Thursday, 11 July 2013

Informal Economy

INFORMAL ECONOMYThe article was published in the money matter on june 10, 2013 
 Debunking myths 
 By Ali Kemal 
The informal sector is considered the backbone of the economy since it provides basic intermediate goods to the formal sector. For the most part, it features small scale industries while large and medium enterprises are part of the formal sector. In 1990, Kibria wrote, based on the findings of a survey, that there are about 20,000 engineering units in the informal/unorganised sector, which provide 37 types of machine tools and 30 different types of chemical and acid plants. Approximately 500 small units provide components which are used in assembling tractors.

Among several misconceptions, two important ones related to the informal sector beg clarification. First, a study carried out at PIDE by Kemal and Qasim in 2012 estimated the undocumented economy stood at 91.4 percent in 2007-08. It includes part of the informal activities and the rest of them are included in the documented economy in the economic survey (such as small scale industries, transport, wholesale and retail trade, private sector construction, and social and personal services).

The second misconception is related to tax payments by the informal sector. A study by Kemal and Mahmood at PIDE in 1993 says that it is sales tax exempt but people working in the informal sector pay income tax. Moreover, goods they buy to produce further goods already include sales tax which is paid in the process of purchasing those products. Thus the notion that informal activity is entirely outside the tax net is false.

The fact that people operating within the informal sector do not pay sales tax does not imply that the informal sector is a bad thing. Informal activities begin with little investment and are usually smaller in scale. Thus paying taxes and being subject to several regulations increases the cost of doing business, which eliminates the competitive advantage they otherwise enjoy. Moreover, if the informal sector is also documented and comes under the tax net and regulations then downstream industry will acquire intermediate goods at higher prices.

For various reasons, labour in the informal sector receives lower wages. The lower wages also help the informal sector remain competitive by bringing down the cost of production. It is generally believed that the informal sector provides a better way to distribute wealth in the community because it does not ask for subsidies or other extra benefits. One of the strongest points in favour of the informal economy is that entrepreneurs have their own ideas and they take risks by investing their own money into the business.

The formal sector has limited capacity to absorb labour due to regulation and need for more skilled labour. However, this may not be the case with the informal sector. For this reason, migrants who move from rural to urban areas in search of work are easily absorbed within the informal sector as opposed to the formal economy. The informal sector creates opportunities to enhance self employment and labour.

Another important aspect of the informal sector is informal training transferred by way of the traditional ustad-shagird relationship, which in the absence of vocational training institutes helps train people. However, workers are paid very little till they are fully trained or receive their ustad’s approval. Most importantly, those trained in this manner, can only work in the informal sector for the most part. This is because the skills they learn usually relate to obsolete tools which are not technically efficient or prevalent in mainstream use.

There are big question marks surrounding the growth of the informal sector – will it grow at the same rate as the formal economy or even faster? What makes us think the informal sector is growing?

Employment share is increasing over time in the informal sector. This shows more absorption of labour in the informal sector than the formal sector. Another reason why we think the informal economy is growing is an increase in urbanisation, which leads to an increase in rural urban migration. People from rural areas usually do not have skills required in the formal sector. This propels them to begin working in the labour intensive informal sector.

Small industries have been hit hard by an energy crisis since FY08. Moreover, some other informal activities must have suffered as well. However, we have been continuing to project the same growth in relation to small scale industries, which may mean overstating actual growth. Miscalculations and inflated figures are expected in the documented GDP for FY11 and FY12. Figures for the undocumented economy may decline however this is not reflected in data as data for the documented economy is overestimated. It emerges that g rowing documented GDP is just an overestimation of data for the last few years. This may be attributed to faulty data calculation. Nevertheless, it does not mean that informal activities are controlled and that controlling informal activities is not good for the economy.

The writer is a research economist at the PIDE

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