Don't believe everything they tell you about breakneck formalization

The SBI report examines the likely loss of output or gross domestic product (GDP) across sectors in the pandemic year (fiscal 2020-21)
The SBI report examines the likely loss of output or gross domestic product (GDP) across sectors in the pandemic year (fiscal 2020-21)


There is good reason to doubt the reported decline in the informal sector’s share of Indian GDP

A State Bank of India (SBI) report that grabbed headlines recently suggests that India’s informal sector has shrunk dramatically in recent years. Given that the claim comes from the economic research team of a major state-owned financial institution, it deserves scrutiny.

The SBI report examines the likely loss of output or gross domestic product (GDP) across sectors in the pandemic year (fiscal 2020-21), assumes this GDP loss to be concentrated in the informal sector, and on the basis of that assumption, arrives at a striking claim that the informal sector’s share in India’s GDP has shrunk from about 52% three years ago to a “max 15-20%" of GDP.

There are four key problems with this analysis. Firstly, the assumption that the entire GDP loss in 2020-21 represents the loss of just the informal sector is too simplistic. The informal sector was undoubtedly hard hit. But given the widespread evidence of revenue losses suffered by the formal sector, it is hard to justify the assumption of zero loss in the formal sector. The report acknowledges the possibility that the formal sector was hit, but justifies its extreme assumption on the ground that it prevents a “downward bias" in its conclusions. This justification doesn’t hold water. A simple example can show how this assumption actually leads to the extraordinarily low share of the informal sector that the report arrives at.

Consider a hypothetical economy with a pre-pandemic GDP of 2,000. Let’s call it Dream Land. Now, let’s assume that Dream Land has a similar structure as the Indian economy, with the formal sector accounting for 1,000 of GDP (50%) and the informal sector accounting for an equal share. Now, suppose the formal sector declines by 20% during the pandemic even as the informal sector shrinks by 50%. In other words, while the formal sector is now generating output worth 800, the informal sector generates output worth 500 and total GDP is at 1,300. This means the overall GDP has declined by 35% [(1300-2000)/2000], and the share of the informal sector has now come down to 38% (100X500/1300).

Now consider an economist at Dream Land, Doctor Stats, who doesn’t have data on the split between the formal and the informal sector, but knows that the overall economy has shrunk by 35% because of the pandemic. She assumes that the entire output loss (amounting to 700) is because of the informal sector. Subtracting 700 from the size of the pre-pandemic informal sector ( 1,000), she arrives at an estimate of 300 for the informal sector. The estimated informal sector share in this case would be 23% (100X300/1300). Note that because of her (erroneous) assumption, Doctor Stats arrives at a figure which is 15 percentage points lower than the actual share of the informal sector (38%) in Dream Land. The SBI report suffers from the same drawback.

The second problem with SBI’s analysis is that it uses an extraordinary reference point (the pandemic year) to make a claim about a structural transformation in the economy. Imagine a drought year where half of India’s agricultural output and employment gets wiped out. That will bring down the share of farm jobs in the economy, but the very next year that share would rebound as the farm sector recovers. It would be absurd for anyone to claim just after the drought that the structure of the Indian economy has changed. Similarly, it would make no sense to claim that the informal sector has disappeared simply because many informal enterprises shut shop during the pandemic. Small enterprises fold easily when faced with external shocks, be they pandemics or droughts. Compared to large firms, they are also easier to restart once the shock subsides.

The third issue with the SBI report is its implicit assumption that the reported GDP figures capture the informal sector’s contribution accurately. No one records growth in the informal sector annually in India, unlike in Dream Land. During the process of GDP revisions and base-year changes, a benchmark survey of informal sector firms is indeed conducted to ascertain their contribution to GDP. But these surveys are not repeated each year. To calculate growth of the informal sector, national account statisticians use the available data on formal-sector indicators for each sub-sector of the economy (with some exceptions such as agriculture). Thus, a significant share of India’s GDP ‘grows’ every year simply by assumption. More assumptions atop such a weak statistical edifice are unlikely to yield robust estimates of the informal sector. To arrive at the truth, we need a well-designed survey.

Finally, apart from the share of output, the share of workers with formal contracts (and social security benefits) is also considered to gauge the extent of formalization across the world. In India, such data is now available annually, thanks to the periodic labour force surveys (PLFS). The story these tell is very different from what the SBI report tells you. An overwhelming majority of workers in India do not have regular employment. Even among the small minority that have regular jobs, a majority don’t have a written contract or paid leave, according to the last pre-pandemic PLFS survey conducted in 2018-19. We know very little about the informal sector’s true size, but we do know that the labour market is yet to be formalized

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