The informality story has a demand side

I have blogged earlier about the challenges associated with shrinking informality. I therefore find this assessment, which is surprisingly commonplace, baffling,

Many units in the informal sector survive because they do not pay taxes. They conduct most of their business in cash. This is true not just for small repair shops and kirana stores but also for larger enterprises, including many small-scale manufacturing establishments. This cost advantage also helps these units compete effectively against their larger and more efficient counterparts in the organized sector, who not only pay taxes but have to comply with a plethora of rules and regulations. In fact, many brokerage reports have pointed out that the introduction of the Goods and Services Tax will be a big help to companies in the formal sector, as they will be able to take away market share from the unorganized sector. The demonetisation impact will be felt most acutely in the informal economy, which relies more on cash payments. This short-run impact, however, will be overshadowed by the long-run effect, which will see its share of the economy shrink rapidly, as the state rams through its vision of a cashless economy and forces them to pay taxes. Many units in the informal sector are likely to fail as a result. The hope is that the process will lay the base for the growth of a modern, capitalist state, instead of the ramshackle Third World petty production-cum-islands of modern industry model we see now. It will speed up the process of accumulation and will ensure the state has more resources at its command. 

It completely misses the demand side of the story. It assumes a seamless and fairly rapid substitution by the buyers of the goods and services produced in the informal sector with those from the formal sector, despite their significantly higher cost of production. In other words, national incomes have to rise rapidly. Since proportionate productivity improvements could not have been achieved on an economy-wide scale within a short time span, and since inputs (capital and labor) increase at the normal rate, it is not clear what would drive the income growth.  

Apart from deeply under-estimating the nature and scale of the informal economy, such optimists also fail to appreciate its role in a country's development trajectory. Informality is just a natural phase in an economy's development. 

None of this is to encourage, leave aside celebrate, informality. It is only a caution against raising excessive expectations, that leave governments fighting impossible battles.