The flip side of GST: its Impact on the Informal Economy

The markets are gung-ho about the shift to the goods and services tax (GST). One factor driving this optimism is the anticipated shift of business from small, unorganized firms in some sectors to organized ones. Since the latter are already in the formal economy, comply with regulations, are generally larger in size and pay taxes, the switch will be much easier for them, which will ultimately translate into increased market share.

Analysts have been preparing lists of companies that will benefit in sectors such as apparel, tiles and sanitaryware, plywood, textile, footwear, electrical equipment and appliances, and plastics and packaging. All these sectors have a high composition of unorganized firms (see chart).

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For example, analysts expect the share of the informal segment in the tiles industry to decline from 40% currently to 20%. Similarly, nearly 60% of the ready-mixed concrete market is unorganized. In the light electrical segment, more than 35% of the businesses are in the informal sector. Certainly, this augurs well for larger companies in the organized sector. This also comes at a time when volume growth has just recovered from the effects of demonetisation and corporate India is desperate for a much-awaited earnings recovery.

But the gain in market share of listed companies means a corresponding fall in the share of units operating in the informal economy. GST is sure to take a toll on the financial health of small- and medium-sized enterprises (SMEs) operating in these sectors. Economists say that the informal or unorganized sector accounts for nearly 50% of India’s gross domestic product and is responsible for more than 80% of total job creation in the country.

Many of the firms operating in this part of the economy make profits largely due to tax evasion and non-compliance with regulatory norms, which allows them to offer products at comparatively lower prices. However, in the GST-era, it will be a struggle for survival for such firms because they will be faced with taxes, lower margins and a sharp spike in the cost of compliance. Some firms in the unorganized sector may go under, while others could find their profits curtailed. 

To be sure, in some instances the two sets of companies cater to different customers, but there is always some overlap. And it is not just the manufacturers in the informal economy who will suffer but also the smaller dealers and wholesalers.

The economics of logistics under the GST regime also favour large companies in the organized sector.