The Governments Formalisation drive may be unwittingly shrinking the economy

The current government has stayed focused on both formalization of the economy and digitization. The first focusses on bringing more of the unorganized economic activity into the formal fold by means of GST, making it uneconomical for others to deal with them, ensuring registrations under various laws governing manufacturing activity and income tax laws. While informal need not necessarily mean evasion, in practice a large proportion of them were. Informal estimates which put 45-50% within formal folds are putting formal economy in the 70-75 % now within a span of 5 years.

It has sought to push digitization by linking most of its subsidies to bank accounts, opening Jan Dhan accounts, and pushing for more digitized payments across all sections.

Both have laudable objectives. They reduce incentives for evasion, provide a level playing field for tax complaint entities besides spreading the tax base so that the burden falls more equitably on all the players rather than a select few, and increase the tax-GDP ratio.

While the salutary effects are already visible, what may have missed our attention is that such formalization may have inadvertently shrunk the economy leading to poorer growth. This article examines how indirect taxes like GST may have caused this.

Effect of Taxes

Our economy was a mixture of formal and informal sector with their various levels of evasion of taxes and dodging of other laws. With the benefits of tax evasion many of the informal and unorganized units in many industries were cost-competitive and enjoyed a fair share of the markets. But with the ‘imposition’ of indirect taxes many of them have become uncompetitive (the dotted bars representing them have moved to the right and hence unable to supply the market, in the middle graph).

It is not that all informal units will fall by the wayside. Several units in Sivakasi, Vapi, Manesar-Dharuhera, Baruch-Ankleswar, Meerut-Moradabad industrial estates – all with a fair proportion of such informal units are very competitive. They have a far better mix of India’s cheap or competitive resource (Labour) and efficient capital utilization. They will survive even after paying taxes.

The net effect of this is that tax collections of the government goes up which is a transfer from the pockets of surviving informal sector units to the government. Market prices go up and volumes adjust downwards due to price increase.

Profitability of previously tax compliant units will go up due to price increase, but of those in informal sector who are still competitive will turn worse.

In the top graph 5 of the 7 units in informal sector were competitive supplying 850 units in the market of 1350 units. After formalization and recovery of taxes from all, only 3 of the previously non-tax compliant units supplying 500 stay competitive and the balance 4 with a capacity of 850 units become unviable.

The shrinking of economic activity

How much economic activity in private sector will shrink will depend on the elasticity of demand of various newly taxed industries. Where demand is inelastic (like food and essential items) people will reallocate from other expenditure lines and maintain purchase volumes in which case volumes may not shrink much. But in discretionary items like purchase of cars or houses, people may not substitute but postpone the decision or downgrade their quality. People might settle for a smaller car or move farther out of city or reduce the size of purchase. In the above case, prices have gone up from say Rs 47 to about Rs 56 and volumes have shrunk from 1350 units to about 1250 units – a fall of 8.5%. If the demand is very elastic and people didn’t want to spend more than Rs 47, volumes would have shrunk to about 900, a fall of 33%.

While nominal incomes may shrink or expand depending upon whether the price effect overwhelms volume reduction, in real terms there will be a shrinkage due both to price increase and volume reduction.

Effect on overall Economy

Taxes need not always result in economic shrinkage. In many cases it is just a transfer from one pocket to another – Government in this case. World over Governments are more compulsive spenders and it may end up boosting the economy also.

An increase in direct taxes may not have any effect on the current volumes or price – it is just a reallocation of profits between the government and the enterprise. But since such taxes will reduce post tax returns on capital employed (ROCEs) and if the Cost of Capital also don’t reduce in tendum, they will impact investment demand directly – a phenomenon being observed now. We have seen a phenomenal increase in entity registrations under income tax, while the cost of capital have been stubborn, which is most likely to have affected the investments in informal sector.

In the case of indirect taxes, it does transfer resources and if the government spends such taxes collected there should be no effect on economy. Shrinkage in one sector will be made up by expansion in areas where government spends its the taxes so collected.

But the current formalization drive is an overall effort and would have most likely shrunk most private sectors as explained above leading to shrinkage of overall private sector economy. The government is not compensating this shrinkage by spending whatever it garners from this drive. It has instead been shrinking its own level of spends (as % of revenue and GDP). Fiscal deficit which were 6.46 % in 2009 and 5.91% in 2011 have shrunk to 3.42% of GDP by 2018 indicating in a sense that a lot of collection is going into reduction from previous levels. Thus when both private sector and Government expenditure is shrinking, the overall economy is bound to shrink.

It is to be recognized that units in informal sector employ more people per output and less capital than formal or organized sector, since employees can be downsized far more easily than capital assets. This also probably explains the job losses or joblessness of our growth story, more so after the formalization drive has gathered momentum.    

 

Formalisation

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