Industrial Sector Updates – Industrial Policy, Ease of Doing Business, etc.

India’s economy and the challenge of informality


From UPSC perspective, the following things are important :

Prelims level: Defining formal sector

Mains level: Paper 3- Challenges of formalisation


Despite efforts by the government, formalisation of economy still eludes us.

Prevalence of informality in India

  • Despite witnessing rapid economic growth over the last two decades, 90% of workers in India have remained informally employed, producing about half of GDP. 
  • Combining the International Labour Organization’s widely agreed upon template of definitions with India’s official definition (of formal jobs as those providing at least one social security benefit — such as EPF), the share of formal workers in India stood at 9.7% (47.5 million).
  • The prevalence of informal employment is also widespread in the non-agriculture sector.
  • About half of informal workers are engaged in non-agriculture sectors which spread across urban and rural areas.
  • Industries thriving without paying taxes are only the tip of the informal sector’s iceberg.
  • What remains hidden are the large swathes of low productivity informal establishments working as household and self-employment units which represent “petty production”.
  • To conflate the two distinct segments of the informal sector would be a serious conceptual error.

Fiscal perspective of formalisation

  • Efforts to encourage formalisation: Currency demonetisation, introduction of the Goods and Services Tax (GST), digitalisation of financial transactions and enrolment of informal sector workers on numerous government Internet portals are all meant to encourage the formalisation of the economy.
  • The formal sector is more productive than the informal sector, and formal workers have access to social security benefits.
  • The above-mentioned efforts are based on the “fiscal perspective” of formalisation.
  • This perspective appears to draw from a strand of thought advanced by some international financial institutions such as the International Monetary Fund, which foregrounds the persistence of the informal sector to excessive state regulation of enterprises and labour which drives genuine economic activity outside the regulatory ambit.
  • Hence, it is believed that simplifying registration processes, easing rules for business conduct, and lowering the standards of protection of formal sector workers will bring informal enterprises and their workers into the fold of formality.

Issues with fiscal perspective

  •  Early on, in an attempt to promote employment, India protected small enterprises engaged in labour intensive manufacturing by providing them with fiscal concessions and regulating large-scale industry by licensing.
  • Such measures led to many labour-intensive industries getting diffused into the informal/unorganised sectors.
  • Further, they led to the formation of dense output and labour market inter-linkages between the informal and formal sectors via sub-contracting and outsourcing arrangements (quite like in labour abundant Asian economies).
  • While such policy initiatives may have encouraged employment, bringing the enterprises which benefited from the policy into the tax net has been a challenge.
  • Political and economic reasons operating at the regional/local level in a competitive electoral democracy are responsible for this phenomenon, too.

Role of underdevelopment

  • Global evidence suggests that the view that legal and regulatory hurdles alone are mainly responsible for holding back formalisation does not hold much water.
  • A well-regarded study, ‘Informality and Development’ argues that the persistence of informality is, in fact, a sign of underdevelopment.
  • The finding suggests that informality decreases with economic growth, albeit slowly.
  •  A similar association is also evident across major States in India, based on official PLFS data.
  • Hence, the persistence of a high share of informal employment in total employment seems nothing but a lack of adequate growth or continuation of underdevelopment.

Impact of pandemic

  • Research by the State Bank of India recently reported the economy formalised rapidly during the pandemic year of 2020-21, with the informal sector’s GDP share shrinking to less than 20%, from about 50% a few years ago — close to the figure for developed countries.
  • These findings of a sharp contraction of the informal sector during the pandemic year (2020-21) do not represent a sustained structural transformation.
  • They are a temporary (and unfortunate) outcome of the pandemic and severe lockdowns imposed in 2020 and 2021.

Way forward

  • Policy efforts directed at bringing the informal sector into the fold of formality fail to appreciate that the bulk of the informal units and their workers are essentially petty producers eking their subsistence out of minimal resources.
  •  The economy will get formalised when informal enterprises become more productive through greater capital investment and increased education and skills are imparted to its workers.

Consider the question “What are the reasons for persistent informality in India? Suggest the way to ensure the smooth transition to the formality.”


Policy efforts to formalise the economy will have limited results as the bulk of informal units are petty producers.

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