Informality cannot be taxed away

Niranjan raises several policy challenges associated with the persistence informality in Indian economy. I have three observations

1. One point I have been struggling with for a long time is the demand-side of informality. Can an economy with this really tiny middle class, be able to support a large formal sector? After all, any formality adds layers to the cost of production which is transmitted into prices, thereby raising questions of affordability or market availability. Productivity improvements in non-tradeables, especially services, takes long time to materialise. Even in a tradeable sector like agriculture, despite the low baseline, we have witnessed very slow productivity improvements. 

2. Post-demonetisation, there has been an increase in debates about causes of informality and policies to increase the share of formal sector. But much of the discussion have revolved around capturing informal firms in the tax net and the role of supply-side reforms like financial inclusion, digital transactions, and the impending Goods and Services Tax (GST) in achieving this objective. 

India's 58.5 million enterprises eco-system is a very deceptive one. Of these, just 0.8 million are formally registered as a firm under the Companies Act. One can safely say that we have maybe about 2-3 million enterprises which can even be remotely called as enterprises. The rest are just subsistence activities. 

So the lens of subsidy and tax may actually be counter-productive. If you try to tax them, then there are both demand and supply-side dimensions which make them unviable economic activities. In fact, the implicit subsidy may actually be what keeps them going, with whatever disguised unemployment that it entails. In other words, the tax and subsidy may be two sides of the same coin, cancelling themselves out. Informality cannot just be taxed away!

3. I am not sure how much of the resource misallocation literature like that of Diego Restuccia and Richard Rogerson applies to the analysis of India's informal sector. Consider this. Just as formal enterprises raise capital through the formal institutions of financial intermediation, informal ones are likely to remain predominantly reliant on own capital or informal intermediaries, and any significant share of the latter form of capital is unlikely to find its way into formal intermediation for a long time to come. Any regulation is likely to have no influence on the informal firms, which by their very nature are outside the regulatory eco-system. If we accept that a very small proportion of the 58.5 million enterprises are ever likely to turn formal, the argument that financial resource misallocation and regulatory arbitrage is squeezing out formality loses its sting. 

I am strongly inclined to the work of Andrei Shleifer and Rafael La Porta who find that it is unrealistic to expect informal firms to transition to formal status and that the transition to formality is best left to the dynamics of economic growth. In fact, the most likely dynamic is that as the economy expands, the share of informality shrinks without, perhaps, shrinking in absolute terms.