To understand why reforms are needed for formalisation, we need to back up a bit and understand why India’s economy came to have such high levels of informality in the first place. In the Union Budget of 1973-74, the marginal income tax rate in India for those earning more than Rs 2 lakh was 97.75 per cent.
Let that number register. It means that for every Rs 100 earned, you can only keep Rs 2.
Of course, this was only one marker of how intrusive and burdensome India’s socialist economy was for people who were trying to earn a living. Several products were reserved for the public sector. Every product that was not, needed a license to produce. If you had a license and wanted to produce more, you needed another license.
So much so that even when customers faced a 10-year waiting list for a Chetak scooter, the government refused to let the company expand production capacity. Importing any spare part required a license and explanations to bureaucrats on why it was needed and could not be procured in India.
How would you respond to this tax and license raj if you were an entrepreneur? Any honest answer would fall into only two options: stop earning or stop telling the government how much you earn. These options explain both India’s slow growth before 1991 and the origins of India's informal economy better than any sociological theory.
The shadow economy of black money and informality was born not because Indians are inherently lawless, but because the unreasonableness of the law made it impossible to survive within it.
The reforms of 1991 took a sledgehammer to this architecture of stagnation and informality. By dismantling the industrial licensing regime, allowing freer trade with the world, and rationalising tax rates, 1991 revolutionised the daily life of the common citizen.
Almost overnight, the 10-year waiting lists vanished. Shortages turned into choices. As competition finally entered the market, the quality of goods improved, prices fell, and both formal and informal employment opportunities rose, lifting hundreds of millions of people out of abject poverty. It was a definitive demonstration that deregulation is the most potent poverty-alleviation programme we have.
The road not taken (yet)
Three decades later, while the worst of the license raj is gone, its underlying logic persists in our regulatory landscape. For small and mid-sized businesses in particular, regulation is still experienced not as a single hurdle but as a constant drag. A complex web of archaic compliances, labour, factory rules, local permits and inspections, together raise the cost of being formal.
For a small entrepreneur today, the unreasonable "tax" is therefore no longer on declared income, but on operations—a hidden regulatory tax that continues to make informality the cheaper, safer option.
This regulatory tax would be fine to accept if formality and informality were just labels with no other implications, but informality places two large constraints on businesses. One, they cannot access global markets, which are several times larger than the Indian market. Two, they cannot grow in scale and become more efficient, trapping them in a cycle where they continue to use human resources and capital inefficiently, preventing the informal parts of India and Indians from achieving their full potential.
These are serious impediments in a country where the informal sector is as large as in India, and where growth is of critical importance for raising the standard of living of the average Indian.
Completing the reform agenda
Thankfully, the government has recognised that a $5-trillion economy cannot operate on a regulatory framework designed in the 1970s. Multiple reform efforts have been launched—a deregulation task force is helping states prune the regulatory burden. A high-level committee has been set up for deregulation in non-financial sectors at the Union government. Several major steps have already been taken—the new labour codes have been implemented, and reforms have been brought about by the RBI for easier reporting by small exporters. Jan Vishwas 2.0 builds on earlier efforts to de-criminalise minor infractions. ‘Jan Vishwas Siddhant’ has been announced.
This approach signals a fundamental shift in the Indian state's philosophy. If the government succeeds in executing this shift, it can help create an India where following the law is cheaper than bribing or circumventing it. More than any mandate or enforcement drive, that shift will herald a realignment of the relationship between citizen and state.
The brakes have been on for too long. Liberating Indian entrepreneurs to create scale and jobs with dignity will accelerate formalisation and vastly improve the lives of the average Indian. All of us should cheer this process on its way.
Ahluwalia is Founder & CEO of the public policy think-tank Foundation for Economic Development (FED) and previously with NITI Aayog. Gupta is manager, policy and communications at FED.
The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.
