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Informal Economy versus Formal Economy

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  • Published
    31st Jan, 2022


The informal economy is a global pervasive phenomenon. According to the International Labour Organization, about 60 per cent of the world’s employed population participates in the informal sector. It is prevalent in emerging and developing economies. The moment informal sectors get regulated, it creates the distinction between formal and informal. It is the introduction of compliance that creates the division between the two. India is predominantly an Informal economy.


About Informal Economy:

  • The informal economy comprises activities that have market value and would add to tax revenue and GDP if they were recorded.
  • In such economies, employers do not provide social security to employees. It is a globally widespread phenomenon.
  • Informal workers in rural and urban areas have been hit the most due to the pandemic, because of the seasonality of their employment and lack of formal employee-employer relationships.

Informality in the economy arises due to a wide range of reasons:

  • To avoid taxes and social contributions
  • To avoid compliance with standard and licencing requirements

It is a misconceived notion that people opting for the informal sector are doing so to cheat or to avoid the tax net. Many times, it is to use informal activities as a safety net:

  • They might be too poor to access public or financial services
  • They may lack education and skill for formal employment

Issues with Informal firms:

  • It is an obstacle to achieving sustainable development (Greening of economy necessitates formalisation).

A green economy is defined as low carbon, resource-efficient and socially inclusive.

  • They do not contribute to the tax pool
  • They tend to remain small with limited access to finances
  • They are associated with low productivity

Characteristics of Informal Economy

  • Prevalence of inequality:
  • Wage gap: workers with similar skills tend to earn less in the informal sector than their formal sector peers, and the wage gap between formal and informal workers is higher at a lower skill level.
  • Poverty: Informal workers are more likely to be poor than workers in the formal sector, both because they lack formal contracts and social protection and because they tend to be less educated.
  • Gender inequality:
  • Women are more likely than men not only to be in informal employment but also to be in the most precarious and low-paying categories of informal employment.

Findings of Periodic Labour Force Survey (PLFS):

  • Over 90% of workers are in the informal sector (419 million in absolute numbers)
  • Rural- 95% (298 million) workers
  • Urban- 80% (121 million) workers
  • 62% rural informal labour in agriculture
  • 93 million in manufacturing, hotel, construction
  • Urban informal- 50% is self-employed
  • Urban informal- 20% daily wagers, 30% salaried


Formal economy:

  • The worker has a formal contract with the employer
  • Defined working conditions and job responsibilities
  • Assurance of a decent fixed salary with perks and incentives
  • Established platforms to express grievances
  • Fixed duration of work-time
  • Stakeholders are aware of their rights
  • Social security net for health and life risks

Informal economy:

  • Absence of formal contract with the employer
  • Work conditions are not defined
  • Irregularly remuneration and uneven payment
  • Lack of established platforms to express grievances.
  • No fixed hours of work and mostly meagre salaries
  • Stakeholders have poor knowledge about their rights
  • No provisions of social security net for the worker


Challenges faced by labour:

  • Long working hours, low pay and difficult conditions
  • Low job security, high turnover and low job satisfaction
  • Inadequate social security regulation
  • Difficulty in exercising rights
  • Child and forced labour discrimination
  • Vulnerable, low-paid or undervalued jobs

For every worker there should be three kinds of security:

  1. Wage Security: The wages (Amendment) Act 2017, ensures that every worker in India is to be paid certain minimum wages.
  2. Job Security: Probability that an individual will keep their job.
  3. Social Security: Employees should be able to take care of themselves and its family during times of need, e.g-medical emergencies etc.

Policy Design to Address Informality:

  • It is a complicated exercise due to multiple causes and forms, both across and within countries to design effective policies to address informality. Informality is a response to a set of country-specific characteristics and institutions, and there is no one-size-fits-all solution to the problem. Extensive research and policy experiments point to a common set of guiding principles for policy design. Four types of policies have proved effective:
  1. Improving access to and quality of education is probably the single most powerful way to lower informality.
  2. Tax system design should avoid inadvertently increasing incentives for individuals and firms to remain in the informal sector.
  3. Policies to enhance financial inclusion by promoting expanded access to formal (or bank-based) financial services can help lower informality.
  4. A range of structural policies can help increase incentives and lower the cost of formalization.

Initiatives Taken by Government:

  • Labour Reform: The Parliament passed three labour codes on industrial relations; occupational safety, health and working conditions; and social security — proposing to simplify the country’s archaic labour laws and give impetus to economic activity without compromising with the workers’ benefits. New labour codes have taken notice of the informal urban segment of the informal economy i.e. the gig economy, workers now are the worst affected in a pandemic like situation.
  • E-Shram Portal: It is the first-ever national database of unorganised workers including migrant workers, construction workers, gig and platform workers, etc.
  • Udyam Portal: It is the Government Portal to facilitate the registration of MSMEs. The Ministry of Micro, Small Medium Enterprises maintains this portal.
  • Pradhan Mantri Shram Yogi Maan-dhan: It is a Central Sector Scheme administered by the Ministry of Labour and Employment and implemented through the Life Insurance Corporation of India and Community Service Centres.
  • PM SVANidhi: The Ministry of Housing and Urban Affairs (MoHUA) has launched Pradhan Mantri Street Vendor's Atma Nirbhar Nidhi (PM SVANidhi), for providing affordable loans to street vendors.


  • SBI in its recent report has estimated that India’s informal economy has shrunk to 15-20 per cent of GDP in 2020-21 from 52 per cent in 2017-18. Formalisation is primarily the reason for the shrinking of the informal sector.

Basis for measuring Contraction in Informal Sector:

  • Formalisation of Financial Transitions:
  • Use of digital payments
  • Formalisation of agricultural credit through Kisan Credit Cards and
  • Increase in online purchases
  • Reduced cash intensity of the economy due to combination of demonetisation and implementation of GST.
  • Formalisation of Tax Net:
  • The provision of GST discourages registered businesses to deal with unregistered entities in the informal sectors.
  • This has encouraged the informal sector to get itself registered to remain in the supply chain.
  • The awareness about the event of loss for the reason of not complying with the tax law has increased the size of the formal economy.
  • Formalisation in reporting of employees in registered enterprises:
  • The data of the EPFO payroll report has estimated that from 2017-18, almost 36.6 lakh jobs had been formalised till July 2021.
  • E-Shram portal, which is the first national database of unorganised workers has facilitated the benefits of social sector schemes. More than 5.3 crore workers had registered until 30 October, last year.

The government has also incentivised establishments under the EPFO to hire more workers along with social security benefits. As part of the scheme, the government is crediting, for a period of two years, the employees’ and the employers’ share of contribution of the EPFO-registered establishments.

  • Formalisation in the share of output produced by the registered companies:
  • An alternative way to assess the informality in the economy is by looking at the contribution of non-agricultural enterprise to GDP.
  • “Udyam” (a new process of registration of small businesses) registration will play an important part in the formalisation of this sector. It will help the government collect data on this sector, and, at the same time, it will help small businesses (MSMEs) access the various schemes offered by the government.


Informality critically affects how fast economies can grow, develop, and provide decent economic opportunities for their populations. Sustainable development requires a reduction in informality over time, but this process will inevitably be gradual because the informal sector is currently the only viable income source for billions of people.

Informality is best tackled by steady reforms, such as investment in education and policies that address its underlying causes. Attacks on the informal sector motivated by the view that it is generally operated illegally and evades taxes are not the answer. Indian economy is witnessing a sea of changes, which could lead to short term disruptions. In the coming time, greater formalisation will see a shift from low-paying, labour-intensive jobs in the informal sector to more productive, capital-intensive formal-sector jobs.


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