Tag: informal economy

There is a difference between making things simple and making them simplistic. In the zeal to make things simple a significant chunk of media’s coverage on the recently introduced Goods and Services Tax (GST) has turned out to be simplistic.

Here’s how.

There are two basic concepts at the heart of the GST. It has a self-policing feature built into it and it allows for an input tax credit. And both are linked.

Let’s start with the second feature first. What is input tax credit? Let’s say you are a manufacturer. The product you make needs different kinds of raw material. You buy this raw material from other suppliers. When you buy this raw material from other suppliers, they have already paid some indirect taxes on it and these indirect taxes are built into the price that you pay.

In the pre-GST era, you could not deduct for the taxes already paid down the value chain, while you paid your share of indirect taxes. In this way, you ended up paying a tax on tax and hence there was a cascading effect on the final price of the product.
GST subsumes many indirect taxes both at the level of the state governments as well as the central government. And that is a good thing because it actually reduces the number of taxes.

With the introduction of the GST, you can deduct the GST already paid as a part of your value chain, while paying your share of the GST. This is referred to as input tax credit.
And how do you get this input tax credit? As Section 16(2a) of the Central Goods and Services Tax Act, 2017, points out: “Notwithstanding anything contained in this section, no registered person shall be entitled to the credit of any input tax in respect of any supply of goods or services or both to him unless,–– (a) he is in possession of a tax invoice or debit note issued by a supplier registered under this Act, or such other tax paying documents as may be prescribed.”

What does this mean in simple English? It basically means that anyone claiming an input tax credit for the GST already paid down his value chain, needs to ensure that his suppliers have registered under this Act (i.e. they have a Goods and Services Tax Identification Number (GSTIN)). The individual also needs to ensure that he is in possession of an invoice from his suppliers.

This is the self-policing feature built into the GST. Anyone claiming an input tax credit needs to ensure that all his suppliers are a part of the GST as well. This basically ensures that if any supplier was operating in the informal economy, he now has to become a part of the formal economy by getting a GSTIN. Wherever this chain breaks, the government knows that somebody is not paying his fair share of taxes. So far so good.

Norman Loayza, an economist with the Development Research Group of the World Bank defines informality as “a term used to describe the collection of firms, workers, and activities that operate outside the legal and regulatory frameworks or outside the modern economy.” And given this, governments are not able to collect tax from firms operating in the informal economy. The GST is a way of ensuring that these firms become a part of the formal economy and they pay taxes.

Much of the writing in the media has focused on this and passed it as a good effect of the GST, which it is. But saying that it is only a good effect and does not have any negative sides to it, is making things simplistic instead of simple.

Let me explain.

Loayza estimates that in a typical developing country the informal economy employs 70 per cent of the labour force and produces around 35 per cent of the GDP. India has multiple estimates of the size of the informal economy.

Take a look at the following figure.

Source: Boosting Growth and Employment in the BRICS’ Prepared by ILO and VV Giri National Labour Institute, INDIA. September 15, 2016.

As per Figure 1, nearly 67 per cent of India’s labour force works in the informal economy. This touches nearly 85 per cent, if we take the informal workers in the formal economy into account as well. Many formal firms under declare the total number of people they employ.

The India Employment and Labour Report of 2014 states: “An overwhelmingly large percentage of workers (about 92 per cent) are engaged in informal employment and a large majority of them have low earnings with limited or no social protection.”

There are other estimates as well. Nevertheless, most of these estimates put the size of the labour force working in the informal economy at around 75 per cent or more of the total labour force. Also, depending on which estimate you believe the informal economy contributes 35 to 45 per cent of the GDP, which is huge.

The question is why are the firms operating in the informal economy, and not formal? The simplistic answer is that they want to avoid paying tax. And GST will make them compliant on that front.

Many Indian firms operating in the informal economy do so because going formal means following a whole host of rules and regulations, which they simply do not have the wherewithal to follow. The National Manufacturing Policy of 2011 estimates that, on an average, a manufacturing unit needs to comply with nearly 70 laws and regulations. At the same time, these units sometimes need to file as many as 100 returns a year.

Furthermore, India has 150 state level-labour laws and 44 central-level labour laws.
GST will force informal firms to go formal, the question is, will they? It really depends on whether it will be viable for them to do so. Instead of going formal, they may simply decide to shutdown. This is also a possibility, which the media seems to have taken great care not to talk about. How this will play out, no one really knows and only time will tell.

If GST has to be a real success then the ease of doing business in India needs to start improving as well. Nothing much has happened on that front.

If the informal firms shutdown, how is the situation likely to play out? Many people will end up losing jobs and this will have an impact on consumption and economic growth.
Will the smaller formal firms cash in on the situation by expanding their production and recruiting more people? Again, it’s not so easy. The average Indian manufacturing firm is very small. In many cases, it employs even less than ten people.

Many formal firms continue to want to stay small so that they don’t come under the ambit of labour laws. As Jagidsh Bhagwati and Arvind Panagariya write in India’s Tryst with Destiny: “The costs due to labour legislations rise progressively in discrete steps at seven, ten, twenty, fifty and 100 workers. As the firm size rises from six regular workers towards 100, at no point between the two thresholds is the saving in manufacturing costs sufficiently large to pay for the extra costs of satisfying these laws.” Panagariya is currently the Vice Chairman of the NITI Aayog.

The situation will end up benefitting the larger firms who will end up capturing a larger portion of the market. And this will give them pricing power as well. Of course, it will mean more taxes for the government, which can then continue with its many boondoggles or create newer ones.

Also, it is worth mentioning here that while the owners of firms working in the informal economy don’t pay taxes, those working in these firms do pay their share. Most of these workers earn lesser than Rs 2.5 lakh. Hence, they don’t come under the ambit of income tax. When they spend the money that they earn they pay indirect taxes. Also, the money they spend is income for firms operating in the formal economy, which then pay their share of income tax.

Given this, simply arguing that all informal economy is bad, is basically a very simplistic way of looking at things. Ultimately, it provides jobs to three-fourths of the labour force and that can’t be ignored. Hence, it is important that the media, economists and analysts, try to explore this other side of the GST as well.

The article originally appeared on Newslaundry on July 12, 2017.

The finance minister Arun Jaitley has been at the forefront in trying to defend the demonetisation or notebandi decision of the Modi government.

He recently said in London: “Demonetisation was a move to change the Indian normal… a new normal had to be created. A predominantly cash economy has now to be substituted with a digital economy, which will bring more money into the banking system and lead to better revenue generation; the integration of the informal economy with the more formal one is now taking place… The post-demonetisation regime is actually going to generate a far bigger GDP in the long run.” He also said that the arguments being made in favour of the cash economy were absolutely trivial.

There is much that is wrong with the above statement, but in this column, I would like to just concentrate on the part that I have marked in red in the above paragraph. Before we get into anything else it is important to define the meaning of the term “informal economy”. Here is a basic definition. It is that part of the economy which is not really monitored by the government and hence, it is not taxed. But there are several nuances to this as well, which we shall see during the course of this column.

In Jaitley’s binary world, the formal economy is good because it brings in tax to the government, and the informal economy is bad, because it does not bring in tax to the government. Demonetisation has managed to create a cash shortage which Jaitley believes will force a large section of the informal economy to move towards becoming formal and allow the government to tax them.

The trouble is economics is never so straightforward. As economist Jim Walker of Asianomics wrote in a research note: “There is nothing intrinsic that says that the informal economy is a less effective or beneficial source of activity than the formal economy.” Allow me to elaborate on this.

Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a recent research note: “India’s informal sector is large and labour-intensive. The informal sector accounts for ~40% of India’s GDP and employs close to ~75% of the Indian labour force.” The point is that the informal sector forms a significant portion of India’s economy and employs three fourths of India’s workforce. There are other estimates which say that the informal sector employs more than 75 per cent of India’s workforce.

Hence, notebandi has ended up disturbing 75 per cent or more of India’s labour force. The cash crunch that has followed has severely disrupted the informal sector. As Mukherjee and Shekhar write in a recent research note: “Panipat in Haryana is the textile hub of North India. It is a ~Rs 31,000 crore industry with Rs 60,000 crore worth of goods being exported. It employs ~350,000 labourers. Whilst our interviews suggested that the export-focused units were largely unaffected, the domestic component of the industry saw business fall by 40-80% as this component of the business is more cash-reliant. As a result, almost half of the 350,000 labourers employed in the region have been temporarily laid off as demand has collapsed in the domestic market and there is no cash to pay the wages.” Similarly, in Tirupur, another textile hub, “the units are running only three days a week (compared to 7 days before demonetisation) due to the lack of demand,” the analysts point out.

This is something that cannot and should not be taken lightly. Jaitley in his London speech said that notebandi will lead to better revenue generation for the government. This means that the government will end up collecting more taxes.

The assumption here is that informal sector does not pay taxes. This is not totally correct. As I said the argument is slightly more nuanced than this. As I write in my new book India’s Big Government-The Intrusive State and How It is Hurting Us: “The National Manufacturing Policy of 2011 estimated that the number of Small and Medium Enterprises (SMEs) in India stood at over 26 million (2.6 crore) units. They employed around 59 million (5.9 crore) people. This means that any SME, on an average, employed 2.27 individuals. The Boston Consulting Group estimated that 36 million (3.6 crore) SMEs (or what it calls micro-SMEs) employ over 80 million (8 crore) employees. This means that any SME, on an average, employs 2.22 individuals.”

What this clearly tells us is that the size of an average Indian SME is small, in fact, very small and it is a part of the informal sector. They employ around 2.2-2.3 individuals on an average. These firms basically employ the owner and one more person, on an average. Interestingly, nearly two-thirds of these firms are own-account enterprises without any hired workers.

The contention is that these people who are a part of the informal economy do not pay any taxes, this includes income tax. The question is do they need to pay an income tax? Let’s look at some data. Take a look at Figure 1. It shows the money being made by different categories of people.

Figure 1:

Take a look at the self-employed (remember two-thirds of small and medium enterprises in India are own-account enterprises without any hired workers). 96 per cent of self-employed earn an income of up to Rs 2,40,000 per year. Individuals come under the tax bracket only if they earn more than Rs 2,50,000 lakh per year.

Almost 100 per cent of the casual labour which works in the informal sector earns an income of up to Rs 2,40,000 per year. Hence, a major part of the individuals who work in the informal sector do not need to pay income tax. Given this, even if the government was in a position to collect income tax from these individuals, it wouldn’t be able to do so. The point being informal economy does not necessarily mean black economy.

Also, it is worth mentioning here that when these individuals who form a bulk of the informal economy spend the money they earn, they do pay indirect taxes which are built into the products being sold. Over and above this, the money they spend is an income for companies and individuals who are a part of the formal economy and pay income tax. Long story short-the situation is not as simplistic as Jaitley wants us to believe.

Having said this, it does not mean that the entire informal sector is kosher. There are individuals and enterprises who need to pay tax but they aren’t. It is these individuals and enterprises that the income tax department should be going after.

Also, more revenue for the government and going cashless doesn’t necessarily mean a good thing. As Walker puts it: “There is every reason to worry about the fact that moves towards a cashless economy will benefit banks (transactions cost) and governments (more taxes). The apologists for demonetisation were keen on the fact that it might prove to be an easier way for government to collect revenues. Governments come and governments go and one thing is for sure, they do not all spend money wisely. Giving them more access to individuals’ money is demonstrably not unequivocally a ‘good thing’.”

And that is something worth thinking about.

The column originally appeared on Equitymaster on March 2, 2017

The Other Side of GST

Mr Jaitley, Informal Economy Doesn’t Necessarily Mean Black Economy