The informal economy has been an important topic of discussion in this blog. I have written here with my co-author about the problems with forced formalisation. History teaches us that informal to formal transitions happen not by way of informal sector firms becoming formal but in terms of expansion of the share of formal sector firms. Informal sector workers and firms face the binding constraints of deficient capabilities and resources to be able to transition to the formal sector.
I have also blogged about how formality introduces layers of costs that the economy cannot support and thereby ends up dampening aggregate demand. Formalisation of all barbers does not take away from the stark fact that there are only so many Rs 100 haircuts that the economy can support. The vast majority of demand is for Rs 50 and below haircuts, which the informal economy cannot ever provide.
Take the example of iron/metal scrap dealers. This economy involves hundreds of thousands of poor scrap pickers collecting scrap and selling it to local scrap dealers, who in turn sell it to upstream aggregators, who in turn sell it to re-rolling mills where the scrap is processed and converted into steel for construction and other lower end requirements. The chain from the scrap picker to the re-rolling mill often consists of several aggregators. Some of these aggregators are pure shell entities established to obfuscate and claim input tax credits (ITC) and evade the goods and services tax.
Apart from these aggregators, there are also several other intermediaries - transportation companies, storage godowns, credit providers etc. But almost the entire network operates in the informal economy. Whilst it suffers from several inefficiencies, this informal sector provides livelihood for millions, including all the different kinds of intermediaries and their employees. This formal economy also exists because of the regulatory and legal arbitrage opportunities that help drive down aggregate costs for the upstream formal economy.
Now consider the formalisation of this sector through Goods and Services Tax (GST). This would entail capturing transactions at different levels of aggregators and intermediaries and ending at the re-rolling mills. Further, a share of the value generated in this economy which was previously captured only by those in the informal sector now gets subtracted as tax revenues.
Further, the re-rolling mill is now able to drive efficiencies by having greater visibility on its supply chain, being able to better monitor this supply chain, and contracting with fewer intermediaries. In the process, redundant layers and intermediaries are eliminated. All this increases the profit margins of the re-rollers and also the few large intermediaries (notwithstanding the loss suffered from difficulty to now indulge in fake ITC claims).
The balance sheet of this transition is that the re-rollers and big intermediaries are likely to undoubtedly benefit. They'll expand and hire more people, and the more skilled and enterprising people in the informal sector will transition into formal sector employees. The government tax revenues from the sector will rise. However, a large portion of existing informal sector workers in the iron and metal scrap industry are likely to lose their livelihoods and be forced into penury and search for new livelihoods.
In the partial equilibrium, the economic pie of the sector does not expand, but its distribution gets even more skewed towards the larger entities, and a share goes to the government. It's only natural that the pie going to the informal sector workers etc declines. In the general equilibrium, the pie will expand and the scrap sector will become more productive. But it'll both take time and the adjustment costs will be significant for a large share of those who were part of the informal economy. And in that time we're all dead or the costs are prohibitive enough to render the adjustment impossible!
In practice, such transitions are about the enrichment of some and the immiseration of others. Whether the former is a majority or not depends on the nature and pace of the transition. Are there sufficient interlinkages, capabilities, and restraints (on the mindless pursuit of efficiency and profits) to minimise the adjustment times and costs? What's the emerging structure of the formal sector in scrap collection, aggregation and trading? Are there adjoining or newly emerging sectors into which those forced out can be accommodated quickly? Is there enough time for these adjustments to happen? Forced formalisations, any change in general, more often than not end up failing and causing misery and suffering.
Formality also introduces efficiency improvements which in turn eliminates redundant layers and intermediaries, technology that introduces transparency and leaves digital trails, and adds cost layers to the activities of intermediaries (they have to pay minimum wages, employment benefits, adhere to standards, pay taxes etc). This is the driving force behind the delayering and consolidation among aggregators. Over time, and it can sometimes be a long time, these trends have the effect of improving productivity and aggregate output.
The example of iron or metal scrap trading applies to all informal sectors. They can be similarly disaggregated to identify the value chain and create a balance sheet of outcomes from formalisation.
The point here is not an argument against formalisation, but to put the transition in perspective and draw attention to the complex nature of such transitions. As I wrote here with the example of climate change, economic transitions come with their costs.
I'll argue that any forced transitions to formality or higher labour or environmental standards is a supply shock induced demand compression, which invariably lowers the output. In general, any economic transition increases costs which if not supported by associated increases in demand, will necessarily lower output... formality introduces layers of production costs which increases the market prices, which in turn reduces market demand. At the higher price, only a smaller number of customers can afford the good or service. The cost structure of the formal market can be met by only a small proportion of the total demand. The market settles down to a lower equilibrium output.
It's important to keep in mind these effects when we discuss and formulate policies on the issue of formalisation.
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