Daily News Analysis

Formalization of the Economy

7th October, 2021 Economy

Figure 2: No Copyright Infringement Intended


  • Data released by the Controller General of Accounts points towards a sustained improvement in central government finances.
  • At the end of the first five months (April-August) of the current financial year, the Centre’s gross tax collections touched almost 40 per cent of the budgeted target — this is far in excess of what has been the trend so far.

Support to the Argument:

  • Gross tax revenue in the first quarter of this fiscal shot up by an impressive 33% even over the same period in FY20 (before the pandemic struck). In stark contrast, nominal GDP in the June quarter grew only 2.4% from the pre-pandemic level.

Benefits of it:

  • This seemingly-accelerated shift towards formalization have boosted the profitability of large companies, leading to strong growth in the corporation tax collection.
  • A shift in wealth distribution away from the poor and the lower-middle class to the upper-middle class or the rich boosts income tax mop-up because the tax regime is usually progressive.
  • Higher tax revenue of the government has helped in increasing the government expenditure leading to kick start of the growth process.


Challenges to it:

  • Formalization may have been a “forced” process, driven mostly by the Covid-induced extinction of several unorganized sector entities, rather than an organic one. 
  • This has led to greater consumer reliance on the formal sector, even though overall consumption demand remains sticky due to large-scale income losses.
  • Private final consumption expenditure shrank 11.9% in real and 2.7% in nominal terms in the June quarter from the pre-pandemic levels.
  • Consumption pattern has shifted more towards discretionary items, including luxury goods (which attract higher GST rates) than the essentials.
  • It weighs down economic growth, given the informal sector’s overwhelmingly large share in employment.
  • Covid crisis has ravaged non-agricultural entities in the unorganized sector more than the rest.
  • Informality also has a gender bias. Women are somewhat more likely to be engaged in the informal economy but significantly more likely than men to be working as informal workers in the formal sector.

Status of Informal Sector:

  • India’s informal sector accounts for about a half of its GDP but employs as much as 80% of its workforce, according to an HSBC estimate.

About Informal Sector:

  • It includes very low-value-added activities in the informal sector, such as rickshaw pulling, barbershops on pavements, domestic service, and street traders.
  • The informal sector describes all those activities that are no formally regulated by the government because they do not come under any legal regulatory frameworks.

Why people Work in Informal Sector:

  • It allows the poor to find an avenue of employment, even though the informal sector provides very low incomes.
  • The informal sector includes activates in industry, agriculture, and services, but the informal service sector is particularly important because it requires almost no capital to enter this sector and so it serves as a final resort for all those who fail to find work anywhere else.
  • Informal service sector jobs usually do not require the workers to set themselves up in business, and so this sector tenders to absorb all those who cannot find jobs elsewhere.

Disadvantage of Informal Sector: 

  • They represent and wasteful use of human resources that could be more productively employed in higher-wage sectors if only jobs were available in those areas.
  • The size of informal service sector activates thus might reflect the lack of a development dynamic in an economy, and its failure to generate high-wage employment in rapidly growing industrial, agricultural, or high value-adding service sectors.

Advantage of Informal Sector:

  • Informal sector service activates represent an escape route for the poor who would otherwise find it even more difficult to survive.
  • Informal sector should not be undervalued in a developing country since it provides vital employment opportunities and is a source of dynamism in the economy.
  • This is the best way to reduce poverty and provide employment opportunities.

Way Forward:

  • Rise in Exports: Most large companies are flooded with orders, so much so that they have started taking the help of the ancillary units (in the informal sector) to fulfil their commitments. While some of the smaller units did suffer initially, things are improving now.
  • Skilling the labor: Unless the labor force is not skilled and educated, they will not be accommodated in the formal sector and the efforts to formalization will result in unemployment.
  • Social security: Investing in social security schemes like Atal Pension Yojna, PM Jeevan Jyoti Yojana, Rashtriya Swasthya Bima Yojana, Aam Aadmi Bima Yojana can help improve the condition of workers. The mention of Universal Basic Income in Economic Survey 2016-17 is a positive step in this direction.
  • Financial support: Giving financial support to help small-scale industries stand on their own is a crucial step in bringing them to the organized sector. Schemes like MUDRA loans and Start-up India are helping the youth carve a niche in the organized sector.
  • Policy reforms: The structural policies designed to promote formality should be implemented with caution, aimed at encouraging formalisation rather than explicitly discouraging informal activity.