Demonetisation and the informality debate

The end-game of demonetisation and less-cash economy is arguably about rolling back the informal sector. But this endeavour has to overcome an externalities play with a set of fundamentally conflicting objectives. 

Businesses and consumers optimise on costs and prices respectively. This is all the more so for the vast majority of enterprises, mostly micro and small, and consumers in a country like India. The net result is an equilibrium where businesses skimp on costs, especially which can be evaded (or avoided) and the resultant costs are affordable. On their side, consumers' very high elasticity (or marginal sensitivity) on prices encourage businesses to keep costs as low as possible. Nobody in this market bears any burden for the external costs of their actions. A weak or non-existent state and deficient formal markets helps maintain the equilibrium where a very significant proportion of transactions are informal. 

On the other hand, formal markets have a different set of dynamics. Here the rules of the game are strongly aligned towards internalising the external costs. The market equilibrium gets established subject to the rules of the game. The layers of external costs get added to the shares of the respective actors in the market. The net result is a higher cost for businesses and higher price for consumers. I have blogged earlier about the costs of formality in manufacturing, labor, housing, and land markets.

Consider the roadside barber shop or street-corner kirana store or small restaurant. They survive in a cash and informal economy, which pervades everything from shop rent, employee payments, purchases of intermediates, to final sales. In the process, they (and their transaction counter-parties) avoid making payments on their legal obligations - income and other taxes, social protections, safety and other standards etc. Everyone in the transaction chain agrees with this bargain with all its attendant compromises on quality.

There is nothing wrong with this. At a fundamental level, development is a process of seizing arbitrage opportunities. Across markets, capital and goods move from areas where they are cheaper to where they are more expensive. The formal and informal markets are no different. People earn incomes in the informal markets to access a progressively increasing share of consumption in the formal market, which expands in turn. Countries see an increasing share of their economic transactions move into formality as they develop. 

Now consider the introduction of formality into these establishments. It immediately exposes two binding constraints. Most fundamentally, the vast majority of consumers will not be able to afford the incremental price. In other words, there are only so many people who can afford the beauty saloon instead of the roadside (or small shop) barber. The other constraint feeds in from the first - businesses will not have the market demand to service if they incur all the costs of formality.

The only way around this is to have standards (on environment, labor etc) that are not benchmarked to global best practices, but pegged to realistic levels and which tighten gradually and progressively. This would have to be complemented with a robust safety net that provides publicly financed social protections for those employed in the country's millions of small enterprises, so that the costs of going formal are not high. After all in the US, the largest beneficiaries of its social safety net are large firms like Walmart and McDonalds. But the argument in favour of a second-best set of standards goes against the grain of political correctness (the debate surrounding the real estate bill was instructive in this regard), while any attempt at building a deep enough social safety net runs into fiscal constraints.

There are no easy answers to such complex development challenges. I am less convinced that we can transition to a significantly less-cash (or less informality) economy over a five or ten year period. As we argue in our new book, the endeavour should be persistent economy-wide capital accumulation that grows national incomes to create a large enough consuming class, encourages firms to start formal and then grow, and builds up state capacity to regulate. That requires diligent action on multiple fronts.