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[Answered] What do you understand by ‘formalisation of economy’? Discuss various merits and demerits of formalisation.

Demand of the question Introduction. Contextual introduction. Body. Discuss various merits and demerits of formalisation. Conclusion. Way forward.

Formalisation of the economy means bringing companies under the regulatory regime of government and subject to laws related to manufacturing and income tax. According to Economic survey 2018, formalisation includes firms providing some kind of social security to their employees and when they form a part of the tax net.

Advantages of formalisation:

  1. Increased tax returns: Informal operations pose many challenges to the government, like the inability to raise tax revenue, collect data, and regulate firms. Formalisation leads to more tax revenues with an increase in tax-to-GDP ratio. Formalisation provides a level-playing field for tax-compliant entities, expanding the tax base so that the burden falls more equitably on all the players rather than a select few.
  2. Scale and productivity: Formal firms can more easily increase production and employment, moving to a larger, more efficient scale of operation and potentially bringing in higher revenues and profits. It helps firms get access to formal credit, comply with the law, and avoid paying fines.
  3. Social spending: Due to more revenues to the government it leads to more investment in the social sector. With increased revenue government can invest in education, health, skill development etc.
  4. Reduce black money: It becomes tough to involve in money laundering and illegal activities as transparency will increase. Due to formalisation companies have to show balance sheets and comply with rules and regulations.
  5. Labour welfare: Transitioning economy towards formality brings benefits by establishing the rule of law and provide benefits of labour laws to entrepreneurs and workers. It enforces minimum wages and proper documentation of benefits by the employer. Formal jobs also end up ensuring the dignity of labour; enable productivity improvements, as well as access to formal training.
  6. Growth and development: Formalisation facilitates doing business, improves the investment climate. This encourages growth and development of a nation.

Issues related with formalisation:

  1. Loss of jobs: In India, which currently faces an unemployment problem, the informal sector provides the vast majority of opportunities both for its youth and for people coming off the farm to earn incomes. Formalisation can lead to loss of employment due to various reasons.
  2. Skill requirement: The labour and MSMEs may lack skill and resources to comply with formal rule and regulations. For example, GST turned out to be complex to most of the small industrial units that led to loss to them.
  3. Red-Tapism: According to a 2015 study by the Centre for Civil Society, there are 44 central statutes and over 150 state statutes governing every aspect of the employee-employer relationship. The process of formalization is too burdensome and costly for small enterprises to remain competitive.
  4. Cost of compliance: Most informal sector works on low labour cost and increased tax compliance, thereby making them profitable. Formalisation would lead to rise in input and labour cost making many informal units non-productive.
  5. Ability to do business: Informal firms are able to improve their ability to do business in various many ways. For example, small entrepreneurs gain from forming effective associations with their peers. They also benefit greatly from ‘mentoring’. They cannot afford the loss of income by taking time off for training under formal rules.

The thrust of the Indian government’s policies should not be to reduce the size of the informal sector. Rather, it must be to improve working conditions for the citizens who earn incomes in the sector. Their safety at work, their dignity, and their fair treatment by employers must be the thrust of any reform.

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