Formalisation is shrinking the economy

The Central government has stayed focussed on both formalisation of the economy and digitisation. Formalisation aims at bringing more of the unorganised sector into the formal fold by means of GST, making it uneconomical for others to deal with it, and ensuring registration under laws governing manufacturing and income tax. Estimates that pegged the formal sector at 45-50 per cent, expect it to now rise to 70-75 per cent within a span of five years.

The government has sought to push digitisation by linking most of its subsidies to bank accounts, opening Jan Dhan accounts, and pushing for more digitised payments across all sections.

Both have laudable objectives. They reduce incentives for evasion, provide a level-playing field for tax-compliant entities, expand the tax base so that the burden falls more equitably on all the players rather than a select few, and increase the tax-GDP ratio.

While the salutary effects are already visible, what may have missed one’s attention is that such formalisation could have inadvertently shrunk the economy leading to slower growth. Let’s examine how indirect taxes like GST may have caused this.

Effect of taxes

Our economy has been a mix of a largely tax compliant formal sector and an ‘informal’ sector with units that indulge in various levels of tax evasion and dodging of other laws. Through tax evasion, many of the informal and unorganised units across most industries were cost-competitive and enjoyed a fair share of the market. But with the ‘imposition’ of indirect taxes many of them have become uncompetitive.

It is not that all informal units will fall by the wayside. Several units in Sivakasi, Vapi, Manesar-Dharuhera, Baruch-Ankleswar, and Meerut-Moradabad industrial estates — all with a fair proportion of such informal units — are very competitive. They have a far better mix of cheap or competitive labour resource and efficient capital utilisation. Some of them will start paying taxes, and will be cost competitive even after paying taxes.

The net effect of this is that the cost structure of the previously informal sector units will go up, shifting the supply curve up. Tax collection of the government rise, which is a transfer from the pockets of surviving, previously informal, units to the government. Market prices go up and volumes adjust downwards due to price increase. This is illustrated in the graph, where the upward shift is due to better tax compliance.

Profitability of previously tax-compliant units will go up due to price increase, but that of units in the informal sector who are newly tax compliant (but still competitive) will turn worse. It is possible that a larger number of erstwhile informal units become unviable on account of the new taxes, to supply at the market clearing prices.

Economic activity

How much economic activity in the private sector will shrink will depend on the elasticity of demand of various newly tax compliant industries. Where demand is inelastic (like food and essential items) people will reallocate from other expenditure lines and maintain purchase volumes in which case volumes may not shrink much.

But in discretionary items like purchase of cars or houses, people may not substitute but postpone the decision or downgrade the quality of their purchases. People might settle for a smaller car or move farther out of city or reduce the size of purchase.

In the above case, prices have gone up from say ₹47 to about ₹56 and volumes have shrunk from 1,450 units to about 1,350 units — a fall of 7.3 per cent. If the demand is very elastic and people didn’t want to spend more than ₹47, volumes would have shrunk to about 900.

While nominal incomes may shrink or expand depending upon whether the price effect overwhelms volume reduction, in real terms there will be a shrinkage due to both price increase and volume reduction.

Effect on overall economy

Taxes need not always result in economic shrinkage. In many cases they are just a transfer from one pocket to another — government in this case. The world over, governments are more compulsive spenders and that often ends up boosting the economy also.

An increase in direct taxes (due to phenomenal increase in entity registrations under income tax) may not have any effect on the current volumes or price — it is just a reallocation of profits between the government and the enterprise. But since such taxes will reduce post-tax returns on capital employed (ROCE) and if the cost of capital also doesn’t reduce in tandem, they will impact investment demand directly — a phenomenon being observed now.

In the case of indirect taxes, it does transfer resources and if the government spends such taxes collected there should be no effect on the economy. Shrinkage in one sector will be made up by expansion in areas where government spends the taxes so collected.

But the current formalisation drive is an overall effort and would have most likely shrunk most of the private sector businesses, leading to shrinkage of the overall private sector economy. The government is not compensating this shrinkage by spending whatever it garners from this drive.

It has instead been shrinking its fiscal deficit (as a percentage of revenue and GDP). The fiscal deficit, which was 6.46 per cent in 2009 and 5.91 per cent in 2011, has shrunk to 3.42 per cent of GDP by 2018, indicating that a lot of the collection has been going into reducing the fiscal deficit from its previous levels. Thus when both the private sector and government expenditure are shrinking, the overall economy is bound to contract.

It is to be recognised that units in the informal sector employs more people and less capital per unit of output than the formal or organised sector, since employees can be downsized far more easily than capital assets. This also probably explains the job losses or joblessness of our growth story, more so after the formalisation drive has gathered momentum.

The writer is author of ‘Making Growth Happen in India’