Daily Answer Writing
01 November 2021

Q. The Pandemic has led to an accelerated formalization of the economy. In this context, is the shrinking informal economy necessarily beneficial to the development of the India prospects? (250 words)

  • Source: The Hindu - Page 9/News - Informal sector shrank sharply in 2020-21’, The Indian Express - Page 1/Front - In three years, informal economy down to 15-20% from 52%, says SBI report
  • GS 3: Employment
  • Based on a similar question asked in 2016.


Approach Answer:

Introduction: A recent State bank of India report concluded that that the share of the informal economy may have shrunk to no more than 20% of the economic output from about 52% in 2017-18. This has been attributed to the Pandemic which forced to government to impose lockdown and forced the businesses to shift their processes online. About ₹1.2Lakh Crore of economy has been formalized.


Impact of Formalization of the economy -

Benefits in development prospects:

    • Reduced black money: The digitalization reduces the flow of cash economy which reduces the black money.
    • Increased tax collection: Tax collection is increased when all transactions are digital. It is difficult to hide the transactions.
    • Higher efficiency in business processes: Digital transactions as well as other processes are cheaper in the formal economy. Convenient mode of payment - It is less time consuming.
    • Digitalization and Financial Inclusion: It would benefit not only the businesses but also the labours which would be more visible to the government.
    • Increased transparency and Planning in Welfare schemes: It would be easier for the government to plan for its schemes and plug the leakages.
    • Contract enforcement - Robust legal Protection: It becomes easier to provide proofs in of various transactions in the formal economy which reduces the litigation.
    • Job Security & protection of labour rights: due to increased visibility by the regulatory and government agencies, rights are produced in the formal economy.
    • Increased growth: All these factors like contract enforcement, increased efficiency and financial inclusion would lead to better growth.


Challenges of Rapid formalization:

    • Lack of digital literacy: about 50% of the Indian population do not have access to internet services which makes it difficult for the smaller businesses to access the formal economy.
    • Compliance costs - Disadvantage for smaller businesses: Smaller businesses have to bear higher compliance costs to bear for the set-up of GST and other registrations.
    • Disruption in the existing supply chain structures: Further, the input-credit system pushes informal players out of the supply chain as formal businesses prefer GST compliant businesses.
    • Creation of two Indias:  The cash transaction based smaller businesses face increased isolation from the formal economy.
    • Impact on Agriculture: Majority of the transactions done by the farmers are in cash such as payments to the labour, buying of seeds and fertilizers and sale and purchase of agricultural commodities. Formalization might be beneficial more to the bigger players rather than the smaller ones.
    • Frauds: the formalization of payment system have seen rapid rise in the number of online financial frauds.


Conclusion: The formalization of the economy is an essential step in the direction of the long term growth prospects of the country. However, the transition towards formalization is a painful step if done suddenly, as it would give little chance to the weaker sections of the society to adjust to the new reality. Better approach would be to increase the pace of financial inclusion and digital literacy to deal with the negative impacts of formalization.

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