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Informal Sector And The Growth Funnel
Amal Sanyal, Department of Accounting, Economics and Finance, Lincoln University  New Zeeland  5/30/2011 1:46:56 AM

Why have recent high rates of growth failed to create noticeable effects on India’s poor people? Why is the funnel through which the proverbial ‘trickle’ is to drop down so constricted? I will like take up one of the reasons here. It is a structural feature of our economy, the informal sector.
The informal sector usually refers to units with the following features. They are engaged in production with the primary goal of generating employment and income for a group of persons, rather than profit. They work on small scale with non-contractual employment mostly based on kinship and personal relations. Often the supply of labour and capital cannot be clearly distinguished. In most cases production activity is difficult to separate from other economic activities of the persons involved and hence production accounting is blurry. Concerned persons raise finance at their own risk and are fully liable for any debts and other payables. I will stretch the scope of my discussion a bit by including small units that do produce for profit but share most of the other features mentioned above. I will use the phrase informal sector to refer to this bigger group.

We do not have good estimates of the size of the informal sector’s output and employment. But there is statistical information on the unorganised sector which, as defined by the National Commission for Enterprises in the Unorganised Sector (NCEUS), includes all private unincorporated enterprises employing less than ten workers. This includes several types of units in which we are not interested in this essay, like cooperatives, trusts, private and limited companies. The informal sector as I described above is a subset of the unorganised sector of NCEUS. Based on 2004-2005 data, NCEUS estimated unorganised sector employment around 393 million of the country’s total employment of 457 million for that year. From the same sources, 50% of the GDP came from the unorganised sector. It would mean that unorganised sector labour productivity was around a sixth of that of the organised sector. Even if we leave agriculture out, which hardly produces any formal employment, 72% of Indian work force was in the unorganised sector. There is no reason to believe that the ratio of unorganised and organised employment and that of their productivities have changed very much in the last few years. Further, we should expect labour productivity and income of the informal part of the unorganised sector to be less than the unorganised sector average. This low productivity is directly reflected in the abysmally low income of a large majority of our employed work force.
Let us look at the informal sector units along the ascending order of their operating surplus. Those at the bottom end: farm labourers and the so-called ‘own-account enterprises’ like rickshaw-pullers, street vendors, and others in similar activities form the bulk of the people below and close to the poverty line. Those with somewhat more (but nevertheless very low) operating surplus work with family labour and a few outsiders hired at abysmally poor wage rate. From this end as we move towards higher levels of operating surplus, wage does not increase all that much. Relatively prosperous informal units that work for profit in construction, food processing, garments, gems & jewellery, leather goods, restaurants, transport and retail trade are notorious for the low wage, poor working conditions and the lack of employee benefits.

It is expected that rapid income growth, like we are experiencing now, would generate effects outside the sectors where the initial stimuli originate. The transmission of growth from the formal to the informal sector, if there is any, has been termed as trickle down. The transmission is expected through consumption demand and the demand for production inputs. Also, the growth of infrastructure, transport and communication in the organised sector and any improvement of governance services are expected to create supply side effects. All these effects have been working within the formal economy over the last two decades. But they have failed to create comparable effect in the informal economy. Hence the widespread belief that the so-called trickle down does not work.

However the transmission of demand from the organised to the informal sector has not been entirely absent. But this demand fails to create much income change in the informal sector. Let me outline the strands of the transmission process to explain why the increase of demand fails to raise income significantly.

(i) Income growth in the organised sector creates consumer demand increase for several informal sector products. Relevant goods and services include transport, retail services, eateries, processed food, and garments and so on. But this does not produce proportionate impact on poverty for several reasons. First, value added as a ratio of price being very low in these activities the demand produces a relatively small change of income. Secondly, the increase of demand attracts more own-account producers to join informal production. For example rapid growth has led to an explosion in the number of rickshaws in our smaller towns; the same is true of street vendors, road-side eateries, domestic help and so on. As long as a local market allows income to exceed the reservation income, it tends to attract more actors. Hence in equilibrium, the income of own-account producers remains at that reservation level close to subsistence. Thirdly, in most cases entry require the permission of local mafia or political bosses and hence new entrants have to part with some income. Further, they rarely own the ‘means of production’— the rickshaw, the hand cart, the three-wheeler or the taxi for example. These are owned by renters to whom they have to surrender a part of the income. The result is that a significant part of the increased income is siphoned out, leaving the workers not much better off.

(ii) Like consumption goods, there is also increase in the demand for informal goods and services to be used as input into formal production. Agricultural goods in general, processed food, fruits, flowers, forest products, handicrafts and a variety of ethnic and cultural items are used as inputs in formal sector. But because of the relatively low value added the effect on informal income, and particularly wage income, is not significant. Similarly, services like security, local transport, hosting and event management, cleaning and laundry, cooking etc are bought by the organised sector as inputs. But these services are mostly provided by informal enterprises that employ contract workers on very low wages.

(iii) A range of informal enterprises link more directly with the formal sector. They are small units working for profit. They produce items like auto parts, electronic goods, metal products, and engineering goods and provide services like repairs, assembly, printing, copying, and publishing and so on. We come across two types of relations here. In one they supply the products which are then processed by the formal sector. In the other, they produce as sub-contractors for formal sector firms. In spite of these linkages, the benefit generally fails to trickle down significantly because of the small wage component in value added. We should note that many of the small profit-making units are in the informal sector by choice. A major reason is to escape the organised sector wage and employee benefit norms. Increase in their activities therefore does not translate into significant increase in workers’ income and benefits.

In all cases, the transmission of income is hampered by the abysmally low wages prevailing in the informal sector, which results from low labour productivity. For formal sector growth to have more substantial effect on the majority of the working people, we need ways to increase the labour productivity of the informal sector.

To Increase Productivity
We can think of a gearing ratio to describe the relation between the growth of the organised sector and the resulting effect on the informal sector. We can define it as the incremental growth of the informal sector income attributable to one percent   growth of the organised sector. To get more from the organised sector growth we need policies for increasing this gearing ratio. I will discuss the broad outlines of a number of strategies. Their details need to be thought out at the level of application as the challenges at the ground level can hardly be anticipated. Relevant policies would be different depending on the income status of the units. I will start from the poorest.

Farm Labour and Own-account Units: Farm workers and own account enterprises have the lowest labour productivity and are the poorest. Contributing factors are the lack of appropriate capital equipment, poor organisation of economic activity, poor health, nutrition and education. Good healthcare, nutrition and education can increase the productivity of these workers significantly. These services also work as public goods, producing external effects on the effectiveness of local governance and hence a second round effect on productivity. The services are in an appalling state almost everywhere in the country. Though significant central government resources have been made available, indifferent management and misuse of funds afflict these sectors. So it is vital to develop purposeful and effective management at the ground level.

However, healthcare and education improve productivity with a significant lag. In the mean time, it is necessary to ensure certain minimum income. For this, the political system has to give its sincere consent to a statutory minimum national wage to be accepted in all states. We also require a statutory list of minimal working conditions and enforce it ruthlessly. NCEUS too has recommended the establishment of a minimum national wage and a minimal set of working conditions. It has further recommended an insurance-based approach to living conditions, calling for a national minimum social insurance that would cover for sickness, maternity, death or accident. In the NCEUS scheme, while the minimum is to be ensured by the centre, state governments would be called upon to top it up according to their financial ability. NCEUS has also recommended an old-age pension. Given that the targeted people have little land or property, income insurance is absolutely necessary as a safety net — not just as a growth strategy but also for reducing hardship. While these measures are eminently sensible as redistributive measures on their own, I want to emphasise that I am proposing them here as productivity-improving.

At the same time we require some strategies for improving the production of own-account units. Access to finance, technology, markets and trade-specific skills need to be strengthened. These are not new suggestions and in fact have become clichés. But it is necessary to restate them as they are not available in spite of repeated pronouncements. We need to establish efficient and clean agencies to deliver them. A large amount of ground work is required to develop government level and grass root level agencies with the right incentives and checks and balances. I will elaborate on them below.

Outside the Own-account: Small Firms: Small units in the informal part of the economy form the backbone of a number of important industries, like forestry and fishing; wood, wood products, furniture and fixtures; textiles and clothing; leather goods and substitutes; construction; beverages and tobacco products; plastic goods. They produce substantial share of output, employment, as well as export. But in spite of it, they transmit the formal sector growth process with but a very feeble gearing ratio. These units are known to be extremely competitive. But, unfortunately, competition is handled by wage repression and avoiding any spending on working conditions. Typically, the response to a rush of demand growth in these units is to stretch working hours and employ more underage workers at lower wage. Hence though formal sector growth creates increase in informal output, it does not create much income rise for the poor working people there.

With some exceptions, these units adopt wage repression as a way of business because they cannot afford new capital and technology to enhance their competitive edge. This in turn happens because they are cut off from the organised capital market. Financial institutions are wary of lending to unregistered units with scarcely anything to secure their loans with. Exclusion from organised finance results in worn out plant and machinery and lack of technical and organisational improvement. The only exceptions are units that subcontract for bigger firms or produce parts for them. They are helped with finance and technology by their collaborators. But it is the others that are more numerous. They have been in difficulty since liberalisation as they find it difficult to compete with imports with their outdated technology and equipment. Even when they manage to keep the cost and price down, they fail to match quality. While the decline of the struggling toy industry is well-publicised, that is not the only industry that has been challenged by imports.

To create an inclusive growth process we have to transform these small informal units into a vibrant group of forward looking, technologically up-to-date smart small firms. Small scale production can be very nimble and can pioneer new practices as the experience of a number of Asian countries show. In India too we have isolated examples of excellence and technical and managerial breakthrough among many small units. We should aim to bring the entire small-scale informal sector up to that standard. This can improve the gearing ratio between the formal sector growth and that of the rest of the economy dramatically. It requires a package of effective measures to provide access to finance and technology and assistance with skill development and upgrade.

There exists a range of agencies of the central and state governments as well as those run by NGOs for assisting with these issues. But it is fair to say that they do not measure up to the task, and very few are at all effective. In most instances the agencies are afflicted by the country’s general problem: disinterested and corrupt officialdom and political favouritism. Nor are the agencies organically related to one another so as to develop a co-ordinated vision or program. We require more integrated and visionary institutions. One possibility is to set up working stations at major habitats of small informal industrial units to attend to industry clusters in an integrated way. The stations should be multipurpose in nature, attending to finance, technology, marketing and managerial issues. They should be staffed by business/ commerce graduates and experts in the production/technology of the products of the given cluster. Stations in a wide geographical area should be laterally connected with regular exchange of case experience and data, and should be part of a bigger regional organisation. Their work should include consultancy, counselling and persuasion even as they provide connection with financial institutions, technology, markets and business practices. They would not only liaison with local banks but also draw up strategies, together with the banks, for successful lending activity.

All this cannot be achieved without registration of the units and giving them formal identity. Registration, identity, and establishing the ownership of units are pre-conditions for getting organised sector finance. The units should be gradually persuaded into more formal accounting and making payments including wages through their banks. Obviously, all this would require a cadre of motivated and able workers, and their remuneration and incentives should be designed to attract and retain the best. Because we are talking about such a large proportion of the GDP and jobs, we can stake a significant amount of expenditure for establishing a dedicated cadre and chain of organisations. It is easy to have a rough idea of how much we might gain in terms of GDP for any given percent   increase of the gearing ratio, given today’s parameters. That in turn would provide a guide to how much we can spend. Note that the changes would amount to modernising the economy in the true sense of the term.

Some Misconceptions: These recommendations amount to asking for ‘formalising’ our informal sector. This may not be liked by many of us who feel that modernising or formalising the informal sector would amount to losing our tradition and even our Indian-ness. First, there is a suggestion that the informal sector is necessary to preserve India’s traditional products and hence to protect the variety of its culture. It is also suggested that work and service based on personal rather than contractual relation is in some sense good as it nourishes healthy social relations. We should therefore preserve and nurture our informal sector as a matter of policy. A second idea is that the informal sector acts as a shock absorber in times of recession. Downswings would be much more severe if we had no informal sector.

These ideas are not convincing. To produce traditional, ethnic, and culture-based products and services, production units need not stay unorganised or informal. In fact better organisation, management, accounting and marketing using formal sector practices would increase not only their ability to generate more income but also their presence and profile. A very important result of industrialisation is to improve the organisation of production, for both large and small units. Successful industrialisation has progressively transformed traditional and informal production in today’s industrialised countries into organised production of higher productivity. North and West European countries handsomely illustrate that this does not result in any loss of the cultural richness of traditional goods and services.

Turning to the so-called ‘recession-proofness’, I would note that it is indeed true but that does not constitute a reason for nursing the informal sector. Recession-proofness is the result of the miserable labour productivity and income of the informal sector. It arises because a fall in formal sector income, even though it reduces demand for the informal sector, does not affect its income very significantly. For a given contraction of demand the corresponding contraction of informal sector income is much smaller. But this is just the obverse of the fact that when there is formal sector growth, informal sector income growth is much smaller. Both result from the low value added and poor productivity of the informal sector. It is odd to justify low productivity on the ground that it keeps people adequately poor so that their income would not matter much for economic cycles! If the productivity of the informal sector was to increase, surely recessions would have more ‘bite’ in this sector. But growth of the formal sector would also generate more growth here. Given that recessions are rarer than upward movement of income, the economy would gain by more formal organisation in the informal sector.

Informal units present a few other challenges for the economy and governance. The administration is powerless to regulate unregistered units who easily escape important regulations on environment and safety, labour conditions, child labour and so on. Given that the overwhelming majority of workers work in the informal sector, the inability to regulate these units leads to overall failure of regulation. Further, though most of the informal sector reflects a desperate struggle to earn just a living, there exist rogue units who use the sector as cover to escape scrutiny. They escape wage and workers’ benefit norms and taxes apart from other regulations and even steal land and power. Some of them help formal sector businesses to hide their output and profit and thus work to produce black income.

Overall, I take the position that an important step for making our growth more inclusive would be to reform the informal sector. If that is done, forums of the future would discuss horizontal income transmission across the economy, not ‘trickle downs’ — a phrase that would lose currency.  

(Mr. Amal Sanyal is associate professor in Economics at Lincoln University, New Zealand. He had also been a former holder of State Bank of India national chair on public policy, former Economic Advisor to the Ministry of Economic Planning in Mauritius and consultant in demand modeling and pricing strategy for core sectors like power, coal, petroleum and steel.

The views expressed in the write-up are personal and do not re?ect the official policy or position of the organization.)


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