July 13, 2018 Yes Institute

Formalising the informal economy

Author : Rana Kapoor, MD & CEO, YES BANK and Chairman, YES Global Institute

Note: This article appeared in the Financial Express on July 3, 2018

With GST, the incentive to operate in the cash economy shall further diminish as more industrial sectors wherein the impact has been felt relatively less are brought into the GST net to avail of input tax credit.

India has completed a year post one of the largest and most significant tax reforms in the world. The immediate gains and losses are now ready for an evaluation and analysis: the tax net has widened (45-50 lakh new tax payers) and an estimated 13% rise is seen in tax revenues compared to the pre-GST period. On the flipside, the unorganised sector has went through temporary transition challenges of higher compliance costs and disruptions in the supply chain leading to muted business growth for a few quarters. The real gains of GST shall, however, accrue in the areas of productivity gains, formal jobs and better competitiveness of the economy over the medium-to-long-term. After 12 months of consensus-led tweaks, some aspects which shall have a larger socio-economic impact in the long run are slowly emerging:

A wealth of credible data:The numbers have been largely based on anecdotal reconciliation in the informal economy due to a lack of reliable data points, instead of hard, reliable, scientific data sets. Some state governments, for instance, have struggled in the past with exact figures on the quantum of exports emanating out of their geographical boundaries. The GST mechanism is throwing up a great deal of extremely valuable and high quality information, which would quantify the formal-informal, state specific production and exports, point of origin of goods/services, and other economic data which shall enable better policy making and governance.

Formal jobs: There are two aspects to growth in formal jobs. The first is reflected in the addition of ~4 million salaried people to the EPFO list in the eight month period from September 2017 to April 2018, as firms put aside higher sums for employee payouts in line with gross value created (which becomes a known variable by the input tax credit claimed). In effect, most people who were hitherto denied social security benefits are now getting their due as they become part of the formal economy. The other effect is going to be felt in the medium to long-term as ‘unorganised’ firms enter the GST net or cede production to formal enterprises, driven by the incentives of claiming input tax credit or by them being forced to comply with larger vendors.

Formal skills: The growth of formal jobs is the first quintessential requirement for building a ‘skill wage premium’ and the improvement in quality of jobs. The ‘Skill India’ campaign can only be successful if we aim at building sustainable competitiveness of the Indian industry through skilled workers, higher productivity and value addition. With GST, the incentive for firms to remain small and unorganised has reduced. The incentive to operate in the cash economy shall further diminish as more industrial sectors wherein the impact has been felt relatively less, such as the building material and plastic goods industries, are brought into the GST net and the remaining loopholes to evade taxes are plugged.

Formal credit: As a result of a much improved digital footprint of MSMEs, they now become attractive clients for banks and NBFCs, and hence, the inefficiencies of the informal money lending system will get eliminated. The cost of credit for MSMEs is decreasing meaningfully for recent entrants to the formal credit system as the mix between mortgage and cash flow-based lending shifts towards the latter. Companies are also assisted by lower logistics costs as interstate taxes and checkpoints are abolished and the overall tax burden starts declining over time as the base swells.

Having counted the benefits, there is still some ground to be covered to simplify the system so that it can enable an ‘ease of doing business’ for the microenterprise; some of them are already in the pipeline including a single form for tax filing, further rationalisation of slabs and the streamlining of the e-way bill mechanism.

The way I see it is that, historically, businesses in India have operated in cash and kept a tab on employee cost to retain the global competitive edge and tide over obvious constraints in logistics, infrastructure, higher and inefficient taxation and procedural delays. As per IMF and World Bank statistics, compensation of employees as a percentage of total expenses is one of the lowest in India (8%) compared to similar developing countries (Indonesia, Bangladesh, Philippines), where it ranges between 16-36%. A helping hand from GST has partly addressed the issues. As the other metrics of the ‘ease of doing business’ come together, we shall move towards a more productive and higher value-added economy to generate prosperity for a billion-plus Indians.