprise. What is even more striking is that the average employment per economic establishment has been coming down since the advent of economic reforms, as my colleague Roshan Kishore showed in a detailed analysis published in this newspaper last April. For example, the average enterprise in urban India had 3.77 people working in 1990. The number had come down to 2.68 in 2014. The proportion of enterprises employing more than 10 people has come down from 37.11% in 1990 to 21.15% in 2014. The proportion of enterprises with between one to five workers has grown by the same extent.

The high degree of informality in India has become a matter of public debate since the demonetisation gamble of 8 November. How does informality affect tax revenue on the one hand and productivity growth on the other? In its latest Fiscal Monitor, the International Monetary Fund (IMF) has provided interesting data on how the high prevalence of tiny firms outside the tax system hurts economic performance. The multilateral lender argues that firms outside the tax system—informal firms as well as bigger firms that evade taxes—have an implicit subsidy that encourages them to stay in business despite low productivity. Countries with wide dispersion in firm productivity usually have some process by which enterprises that ought to fail continue to survive.

The scatter plot here shows this problem in stark terms. The productivity in an economy tends to be negatively correlated to the degree of self-employment in that economy. In other words, countries with high levels of self-employment (a proxy for informality) are further away from the productivity frontier. Other data shows that value added in Indian informal firms is nearly a fifth of the value added by formal firms.

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.

Niranjan Rajadhyaksha is executive editor of Mint. Read Niranjan’s previous columns at www.livemint.com/cafeeconomics

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