India’s Shadow Economy Needs Fixing, but How?

India’s government faces a number of complex economic decisions as it navigates an uncertain COVID recovery and rising global inflation. Because of unique challenges that come from its massive informal economy, the country’s policy leaders may not have a lot of room to change from their current expansionary fiscal policies and deficit spending, and that has the country in a wait-and-see posture while the global economy settles.

A key determinant of India’s economic performance ahead is likely to be the disruption to a vast, but fragile, informal economy. This system comprises workers and businesses that operate outside of government regulation, may not have or offer insurance or benefits of formal contracts, and that don’t pay taxes.

Of course, an informal economy is not endemic to India. Most APAC countries depend on informal systems of trade and labor, and the sorts of contracts used in India would look familiar around the region. That said, India’s share of informal economic dependency is bigger by comparison, and its problems may be more complex.

The Size of India’s Informal Economy

In India, it’s estimated that almost 90% of the workforce and 53% of the entire Indian economy are considered informal. Major sectors like agriculture (97% informal), construction (75% informal), and trade — repairing and foundation — (87% informal) almost completely rely on informal contracts and payments, according to figures from India’s Central Statistics Office that were taken from the Enterprise Survey, which is done every five years.

This informal economy is tied up tightly with India’s formal economy, on both the demand side and supply side.

India’s Informal Economy: Supply and Demand

Agriculture provides a good example of how the informal economy is affected by supply side: food comes from farms, which are almost completely informal, into mostly informal shops and goes out into the system. If the distributors up the prices, or if the shops charge more, the whole economy takes a hit, particularly the urban informal workforce because food accounts for a big part of monthly budgets. Supply of migrant labor is another link with the formal sector, particularly in construction and various services.

For the effect through demand, look to the construction industry where businesses, contractors, and subcontractors working in the informal economy shell out for expensive, durable goods in order to participate in formal economy activities, like building homes and offices. More broadly, aggregate consumption (and investment) expenditures depend upon purchasing power in the hands of workers, most of whom are in the informal economy.

India’s Informal Economy: Good or Bad?

There’s plenty of debate about whether India’s informal economy is good or bad. Some see the issue as purely fiscal and argue that the shadow system should be eradicated so that the government can reap the tax revenue, and workers moved into jobs with higher productivity and wages.

Others frame the informal economy in social terms and say the jobs available to individuals in these informal structures act as a sort of safety net because much of the work is low-skilled, and the businesses are of the mom-and-pop variety. They argue that the informal economy offers opportunity for unskilled, transient, and migrant workers, and keeps many families from falling into destitution and extreme poverty.

If the jobs and businesses that make up India’s informal economy were to disappear, India’s government would have myriad social welfare issues to solve, such as unemployment, job retraining, healthcare, and increased poverty. Providing relief could be quite expensive from a public investment view, and an inferior option relative to creation of sustainable jobs, but growth needs of the informal sector need to be addressed. A worsening income inequality problem over a sustained period can pull down growth rates for any economy and, in extreme cases, can spill over into discontent and have fairly serious consequences for any country.

The demand side of the economy requires more immediate attention from policymakers. A decimation in the informal workforce would lead to diminished purchasing power among displaced workers and business, which is more than a simple transactional dilemma. It has a lot to do with aggregate private investment into India’s economy, a necessary growth engine.

Private investment is recovering to some extent because of better positioning of the formal, larger firms in the economy, but if those firms don’t see adequate consumption and adequate aggregate demand going forward, the investment on the private side may not come.

Many Indians have already been caught up in the country’s economic shifts. For years, India’s informal economy has been experiencing large-scale disruption in the retail sector from big-box digital platforms like Amazon and BigBasket, which make it impossible for mom-and-pop retailers to compete.

This disruption started before COVID-19, but the pandemic exposed the fragility of the shadow system in more than just retail. Many jobs and firms from across the informal economy are lost forever.

What India can do to change this trajectory isn’t clear because of the lack of a robust growth path and employment generation even as its government is faced with fiscal constraints that are well known.

Over the last two years, the government has adopted an expansionary fiscal stance and accommodative monetary policy. The result has been that the deficits have widened considerably and its debt-to-GDP ratio has increased by almost 20% to 30%. It’s now about 90% of the GDP.

The good news for India is that from a debt sustainability point of view, the country is seen as having some space to continue running on deficits and on relatively looser monetary policy for at least another year or two — provided there is a credible and coherent plan for reducing the deficits going forward and growth to match.

A lot of that will have to do with rising interest rates and tightening monetary policies around the globe.

If India grows faster than interest rates, then it should have fiscal space needed for the pandemic recovery and to continue with public investment. In short, the government seems like it will stoke the demand side, hoping to grow out of increased debt.

The concern with this stay-the-course approach will be inflation, which is rising but not yet urgent. If inflation stays in the 5% to 6% range, the government may be willing to bite that bullet if it can manage enough growth.

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About Pradeep Srivastava

Pradeep Srivastava was previously Country Director at Asian Development Bank. Prior to this, he held the position of Principal Economist at Asian Development Bank. Before this, Pradeep held the position of Senior Economist and Economist at Asian Development Bank. He has also held the role of Chief Economist at National Council of Applied Economic Research (NCAER). Other roles have included Economist at The World Bank Group and Associate Lecturer in Economics at Harvard University.

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This global economics article is adapted from the GLG teleconference “Divergence in India’s Recovery: A Persistent Informal Economy, Inflation, and Other Challenges Ahead.” If you would like access to events like this or would like to speak with like Pradeep Srivastava, or any of our approximately 1 million industry experts, please contact us.