The Road to Economic Prosperity: Why Formalization Matters for India

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India's informal sector employs over 90% of its workforce. (Image:The New York Times)
 Introduction: Formalization of the economy refers to the process of transitioning economic activities, businesses, and workers from the informal (unorganized) sector to the formal (organized) sector. According to Citi Research (2024), the formal sector's share in India's GDP has risen to 56% by 2022, a significant jump of over 25 percentage points in last four decades.

The graph depicts a consistent rise in the share of the formal sector in the Indian economy from 1981 to 2022. (Image:Citigroup)
Key Characteristics of Formalization:

  • Better Registration and Legal Compliance:
  1. Systematic registration of businesses with government authorities, involving obtaining licenses, permits and unique identification numbers (e.g GSTN in India).
  2. Compliance of businesses with a wide array of laws and regulations such as company laws, tax laws, labour laws, environmental regulations, health and safety standards and intellectual property laws.
  • Expansion of Tax Base and Revenue Generation:
  1. Tax base becomes broader as more economic activities become traceable and subject to direct and indirect taxes.
  2. The expansion of tax base results into a significant rise in government revenue which can be utilized for various purposes including public services, infrastructure development, and social welfare programs.
  • Formalization of Employment and Social Protection Measures:
  1. Workers progress from informal to formal employment contracts with definite terms and conditions.
  2. Workers acquire access to social security benefits, encompassing provident fund, Employee State Insurance, pension schemes, gratuity, along with ameliorating working conditions.
  • Enhanced Access to Formal Financial Systems:
  1. Businesses and individuals gain access to affordable formal credit from banks and financial institutions, clearing the way for investment.
  2. Transitioning from cash-based transactions to digital payment methods (e.g UPI) enhances transparency and contributes to the integrity of the financial system.
  • Improved Data Collection and Policy Making:
  1. Registration of more and more economic activities enables the government to have access to comprehensive data on employment, output, investment, and consumption, aiding in policymaking.
  2. Evidence-based targeted policies can help achieve economies of scale, engendering higher efficiency and lower unit costs.
Hurdles to Economic Formalization in India:
  • Structural Challenges:
  1. The immense size of India's informal sector, employing over 90% of the workforce, makes large-scale formalization extremely difficult.
  2. Workers and businesses in the informal sector lack proper documentation which impedes their effective regulation as highlighted by the e-Shram portal.
  3. Most informal units operate on thin margins that constrain their ability to absorb additional costs stemming from the process of formalization such as compliance costs, taxes and social security contributions.
  • Economic Constraints:
  1. Compliance with formal sector regulations (e.g registration fees, maintaining records, filing taxes etc) involve considerable upfront and ongoing costs which small business units often find prohibitive.
  2. Fear of taxation, scrutiny, audits and potential penalties disincentivizes small informal firms to join the formal sector.
  3. Limited access to formal avenues of credit due of lack of collateral acts as a drag on the informal sector's willingness to formalize.
  • Social and Behavioural Barriers:
  1. Deep-rooted resentment against the administration because of harassment, endemic corruption and punitive measures generates resistance in the informal sector against formalization.
  2. Women, comprising a majority share of the informal sector, often encounter additional gender barriers including lack of childcare, gender-based wage discrimination, and limited access to information or resources.
  3. Challenges remain in terms of ensuring the portability of social security benefits across different states for the highly mobile informal workers (e.g migrant workforce).
  • Administrative Issues:
  1. Complex and overlapping regulations produce confusion for small businesses to navigate, without proper guidance.
  2. Inconsistent and weak enforcement of labour laws allow informal businesses to continue operating outside the formal framework.
  3. Exclusionary eligibility criteria in some government schemes (e.g requirement for EPFO track record), designed to promote formalization, unintentionally leave out a large share of informal enterprises.
Key Initiatives and Strategies:
  • Financial Inclusion and Credit Access:
  1. Pradhan Mantri Jan Dhan Yojana (PMJDY): Provides universal access to banking facilities including zero-balance bank accounts.
  2. Pradhan Mantri Mudra Yojana (PMMY): Provides collateral-free loans up to ₹10 lakh to non-corporate, non-farm small/micro enterprises.
  3. PM Street Vendor's AtmaNirbhar Nidhi (PM SVANidhi): Provides collateral-free working capital loans to street vendors affected by COVID-19 pandemic.
  4. Stand-Up India Scheme: Promotes entrepreneurship among women and SC/ST communities by facilitating bank loans for setting up greenfield enterprises.
  • Taxation and Business Regulation:
  1. Goods & Services Tax (GST): Implemented in 2017, GST replaced a fragmented indirect tax system with a unified, nationwide tax.
  2. Digitization of Payments (UPI, BHIM etc.): Increases traceability and transparency in financial flows by reducing reliance on cash transactions.
  • Labour and Social Security: 
  1. e-Shram Portal: Creates a National Database of Unorganised Workers (NDUW) seeded with Aadhar in order to register all unorganized workers, including migrant workers, gig, and platform workers.
  2. Four Labour Codes aim to universalize minimum wages, simplify trade union rules, provide universal social security coverage to both organized and unorganized workers and deal with safety, health, and working conditions.
  3. Pradhan Mantri Shram Yogi Maan-dhan (PM-SYM): Provides an assured monthly pension of ₹3,000 after attaining the age of 60 years to unorganized workers with a monthly income of ₹15,000 or less.
  • Skill Development and Entrepreneurship:
  1. Pradhan Mantri Kaushal Vikas Yojana (PMKVY): Provides skill training to youth to enhance their employability, including certified skills.
  2. Prime Minister's Employment Guarantee Programme (PMEGP): Provides financial assistance for setting up new micro-enterprises in the non-farm sector, promoting self-employment and the creation of formal small business.
  3. PM Vishwakarma Scheme: Provides end-to-end support to artisans, including recognition, skill upgrading, credit and marketing support. 
Way Forward:
  • Offer direct financial incentives, tax rebates and subsidized access to technology to businesses willing to formalize.
  • Implement a truly unified digital platform for business registration, tax filing, and labour law compliance.
  • Simplify bankruptcy procedures to encourage ease of exit for foreign business units.
  • Promote cluster-based formalization through tailored formalization strategies, involving common facilities, market linkages etc.
  • Provide widespread, affordable, and accessible training in digital literacy and the use of digital payment platforms and government portals.
  • Ensure robust data collection and comprehensive surveys to accurately map the size, structure and challenges of the informal sector.
Conclusion: Effective formalization requires a multi-pronged, agile and humane approach. By fostering an ecosystem that encourages growth, provides protection, and enhances productivity for all economic actors, India can truly unlock its demographic dividend and build a resilient, inclusive, and transparent economy capable of achieving its long-term development aspirations.

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