Home / Opinion / Views /  The informal economy’s share may be one-fifth at most

Our recent State Bank of India (SBI) Ecowrap report (bit.ly/3luWoPU) suggesting that the share of India’s informal economy has shrunk to no more than 20% has generated a lot of interest. A recent column in Mint, ‘Big claims of rapid economic formalization are suspect’ (bit.ly/3ku4xuN), had a critical review of that report. While healthy reviews are always welcome, this one seems to have misunderstood the research methodology. This is surprising, as it was clearly enunciated in the report.

The said column makes four points about the SBI report. This oped provides a detailed response to each.

The first point relates to research methodology. The column in question constructs a hypothetical model of India’s gross domestic product (GDP) by assuming an equal share of formal and informal sectors. Next it assumes a post-covid GDP by ascribing losses to the formal and informal sectors, and then re-estimates the post-covid share of each. It then compares these figures with a second set of numbers by assuming a zero loss for the formal sector, ascribing such an assumption to the SBI report. Obviously, when these two sets of figures are compared, the informal share is much higher in the second case. The column uses these numbers to conclude that the SBI report suffers from this drawback.

However, the column misses a crucial point. The SBI report had clearly stated “our starting point is an assumption that the shrinkage in the economy post pandemic is mostly informal and hence the loss in output across sectors gives us a measure of the informal sector". Thus, it is important to note that Ecowrap has said “mostly informal" and not entirely informal in describing the post-covid GDP loss. Second, since we were aware of the significant limitations of using informal to formal ratios for any inference, we took an entirely hybrid approach. Let us illustrate our methodology with numbers.

Assume a quarterly pre-pandemic GDP level of 100 in April-June 2019. Now assume that the economy was at a level of 75 in April-June 2020, when the covid lockdown happened, an output loss of 25. Let’s also assume that this recovered to 88 in April-June 2021, implying that the economy was still to recoup a loss of 12. Smoothening out , the average of 75 and 88 is 81.5, rounded to 82. We make a logical assumption that whatever the economy has recovered is purely attributable to the formal sector. Going by this, the formal economy is at 82 and the informal economy estimated as a residual is at 18. If we make this assumption, though, then we will get an upward bias in our estimation of the informal sector, as there have clearly also been formal-sector losses that we are ignoring. However, the recent column in Mint, by using the ratio approach erroneously, reinterprets the entire loss as informal.

Second, why did we use the pandemic as a reference point? This is a fair question. The column admits that it is easier for informal firms to restart operations than for large firms. This is contrary to the widespread belief that the informal sector just vanished during pandemic, an assumption that we made. We reiterate that our only objective of using the pandemic was to understand the extent of GDP destruction for the measurement of formal and informal sectors, and nothing else. It is always better to use real-time data than surveys.

The third point made is that we implicitly assume our GDP figures capture the informal sector accurately. This is not correct. We just made a holistic attempt to capture the informal sector’s share by using a different methodology. We are surprised that a lot of articles, including the column, only refer to the headline informal number. Our report also clearly says that the agriculture sector is still 75% informal and even the trade, hotels and construction sectors have an informal share of 35%-45%. However, sectors like finance have an informal component that is close to zero, thanks to many initiatives of the government, and this averages out the headline number. In fact, the finance sector was the only one that gained 10% after the pandemic.

Finally, we clearly acknowledge that a large swathe of India’s workers are bereft of formal contracts, including social-security benefits, as the column says. The informal economy is indeed heterogenous. Self- and wage-employment differ. However, the government is making attempts in this direction by going on an overdrive to regularize informal workers on the E-Shram portal. But another noted economic commentator recently said in an article that if such people are not entitled to social security benefits, it is foolhardy to talk of formalization. Well, the SBI report only said it’s a continuous process. Recall that when Jan Dhan accounts were first opened, more than 95% had a zero balance and this was constantly highlighted as a policy failure; yet, these accounts are now serving as a vehicle for women’s empowerment.

Finally, the increase in India’s currency-to-GDP ratio to 14.5% in 2020-21 from 12.4% in 2010-11 is also being cited to support an argument of sustained informality. But if we adjust for the pandemic loss in 2020-21, this ratio is only 12.7%. A similar example is of the tax-to-GDP ratio jumping from 10.5% in 2015-16 to 11% in 2018-19 and retreating since then as the exemption limit was raised to 5 lakh in 2019-20. But critics miss such tax changes and ascribe a decline in that ratio after 2018-19 to less formalization. Are these not examples of convenient stats?

Soumya Kanti Ghosh is group chief economic advisor, State Bank of India. These are the author’s personal views.

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