Understanding manufacturing informality employment and productivity linkages with the formal economy

Looking at data on Indian manufacturing, this paper investigates employment and productivity linkages between formal and informal firms and refutes the classical theory of Economic Dual

YSI Asia Convening, August 2019, VNU University of Economics and Business, Hanoi

Paper Theme: Urban and Regional Economics

Understanding Manufacturing Informality:

Employment and Productivity Linkages with the Formal

Economy

Author: Abhinav Verma, B.Sc (Hons) Economics and Finance, Ashoka

University, India

Abstract: This paper on spatial economic relationships explores the possibility

that the formal and informal sectors of an economy are deeply interconnected through buyer-supplier networks and through agglomeration effects Looking at data on Indian manufacturing, this paper investigates employment and productivity linkages between formal and informal firms and refutes the classical

theory of Economic Dualism Linkages are estimated by using National Sample

Survey and Annual Survey of Industries datasets that contemporaneously survey the informal and formal economy respectively at a nationally representative level Data from 2001 and 2005 is used, and the unit of analysis is at the state-industry level An OLS regression with fixed effects shows that a 1% increase in average form formal firm size in a particular state-industry category leads to a 0.083% increase in individual informal firm size In terms of productivity, the impact of formal productivity in state-industry on informal productivity is positive but not significant

Acknowledgements: I would like to thank my faculty advisor at Ashoka

University, Dr Anisha Sharma for her continued guidance, feedback, and support while I was completing this paper I would also like to thank those that took the time to discuss my topic and provide insights into areas of research Among them,

I would like to mention Mrs Sanchita Mitra: National Program Manager of Employed Women's Association (SEWA) Bharat and Dr Ajit Ghose: Honorary Professor at the Institute for Human Development, New Delhi Finally, I am truly grateful to my friends who took the time to proofread my paper and provide invaluable feedback

Self-I Introduction:

Manufacturing is an important lever of growth and a source of employment for low-skilled workers However, like in many emerging economies, Indian manufacturing has a large, unproductive, and persistent informal sector Informal manufacturing is responsible for 80%

of India’s manufacturing employment while contributing only 20% of output; these shares have remained stable over the last 4 decades (Raj and Sen, 2016) If the majority of manufacturing jobs are coming from the informal economy, it becomes important to study its relationship with the rest of the economy, and in particular with the formal sector What is the nature of the relationship between formal and informal firms? What kinds of informal firms have stronger linkages to formal firms? Does the growth of formal firms affect employment patterns in the informal economy?

Classical theories of development see informality as a transient phase – with growth, large modern manufacturing enterprises take the place of less productive, small informal enterprises The Dual Economy Model, drawing on the work of Harris-Todaro (1970) and Lewis (1954) states that the rural agricultural sector has surplus labour that is queuing to work in the urban formal sector which has a higher marginal product (Bardhan and Udry, 1999) Rural migrants that don’t get formal jobs make up the informal economy Unlike the formal sector, the primitive informal sector is incapable of saving and investment As capital flows to the formal sector, more jobs are generated and the size of the informal economy shrinks However, the transition from farm to factory hasn’t been as straightforward in developing countries Manufacturing in developing countries has a large informal component; this is true even if the country in question has a high growth rate (Moreno-Monroy et al., 2014) In South Asian alone, the informal economy accounts for 82% of total employment in the non-agricultural sector.1

This paper explores the reasons for the failure of dualism, and argues that the formal and

informal economy are deeply interconnected Using NSSO data, it is seen that the informal

economy is diverse; it does have subsistence based firms like dualism models, but it also has more productive capitalist type firms that are capable of saving and investing Moreover, it is possible that agglomeration effects are at play where informal firms that operate in close proximity to formal firms can imitate these more advanced enterprises and benefit from

increases in formal employment and productivity Agglomeration effects were first proposed

by Marshall (1919) These are positive externalities associated with clustering of firms, which makes it easier to move labour, goods, and ideas (Ellison et al., 2010) Agglomeration effects have largely been used to explain the clustering of formal firms (Combes and Gobillon, 2015) However, it can be argued that these effects might be more pronounced in the informal economy which is heavily dependent on informal buyer-supplier networks

Linkages between formal and informal firms can exist in a number of different ways A formal firm can form a vertically integrated supply chain with an informal firm – this involves the

1 In sub-Saharan Africa it is 66%, in East and South-East Asia (excluding China) it is 65%, and in Latin

America it is 51% (ILO, 2016)

formal firm subcontracting work to informal firms that can cheaply produce goods with household labour In other situations, informal firms might sell to middlemen who scout the informal economy and sell its products to formal firms Informal firms can also transact with formal firms in open-market style transactions through sub-sector networks where prices and quality standards are dictated by formal firms (Chen, 2005; Daniels 2004) Most of the work

on formal-informal linkages has focused on the role subcontracting (Mukim, 2011) However, agglomeration effects imply that formal-informal interactions occur through other channels as well

This paper estimates such linkages between formal and informal manufacturing, both in terms

of employment and productivity In the datasets used, only 27.36% of the informal firms engage in subcontracting Nevertheless, positive and significant employment linkages are found, suggesting that formal-informal linkages extend beyond subcontracting linkages It is seen that a 1% increase in average form formal firm size in a particular state-industry category leads to a 0.083% increase in individual informal firm size In terms of productivity, the impact

of formal productivity in state-industry on informal productivity is positive but not significant

What do these linkages mean for the evolution of informal manufacturing in India? A rich dataset that collects data on the different characteristics of informal firms makes it possible to study how these linkages vary with the type of informal firm It is seen that informal firms in cities have weaker employment linkages with formal firms, suggesting that informal firms that try to compete with formal firms to capture the same market eventually get crowded out Empirical studies in West Africa and India have found that formal firms tend to subcontract work to more modern capital intensive informal firms (Bohme and Thiele, 2014; Moreno-Monroy et al 2014) In line with their results, it is seen that formal firms have stronger employment linkages with informal firms that have a higher capital stock This might explain the trend of increasing capital intensity of informal firms seen in India (Natrajan et al., 2010) This suggests that labour intensity in the informal economy will continue to fall as informal firms seek formal firms to partner with Though formal firms tend to partner with capital intensive informal firms, employment linkages are stronger in the case of informal firms that are not registered with local authorities as well as informal firms that have shrunk in the recent past This might imply that formal firms seek to partner only with smaller informal firms that

do not have sufficient bargaining power In summary, formal firms crowd out informal firms that try to compete with them and subordinate other informal firms to produce cheap inputs for them Taken together, these results indicate that formal-informal linkages can negatively impact the informal economy’s ability to generate jobs

The rest of the paper is organized as follows Section II defines informality in the context of Indian manufacturing Section III explores reasons for the persistence of the informal economy and explores the possibility of formal-informal linkages Section IV describes the datasets used Section V lays out the paper’s estimation strategy to estimate formal-informal productivity and employment linkages The results are also discussed in this section Section VI concludes At the end of the paper, an appendix that contains definitions of variables used and detailed regression results

II Understanding the Informal Economy

manufacturing for example, an Indian firm is unorganised if it is not registered as per the Indian

Factories Act of 1948 (NSC, 2012)2 The unorganized sector accounts for over 80% and 99%

of Indian manufacturing employment and establishments, respectively, while contributing to only 20% of output (Ghani et al., 2015)

Is informality bad? Reigning in informality can expand the nation’s tax base Naturally, informality tends to be correlated with abysmal tax collection rates 0.32% enterprises of the total businesses registered in Philippines are VAT registered, 1.23% in Mexico, 4.2% in Turkey and 1.02% in South Africa (ILO, 2016) Lower tax collection means there is lesser money to spend on public services This also results in a sort of subsidy to informal firms, allowing them

to produce at a lower marginal cost than taxpaying formal firms However, it is not fair to judge the informal economy as a disease that needs to be eliminated If the informal economy did not exist, it is possible that there might be massive open unemployment Therefore improving the performance of informal firms can actually result in an improvement of the standard of living

in a country Raj and Sen (2016) find a negative correlation between labour productivity of informal firms and urban poverty

Heterogeneity of Informal Firms

2 The Act requires all firms engaged in manufacturing to register if they employ 10 workers or more and use power, or if they employ 20 workers or more (NSC, 2012)

The informal sector is not an amorphous pool of workers As seen in figure 1, there is significant variation in informal firm size, with a very large number of small informal firms Informal firms can also be group into different categories as defined in India Unorganized manufacturing firms in India are categorized as Own Account Manufacturing Enterprises (OAMEs), Non-directory manufacturing enterprises (NDMEs), and Directory manufacturing enterprises (DMEs) – in increasing order of firm size OAMEs have no hired workers with family members engaged in the production process

When it comes to the performance of informal firms, there are modern and productive firms that are out to maximize profits, but there are also traditional subsistence-based informal firms This distinction can be made clearer by summarizing informal firm characteristics depending

on whether or not they are registered with any local authority In table 1, using t-tests on the

available NSSO data for 2001 and 2006, it is seen that registered firms employ more workers, use more capital, have a higher output per worker, and are more likely to sell to enterprises and

middlemen as opposed to selling to individuals This heterogeneity is important to acknowledge, as it is likely that different kinds of informal firms have different relationships with formal firms

Table 1: Registered Informal Firms

Not Registered (1) Registered (2) T-test: Ha [1-2] < 0 Workers Employed 1.723 3.784 0.000

Output Per Worker (INR) 15,647.21 43,639.18 0.000

Capital (INR) 42,610 3,57,640 0.000

Maintains Accounts (y/n) 0.014 0.182 0.000

Figure 1: Histogram of frequency of informal firms for different size classes, over time The

average firm size deceased from 2.15 to 2.02 people from 2000-01 to 2010-11 Source: (Raj

& Sen, 2016, p 95)]

Formal vs Informal Manufacturing

Though the informal manufacturing firms play an important role in employment generation, they are significantly less productive than formal manufacturing firms As is

apparent in figure 2, the process of growth becomes less inclusive with the presence of

informality – in Indian manufacturing, the output per worker was 8.8 times higher for the formal sector in 1984; despite the 1991 reforms, the productivity gap went up to 14.7 by 2005 Natrajan et al (2010) find that there was a steady decline in unorganised firms’ total factor productivity (TFP) over 1994-2005 while total factor productivity grew in organised manufacturing This is troubling as it implies a diverging trend in formal and informal productivity The low productivity that is characteristic of the informal economy has clear ramifications on the standard of living of workers Further, despite high growth rates since the 1990s, there has not been a commensurate reduction in poverty (Raj and Sen, 2016) Without access to formal legal and financial institutions, informal firms also find it hard to scale up Globally, an average formal manufacturing firm employs 126 people, while an average informal manufacturing firm employs only 4 (La Porta and Shleifer, 2014)

III Why does Informality Persist?

La Porta and Shleifer (2014) note that “an average surveyed informal firm has been in business for nearly a decade without attempting to become formal.” (p 117) Moreover, firms

do not formalise unless forced to do so Attempts to pay firms to formalise and even the implementation of surprise inspections by municipal inspectors have not significantly

Figure 2: Labour Productivity Levels by Enterprise Type Unorganised firms are subcategorised Own Account Manufacturing Enterprises (OAMEs), Non-directory manufacturing enterprises

(NDMEs), and Directory manufacturing enterprises (DMEs) – in increasing order of firm size Source: (Raj & Sen, 2016, p 137)

increased the likelihood of registering (La Porta and Shleifer, 2014) However, a review of the literature makes it clear that formalisation does not mean an increase in firm productivity In fact, it is the more productive firms are the ones that find it worthwhile to formalise Further, informal firms might persist because of their relationship with formal firms and the rest of the economy

Better Firms Formalize

There is overwhelming evidence that suggests that the better firms formalize Empirical evidence from Hsieh and Olken shows that the average return to capital is not high for small firms in poor countries (98) From this pool, older firms that have grown larger and have tried and tested business models, are more likely formalize (De Mel et al., 2008) Many have tried

to solve the endogeneity problem and evaluate the impact of formalization on firm profitability There is definitely heterogeneity in the ability of entrepreneurs in the informal economy3; the story that unfolds is that firms with more able entrepreneurs are more likely to benefit from formalizing McKenzie and Sakho use the distance to the tax offices as an instrument for formalization and find that there is a strong and significant effect of entrepreneurial ability on profits (McKenzie and Sakho, 2007) Fajnzylber et al (2010) compare firms established shortly before and after the Brazilian SIMPLES program that made formalisation easier and find ability to play an important part too In a similar vein, Raj and Sen (2016) find that on average, more educated workers have larger and more productive firms Even when it comes to the registration of informal firms with local authorities, it is seen that registered informal firms larger and more productive (see Table 1)

Existence of Formal-Informal Linkages

So why don’t the more productive firms simply wipe out their informal competitions?

It is possible that there exists a symbiotic relationship between formal and informal firms A

key idea here is of agglomeration economies – the benefits that firms gain from locating close

to each other – was first proposed by Alfred Marshall in 1919 Proximity to similar firms

facilitates the reduction three types of transportation costs – those associated with moving

goods, people, and ideas (Ellision, Glaeser, and Kerr, 2010) The literature on agglomeration

largely focuses on the clustering of formal firms However, there are reasons to believe that clustering exists and might be more pronounced in informal firms Mukim (2011) makes a case for such agglomeration effects by arguing that buyer-supplier linkages and access to networks might well be more important to informal firms that do not have access to formal institutions For instance, informal firms might need formal firms to sell their products in non-local markets They might also need working capital loans from their suppliers, given that they don’t have easy access to formal credit Moreover, formal firms that have to pay taxes might seek to reduce their costs by partnering with informal firms

While analysing clustering of informal firms around formal firms, it is important to note that there can be conflicting forces at play There are the Marshallian forces that predict co-

3 Workers that voluntarily transiting into self-employment from formal sector earn substantially more than those who transition involuntarily (Maloney, 2004)

location of firms However, there can also be negative effects of clustering, where competition

to capture a market can negatively impact the performance of some firms Both Mukim and Ghani find evidence of the negative impact of clustering on small informal firms that can’t compete with larger firms Mukim (2011) finds that localization or clustering of firms within the same industry makes it less likely that new small-scale informal firms will come up in a

district Ghani et al (2015) note that one-person firms don’t put up with competition very well

From 1989 to 2010, the share of 1-person establishments is higher in districts that are smaller, less dense, and less urban, have less literate populations, worse infrastructure, larger share of SC/ST population, and larger female workforce participation

Nature of formal-informal linkages

What kind of firms do formal firms partner with? There are two contrary viewpoints – stagnation and modernization hypotheses (Moreno-Monroy et al 2014) The stagnation hypothesis states formal firms interact with more labour intensive traditional informal firms in order to minimize labour costs Formal firms have all the bargaining power which they effectively use to push down their input costs This results in a subordinate relationship where informal firms are unable to accumulate a surplus and their survivalist characteristics get accentuated In contrast, the modernization hypothesis claims that formal firms choose to partner with relatively modern informal firms in order to reduce their wage bill while ensuring that certain quality standards are met Thus, formal-informal interactions can set informal firms

on a path to modernization

There is empirical evidence to support the modernization hypothesis An empirical study conducted in six West African countries indicate that formal firms tend to partner with informal firms that have more capital stocks (Bohme and Thiele, 2014) For the first time in India, Moreno-Monroy et al (2014) use manufacturing data find evidence to support this claim.4 Raj and Sen (2016) also find evidence that formal firms are using informal firms not just as a source

of cheap labour, but also as providers of specialized inputs

IV Data Used

This paper uses repeated cross-sectional surveys on both formal and informal manufacturing firms from 2 years: 2000-01 and 2005-06 Formal and informal firms are surveyed contemporaneously during these years Data on informal firms comes from NSSO Unorganised Manufacturing Surveys conducted every five years These surveys are a rich source of information on informal firms as they record a variety of firm-level characteristics, making it possible to study heterogeneous effects Data on formal firms comes from the Annual Survey of Industries Collectively, these datasets provide a detailed picture of the manufacturing landscape of India To study formal-informal linkages, formal firm data is

4 In their approach, they create a state-industry panel of aggregate data on formal sector subcontracting and informal employment A continuous index of modernity was created for each state-industry On interacting formal sector subcontracting with the modernity index, they find that informal employment growth is skewed towards more modern state-industries

aggregated at the state-industry level Informal firm-level traits are then regressed on average formal traits by state-industry District level controls like the total population and education

level have also been added in from the 2011 Census Please refer to the appendix for a complete codebook of variables used

In order to pool data across surveys, the datasets had to be modified in a number of ways Between 2000 and 2005, the system of National Industry Classification (NIC) codes that are used to categorise industries underwent a change Further, a different system of state codes was used in the 2000 NSSO survey Both these variables were concorded across the years to ensure comparability It was also seen that new districts were carved out of old ones between 2000 and 2005 New districts were merge with their parent districts Finally, the 2005-06 datasets were adjusted for inflation using WPI multipliers The datasets were then cleaned by replacing missing values with zeros, in order to perform operations on the variables.5 Negatives and zero values of capital and gross value added were replaced with 1 before log values were calculated The data was then winsorized by making cuts at the 1% and 99% levels Following Natrajan et

al (2010) and Ghani et al (2015), data for only 15 of India’s major states was kept This accounted for around 80% of the unit-level observations in each dataset

Totally, there are 226,090 unit-level informal firm observations, of which 73.46% are from

2001 and 26.54% are from 2006 Formal firm data was collapsed at the district-2 digit industry level and the state- 2 digit industry level To study agglomeration effects, analysing the impact

of formal firm characteristics at the district-industry level on informal firm employment would have been ideal However, only 47.54% of the unit-level informal firm observations were merged with formal district-industry data points On the other hand, 99.87% of unit-level informal firm observations were merged with formal state-industry data points Hence, only the impact of formal characteristics at the state-industry level was studied

One of the limitations of matching informal firms with state-2 digit industry aggregates is that inter-industry linkages cannot be measured Studying linkages within broad 2-digit NIC industry categories is problematic because firms might be similar in some dimensions but might be dissimilar in others It is not necessary that all the industries under a 2-digit NIC code employ similar workers or sell to similar markets On the other hand, there might be strong inter-industry linkages For example, textiles and apparels are classified as separate 2-digit industries A potential solution is to add formal firm aggregate vales from each industry in a state to the regression equation Matching industries based on input-output tables can also fix this problem

5 It is important to note that this has the potential to bias the results if values are systematically missing, say if the respondents were unwilling to provide an answer or were unable to recollect specific details Since most of the missing values ought to have positive values (like wages), it is possible that the results could be biased downwards

V Quantifying Formal-Informal Linkages

Employment Linkages

As discussed earlier, there are reasons to believe that there are strong formal and informal linkages Studying the impact of formal firm traits on informal firm employment and productivity can improve our understanding of how the informal economy evolves over time

To study employment linkages, the average formal firm size for each state-industry was calculated (SIm_l_laboursit) Average formal firm size is used here, since total formal employment wouldn’t convey much about the performance of formal firms A large figure could result from many small formal firms or fewer larger ones For each state-industry, average formal firm labour intensity (labour/capital) was also calculated Informal firm level employment was then regressed on average formal firm size and labour intensity for a particular state-industry Informal firm controls and district level controls were sequentially added This helps answer the question: controlling for labour intensity, how does an increase

in the average formal firm size in a state-industry affect informal firm level employment? To study how formal-informal employment linkages vary with informal firm type, certain informal variables of interest were interacted with SIm_l_laboursit

Estimation Strategy:

l_labourjidt = β0 + β1SIm_l_labourintensitysit + β2SIm_l_laboursit + ∑k>1βkPjidt +

∑v>1βvPjidt*SIm_l_laboursit + ∑g>1βgQjidt + ∑m>1βmZdt + γs + λi + δt + εjidt

Subscripts: Firm j, Industry i at the 3 digit NIC level, State s, District d, Time t

Informal firm variables of interest P: These include whether a firm has a higher than average

capital stock, whether it is located in an urban area, whether it produces tradable goods, whether it engages in contract work, whether it sells to and buys from enterprises and

middlemen as opposed to dealing with individuals, whether it has a female proprietor,

whether it is located within the household, whether it is growing, new or stagnant, and

whether it registered with local authorities

Formal firm variables at the state-industry level:

● SIm_l_labourintensity sit : Log of average labour intensity

● SIm_l_labour sit: Log of average firm size

Informal firm controls Q: Variables included record whether a firm produces throughout the year i.e is a ‘perennial firm’, whether it faces a shortage of capital, whether it has an

uninterrupted supply of electricity, whether it maintains accounts, and whether it has received any sort of assistance

District level controls Z: Log of total population, share of population that is urban, share of SC/ST population, share of population that is literate, share of population that is part of the workforce, share of females that is in the workforce

Fixed effects:

Standard errors clustered at the state level See appendix for detailed definitions of variables

Results:

Please see the appendix for regressions with controls sequentially added The following is a

discussion of the coefficients, keeping endogeneity issues in mind

Table 2: Employment Linkages Variable Coefficient

State-Industry Formal Mean Log Labour (SILL) 0.0830*

High Capital * (SILL) 0.0985***

Sells to Enterprise/ Middleman * (SILL) 0.0699**

Buys from Enterprise/ Middleman * (SILL) 0.00790

Female Proprietor * (SILL) -0.0595*

Located Within Household * (SILL) -0.0896***

Growing Firm * (SILL) -0.0350***

Stagnant Firm * (SILL) -0.0361***

Registered with Local Authorities * (SILL) -0.108***

state-in a district has not been controlled for This is a concern as better and cheaper state-infrastructure can promote the development of larger formal and informal firms State fixed effects control for infrastructure at the state level, but not changes in the level of infrastructure across time

As one might assume, firms that are engaged in subcontracting tend to have stronger linkages with formal firms A 1% increase in average form formal firm size in a particular state-industry leads to a 0.1225% increase in individual informal firm size Interestingly, formal firm growth has positive net impact on a large variety of informal firms, though only 27.36% of the sample

is engaged in subcontracting This suggests that there are formal-informal linkages beyond just subcontracting

An important informal variable of interest is High Capital which measures whether or not

informal firms have a higher than average capital stock In line with the findings of Bohme and Thiele (2014) and Moreno-Monroy (2014), firms that have a larger capital stock tend to have

stronger linkages to formal firms Employment linkages are more than twice as strong in the

case of informal firms that have a higher than average capital stock A 1% increase in average formal firm size results in a 0.1815% increase in the size of high capital informal firms This suggests that formal firms are indeed interacting with more modern, capitalist-type informal firms This becomes clearer while analysing interactions with other variables of interest For instance, linkages tend to be stronger in the case of firms that either buy from or sell to enterprises or middlemen, as opposed to dealing directly with individuals Less productive firms that are located within the household or have a female proprietor tend to have weaker linkages

What is surprising to see is that linkages are much weaker for informal firms that are registered

In fact, a 1% increase in average formal firm size corresponds to a 0.025% decrease in the size

of informal firms that are registered Thus registered informal firms actually shrink as formal firms grow in size Moreover, firms that are growing, new, or stagnant have weaker linkages than the base group of firms that owners reported to be contracting (shrinking) It is important

to dig deeper and determine the direction of causality – are formal-informal linkages exploitative as Tokman hypothesized or do badly performing informal firms seek out formal firms to partner with? The weaker linkage that registered informal firms seem to have might indicate that informal firms with less bargaining power enter subordinate relationships with formal firms

Finally, it is seen that firms in urban areas tend to have weaker employment linkages with formal firms For urban firms, a 1% increase in formal firm size results in a 0.0547% increase

in informal firm size in a particular state-industry This is in line with the findings Mukim (2011) and Ghani et al (2015) that localization or clustering of firms within the same industry can have negative externalities resulting from competition This could imply that as formal firms in cities grow, they absorb informal firms It could also be the case that urban formal firms simply put informal firms out of business, and these informal workers easily find other jobs in the city