Conceptualizing the Ubiquity of Informal Economy Work [1st ed.] 9789811574276, 9789811574283

Table of contents :
Front Matter ....Pages i-xix
When Will Formality Become the Norm? (Errol D’Souza)....Pages 1-12
Self-Employment and Human Capital (Errol D’Souza)....Pages 13-18
Informal and Formal Employment in a Liberalizing Economy (Errol D’Souza)....Pages 19-32
Migrants and Informal Casual Labour Markets (Errol D’Souza)....Pages 33-49
Wage Disparity and Human Capital Accumulation (Errol D’Souza)....Pages 51-58
The Pervasiveness of Self-Employment (Errol D’Souza)....Pages 59-69
Secure Livelihoods (Errol D’Souza)....Pages 71-86

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SPRINGER BRIEFS IN ECONOMICS

Errol D’Souza

Conceptualizing the Ubiquity of Informal Economy Work

SpringerBriefs in Economics

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Errol D’Souza

Conceptualizing the Ubiquity of Informal Economy Work

123

Errol D’Souza Department of Economics Indian Institute of Management Ahmedabad Ahmedabad, Gujarat, India

ISSN 2191-5504 ISSN 2191-5512 (electronic) SpringerBriefs in Economics ISBN 978-981-15-7427-6 ISBN 978-981-15-7428-3 (eBook) https://doi.org/10.1007/978-981-15-7428-3 © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Testimonials

“Errol D’Souza’s book on informal work in emerging economies, especially India, is an important new arrival for our shelves. The informal economy has been of interest to economists since the early work of Arthur Lewis, but many open questions remain, such as why the informal sector has remained so large, contrary to what the early writings predicted. D’Souza’s book brings theory and evidence to bear on these themes, including, somewhat prophetically, on what has acquired great urgency in India today, namely, the challenge of the vast migrant labor market. I would expect the book to be of wide interest to students of economics.” —Kaushik Basu, Professor of Economics and Carl Marks Professor, Cornell University. Former Chief Economist of the World Bank “When we talk in terms of grand abstractions like the Indian Economy or India’s GDP or its growth rate, what is often forgotten is that more than three-quarters of Indians in the labour force are self-employed in the informal sector. Yet, the standard development framework focuses mainly on wage employment when talking about labour markets and not at self-employment. This masterly book by Errol D’Souza provides an analytical framework that locates the problem of development as a process of transition from self-employment to wage work, identifying the roles of market frictions as well as distortions stemming from regulation on the one hand as well as the changing nature of technology and human capital accumulation as dynamic forces driving it. It is a must-read book that provides a granular view of the development process of the Indian economy, deftly weaving theory, evidence, and policy debates, with a clarity that is truly impressive.” —Maitreesh Ghatak, Director, Development Economics Programme, STICERD (The Suntory and Toyota International Centres for Economics and Related Disciplines), LSE

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“This excellent volume combines economic theory with an empirical knowledge of market structures in India and elsewhere to provide insights into the nature and evolution of informality. It will be valuable to analysts of jobless growth, and will provide policy advisers with ideas on how to address a major issue of our time—the ubiquity of informality.” —Ravi Kanbur, T.H. Lee Professor of World Affairs, International Professor of Applied Economics & Management, Professor of Economics, Cornell University “In this book, Errol D’Souza provides an interesting, well-researched perspective on a very critical issue in development—informal employment. He analyses informal working conditions and bargaining power of informal workers on the one hand, and the interlinkages between formal and informal employment, on the other. D’Souza moves from the micro economics of informal labour contracts and non-implementation of labour standards to macroeconomic issues of jobless growth in the Indian context, with lucidity and simplicity. Addressing the many different dimensions of informality in a developing economy context, the book makes a very important contribution to our understanding of labour markets and development processes.” —Sukti Dasgupta, Chief, Employment and Labour Market Policies, International Labour Office, Geneva

For Seema

Preface

A defining characteristic of the Indian economy is jobless growth. Even during phases of high growth there has been moderate labour market performance with a low rate of job creation. The large size and expansion of the population is a cause of pressure on labour markets as the fast growth in working age population results in between 8 and 9 million additional young people joining the labour force every year. The decline in the employment rate or share of the employed among the working age population is partially ascribed to an increase in school enrolment rates and the corresponding decline in young entrants into the workforce (attributed by some to the Right to Education Act), and additionally, a fall in female labour force participation as females have opted out of the labour force. The striking feature of the Indian scene that the labour force is growing at a quicker pace than the number of jobs results in discouraged workers and increasingly lesser people entering the labour force as they expect good jobs are not available. Correspondingly, there is an increasing willingness by those who do participate in job search to compromise on job quality and to accept any kind of job that they can find. It is not surprising then that informality pervades the economy and most jobs are of low quality. Informal employment includes the workers hired by unincorporated small and/or unregistered enterprises (i.e., they have no reporting requirements to government) as well as those workers who have no employment contracts (such as domestic workers) or those hired without social protection contributions (such as paid annual leave and sick leave). They accordingly often receive low levels of remuneration and are not covered by employment legislation. This type of employment includes a range of diverse categories of employment that range from wage employment to self-employment. As per ILO statistics,1 the share of informal employment in total employment in India is 88.2%. The usual notion is that informal employment is mainly prevalent in agriculture. However, the share of non-agricultural informal employment in total non-agricultural employment is 78.1%, indicating that informality is a ubiquitous feature of the economy. “Women and Men in the Informal Economy: A Statistical Picture”, ILO Geneva, 2018.

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A defining trait of developing and emerging economies is the widespread prevalence of self-employment which comprises own-account employers and workers in informal enterprises or contributing family workers in both informal and formal enterprises. This type of employment category has not been given the importance it deserves in theories about development which have tended to focus on wage employment. This book provides an analysis of this neglected aspect of the development literature. Own-account employers comprise 1.2% of informal employment, own-account workers comprise 70.3% of total informal employment, and contributing family workers 14.9% of total informal employment in India. Hence, 86.4% of informal employment in India is self-employment. Wage workers are considered to be informally employed when their work is not legally regulated and does not involve the receipt of employer contributions to social protection. Such workers are usually casual or day labourers, temporary and part-time workers, contract workers, home workers (or industrial outworkers), and domestic workers. Interestingly, such informal employment has been increasing among formal and registered firms and this aspect of the economy has not received adequate attention. We explore the dimensions of this phenomena and suggest a framework within which this aspect of economic development may be comprehended and policy issues related to it addressed. Wage workers who are informally employed constitute 13.7% of informal employment in India. There is no apparent gender difference in informal employment in agriculture with both men and women to the extent of 99.7% of total employment being so employed. In industry 77.5% of men are informally employed and 88.8% of women. In services it is the reverse with 78.7% of men and 71% of women being informally employed. Empirically across the world there is a broad association between informal employment and indicators of development. For instance, the share of informal employment declines with the level of GDP per capita,2 the proportion of wage workers in total employment increases as the share of informal employment declines, and the poor face higher rates of informal employment. The share of informal employment has been found to decrease with increases in the level of education of workers, and to be positively associated with the burden of regulations and negatively with the strength of enforcement of regulations. We engage with the two main approaches taken to the informal sector in the literature. One thread adopts a public economics framework and emphasizes that informal enterprises avoid taxes at the cost of reduced access to public services and penalties. Our approach extends this literature by focusing on the access to formal sector credit which has been neglected as a factor considered by an enterprise when it contemplates whether to incorporate or not. The second thread of the literature takes a labour perspective and focuses on mandated labour costs such as hiring and firing constraints, benefits, and minimum wages as considerations when deciding whether to offer formal or informal labour contracts. We extend this literature too

See “Women and Men in the Informal Economy: A Statistical Picture”, ILO Geneva, 2018, Chap. 2.

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by considering how levels of education and monitoring costs inform the decision with regard to informality. The first chapter titled “When Will Formality Become the Norm?” looks at informality as a choice in relation to regulation by the state. In order to grow an enterprise requires external funds that can be accessed from financial institutions. To receive such funding the enterprise must provide details about their assets to the financial institution. Revelation and pledging of assets as collateral allows the financial intermediary to disburse a loan at a reduced cost of credit to the enterprise. Relatedly, once a firm accesses the financial sector it leaves a paper trail that facilitates tax enforcement. In developing economies, the availability of information to an external agent about a firm’s economic activities is limited. Information from outside a business establishment about the scale of activities is available to fiscal authorities from the recorded transactions that are made through the formal financial system which is a good source of checking the information that the firm may provide. Taxation and its enforcement are thus enhanced to the extent that firms use the formal financial system. If informal finance and cash transactions are used, they become difficult to monitor and tax. Thus there is a link between taxation, formal financial intermediation, and the decision of firms as to whether to operate formally that we explore. Financial intermediaries are important to firms that seek external finance which is associated with an increase in the productivity of its operations. On the other hand, using formal financial intermediaries exposes the firms’ scale of operations which makes them liable to taxation. Firms will then only use the formal financial system if it provides significant value addition to them that exceeds the loss from being part of the tax net. Continuing to be informal then we show is a choice that is made when the productivity enhancement of the enterprise from accessing formal finance is insufficiently high, when the costs of operating in the informal sector is low, when indirect taxes are set at a high level, and if the fixed regulatory cost of setting up in the formal sector is high. We investigate what financial development in terms of a reduction in the cost of financial intermediation does to the decision regarding whether to operate formally or informally. We demonstrate some counterintuitive possibilities such as a decline in capital intensity by switching to becoming a formal enterprise since the increased productivity is offset by the fixed costs of set up and other relevant costs. We also refer to the role of collateral regimes, bankruptcy laws, and judicial efficiency in affecting the choice of whether to continue to be informal. The second chapter titled “Self-employment and Human Capital” proposes a framework to understand how the structure of production in the process of economic development embodies a shift from self-employment to wage work. A labour allocation model with human capital is shown to be an important determinant of the structure of employment. An important input that has not been given adequate attention and that enables the transition to formality is entrepreneurial and management skills. Managers of informal enterprises are considerably less educated than those of formal enterprises. Similarly, self-employment is associated with noticeably lesser levels of education than wage employment. We posit that the acquisition of human capital increases managerial ability and the income from

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self-employment, whilst at the same time raising the wage-earning capacity of the individual as higher costs of acquiring skills are compensated for with higher wages in the wage labour market. We show that as human capital acquisition increases in the initial stages, it is allocated to self-employment as it positively impacts managerial ability and the efficiency of production. However, at higher levels of human capital there is sufficiently higher wage-earning possibilities in the wage labour market and self-employment declines. Lack of human capital skills would then be the very important constraint on transitioning from low income self-employment to wage employment and of managers in informal enterprises transitioning to larger formal enterprises. The next chapter titled “Informal and Formal Employment in a Liberalizing Economy” looks at the phenomenon of growing informal employment in the formal registered sector of the economy. Increased liberalization has not resulted in formalization of jobs in the formal sector of the economy but rather the growth of informal employment. Even in the public sector it is estimated that a third of all jobs are informal. There has been an increase in this sort of employment not just in industry but also in the service sectors such as financial services, real estate business, education, and health. We adopt the lens of an employer in the formal sector who offers formal employment for those jobs requiring initiative and which are not easy to monitor. A typical informal job, in contrast, would be the one that is short-lived, relatively simple, and most importantly, easily supervised. The intensity of enforcement of employment protection regulation influences the effort of workers in the formal sector since such workers are protected by regulations that provide them relatively more employment security. Employment protection regulation makes firing difficult and employers have to pay an additional amount to offset the reduction in effort induced by employment security. As employment protection regulation is eased in a liberalizing economy, it increases the effort of those with formal employment contracts and incentivizes the employer to offer formal contracts. However, since a decrease in regulatory enforcement reduces the cost of evading regulations, there is an incentive to substitute towards informal contracts and we investigate the conditions under which this factor could dominate and increase the proportion of informal employment in a formally registered enterprise. We show that this has implications for the declining share of wages in the economy. Our next chapter, “Migrants and Informal Casual Labour Markets”, focuses on internal migration and casual labour markets. Internal migration is estimated to be at around 100 million people, and short-term seasonal migration for work is estimated to vary between 80 and 140 million. Employers may benefit from the increase in the supply of labour and middle-class households may benefit from the lower price of household services provided by the migrants and their families. Local residents with comparable skills to those of migrants may find that they have to compete for jobs in the labour market. Many regions implicitly differentially prioritize the interests of local residents and of migrants whilst filling vacant jobs, resulting in a tradeoff between welfare rights and openness to migration. Migrants take into account the tradeoffs of poor working conditions and unwritten and unenforceable contracts,

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with the higher income in the destination region, and all considered migrate. We provide a framework for understanding this socio-economic outcome. In many urban contexts, migrants and other low-skilled workers gather at some focal point such as a busy market place or crossroad in the morning and meet with potential employers who negotiate the type of work to be performed, the wage, and the number of hours that the worker has to work. Surprisingly, there has been a paucity of research on the employer–employee match in the daily urban casual labour market. Working days are usually long—between 12 and 14 hours in many instances—and the wage and working conditions is usually negotiated. The market wherein the bargain takes place is a flexible labour market where workers can be replaced by the employer at a minimal cost to the employer. In most of such contracts workers report that they have been cheated and face harassment. The requirements for complete contracting are severe in this market. It is difficult ex ante to specify what constitutes a satisfactory performance of the contract (as it is difficult to record and measure performance) and accordingly it is difficult to enforce the contract via a third party. This leads to opportunism as the employer holds up the worker by requiring further responsibilities such as longer hours of work to be undertaken that were not negotiated in the first place. We postulate a bargaining approach to unearth the role of regulation and the determination of wages and work conditions in the informal casual labour market. Our next chapter, “Wage Disparity and Human Capital Accumulation”, is about human capital accumulation and the growth in wage disparity. The cost of education is a deterrent to investment in skills but this can be overcome if there is a strong complementarity between skills and technology. This chapter explores the consequences of the view that increases in human capital enables more technological change because more skilled workers enable the introduction of more sophisticated and productive machines. The technological change in turn influences the demand for skilled workers and affects the return on the acquisition of human capital. With technological change and the acquisition of skills having mutually reinforcing effects that enhance the returns to skilled labour and to investments in technology the gap between skilled and unskilled workers can increase which results in disparities that have political and social consequences. We show that some counterintuitive outcomes are possible. In an economy with a poor endowment of skilled labour for instance and where unskilled workers are relatively productive in the production of goods and services a feeble technology-driven demand for skilled labour raises the return to skilled labour relative to unskilled labour and simultaneously causes a substitution for skilled with unskilled labour that is abundantly available. Similarly, an increase in the cost of education paradoxically can raise the investment in education due to the complementarity between investment in education and technological change which causes wage disparity to rise along with the stock of skilled labour in the economy. The cost of education then is not a deterrent to investment in education if the skills produced can trigger off changes in technology that raises the return to education strongly enough so as to pay for the cost. The quality of skills imparted in education is the key to development.

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There is a view we question in the next chapter titled “The Pervasiveness of Self-employment” that the costs of social security and health benefits result in lower in-hand payouts in the formal sector and these are not valued by workers as there are weak linkages between benefits and contributions and they would prefer that such benefits be substituted with monetary remuneration. In this case it is the attractiveness of informal self-employment where remuneration can be structured flexibly that causes enterprises in the formal sector to pay above market clearing wages which in turn reduces the vacancies a firm may create as well as impacts on informality. In this understanding it is the pull of the informal sector that forces firms in the formal sector to pay above market clearing wages so as to retain workers. We contradict this by pointing out that the meagre incomes of the dominant part of the workforce that is self-employed implies that it is not a form of employment that is voluntarily chosen or preferred. We contrast this with our approach where self-employment is due to accessing resources in the social network by self-employed enterprises that enables them to reduce the cost of opportunism and shirking and thereby to pay lower wages than in the formal sector. High unemployment rates or low rates of job creation in the formal sector or high discount rates of individuals we show induces individuals to accept such self-employment contracts. The informal sector we maintain stresses mutual and joint liability for the success of the enterprise in the sense that if one member shirks then all members of the enterprise are affected as joint performance is the strength of the enterprise. The individuals in a self-employed enterprise participate in a joint contract that promotes more effort by all as only by reducing the costs of shirking do they have an advantage over individual contracts in the formal sector that pay efficiency wages to deter shirking. By stressing joint liability the self-employed enterprise is able to add value compared to the alternative contracting that targets the individual alone outside her social setting. An implicit contract where coworkers monitor opportunism makes informal self-employment an economic proposition that survives by paying lower wages than formal firms. These lower wages are acceptable over queuing and search for meagrely available formal jobs, high unemployment rates, or high discount rates of individuals. Informal self-employment cushions individuals from unemployment and possible destitution. In the last chapter titled “Secure Livelihoods”, we scrutinize the vast literature on social security for unorganized workers in India that does not carefully provide a justification for this type of public assistance, treating it as rather an obvious obligation of any civilized society. Moreover, by viewing social security as a state its focus is restricted to the outcomes of deprivation and vulnerability that characterize it. In contrast, we argue for shifting the focus of attention to processes whereby stochastic shocks and institutions empower or hinder households from attaining satisfactory incomes and well-being. A justification is provided in terms of the principle of equality of opportunity and it is argued that the concept of secure livelihoods is the appropriate vehicle for mobilizing the full import of this principle. The policies that are suggested by this reading are social assistance when the fundamental capacity to transform assets into well-being is impaired,

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credit-cum-insurance services when contingencies do not allow the smoothing of consumption, and the provision of complementary social and economic infrastructure of adequate quality and priced so as not to exclude the needy. I am grateful to Prof. Alakh Sharma and The Indian Society of Labour Economics for allowing me to reproduce some of my ealier work that appeared in The Indian Journal of Labour Economics. I would also like to thank Ms. Nupoor Singh, Editor, Springer Nature, whose patient nudging did not permit my procrastination to waiver towards non-completion of this book project. Much of the work presented in this book has evolved over the years and I owe much to conversations and feedback that were provided by myriad individuals. These include K. P. Kannan, Alakh Sharma, Arun Kumar, Ravi Kanbur, L. K. Deshpande, Anjan Mukherji, Avadhoot Nadkarni, Shubham Chaudhuri, S. Mahendra Dev, K. J. Joseph, R Nagaraj, Raaj Sah, Mala Lalvani, M. H. Suryanarayana, Y. V. Reddy, K. V. Ramaswamy, Jayati Sarkar, Subrata Sarkar, Ravi S. Srivastava, Tathagata Bandyopadhyay, Bino Paul, Sunil Mani, Vijay Kelkar, Shankar Acharya, Indrajit Thakurta, Shubhashis Gangopadhyay, C. Rammanohar Reddy, Romar Correa, Sudipto Mundle, Rajkamal Iyer, Jehangir Aziz, Ajit Ranade, Reetika Khera, Pavneet Singh, Jayshree Vyas, Tan Tai Yong, Jeemol Unni, D. Narasimha Reddy, Ram Singh, Partha Ray, Praveen Jha, Rakesh Basant, Sukti Dasgupta, Partha Sen, Raghuram Rajan, Sher Verick, Rajas Parchure, Chetan Subramanian, Uday Bhanu Sinha, Pratap Bhanu Mehta, Tridip Ray, Christophe Jaffrelot, Dinesh Awasthi, Maitreesh Ghatak, Peter De Souza, Duvvuri Subbarao, Amita Shah, Satya Das, Debashish Bhattacherjee, Manjit Singh, Samuel Asfaha, Rajat Acharyya, Alito Sequeira, the late Subir Gokarn, Abhay Pethe, Abhiroop Mukhopadhyay, Indira Hirway, Jay Surti, Lia Pacelli, Subrata Guha, Ramesh Datta, Sasheej Hegde, Kaushik Basu, Rupal Kulkarni, Sugata Marjit, A. Vaidyanathan, Christoph Scherrer, M. Ramachandran, Devesh Kapur, Partha Chatterjee, J. B. G. Tilak, Sangheon Lee, Amal Sanyal, Bhupat Desai, Amit Bhaduri, the late V. S. Vyas, Sujoy Chakravarty, the late Sharit Bhowmik, Pritha Dev, Y. K. Alagh, Pushpa Trivedi, Ajit Karnik, Mitul Surana, Neeraj Hatekar, Soumyen Sikdar, the late T. S. Papola, Dilip Nachane, Atul Sarma, Divya Varma, Krishnavatar Sharma, Rajiv Khandelwal, Juan Chacaltana, and Frédéric Lapeyre. Ahmedabad, India

Errol D’Souza

Contents

1 When Will Formality Become the Norm? . . . . . . . . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taxes and Financial Intermediation . . . . . . . . . . . . . . A Theoretical Framework . . . . . . . . . . . . . . . . . . . . . The Role of Indirect Taxation . . . . . . . . . . . . . . . . . . Direct and Indirect Taxes . . . . . . . . . . . . . . . . . . . . . Availability of Formal Finance and Judicial Efficiency Concluding Comments . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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2 Self-Employment and Human Capital Introduction . . . . . . . . . . . . . . . . . . . . . Labour Allocation . . . . . . . . . . . . . . . . . Concluding Remarks . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . .

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3 Informal and Formal Employment in a Liberalizing Economy . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Informal Employment in the Formal Sector . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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4 Migrants and Informal Casual Labour Markets . Informal Casual Labour Markets . . . . . . . . . . . . . . Wage Regulation . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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5 Wage Disparity and Human Capital Accumulation . . . . . . . . . . . . . Human Capital, Technology, and Development . . . . . . . . . . . . . . . . . . The Process of Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Contents

Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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6 The Pervasiveness of Self-Employment . Introduction . . . . . . . . . . . . . . . . . . . . . . Efficiency Wages and Self-Employment . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . .

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7 Secure Livelihoods . . . . . . . . Introduction . . . . . . . . . . . . . . Equality of Opportunity . . . . . Stochasticity and Institutions . . Credit-Cum-Insurance Services Bibliography . . . . . . . . . . . . .

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About the Author

Errol D’Souza is Professor of Economics and Director, Indian Institute of Management Ahmedabad. He obtained his Ph.D. as a University Grants Commission National Research Fellow from the Jawaharlal Nehru University, New Delhi. He has held appointments such as the IFCI Chair Professor at the University of Mumbai, India Chair Professor at the University Sciences Po in Paris, as a Visiting Professor of the Indian Institute of Advanced Study, Shimla, as an Honorary Senior Fellow of the Institute of South Asian Studies at the National University of Singapore, a Visiting Scholar at Columbia University, and as a Visiting Professor at the Turin School of Development of the ILO. He has worked on academic committees of the University Grants Commission and the Indian Council of Social Science Research, and has been associated with the Planning Commission of India and the Reserve Bank of India in various capacities, including as a Member, Technical Advisory Committee on Monetary Policy. He has served on the Academic Councils of the Tata Institute of Social Sciences, Indira Gandhi Institute of Development Research, the Institute for Human Development, Delhi, and is on the Advisory Board of the International Centre for Development and Decent Work at Kassel, Germany, and the Boards of the National Institute of Public Finance and Policy, and India Gold Policy Centre. Professor D’Souza is on the editorial board of the Journal of Quantitative Economics (Springer), the Indian Journal of Labour Economics (Springer). His areas of research interest are macroeconomics, development finance and public policy.

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Chapter 1

When Will Formality Become the Norm?

Introduction In some ways, the more you think about economic growth and development, the less can you say with some confidence what the big picture is. Many years ago, there was some consensus that governments can be the main agent for promoting industrialization, that capital accumulation was vital for brisk economic growth, and that assimilation with the world economy through trade was not important for growth. Planning by the government was given a central place in the mobilization and allocation of capital. Development was about large investment projects especially in basic and core sectors that were important for industrialization. Trade was only important in as much as it enabled a country to access inputs that it lacked. By the 1980s the failures of central planning began to show up in the low growth that was experienced. Capital-intensive investments did not produce the productivity that spurs growth; instead it required more regulation and financial support, leaving less resources available for investing in future growth. The emphasis shifted from government as the driving force in development to government as an agent that hampers development. Investment was visualized as more driven by the private sector, and trade began to be promoted as the engine of growth as well as a source of efficiency gains for the economy. The benefits of imports in disciplining domestic industry and exports in providing economies of scale and learning were given greater prominence. The multiple distortions that spanned across different markets—capacity licensing, monopoly control, small-scale industry reservation, import licensing with tariffs and quotas, land and labour market distortions—were relaxed over time. India did not follow the typical trajectory of development that occurred in successful East Asian countries. Those countries specialized in unskilled labour-intensive activities and then slowly shifted their economic activity towards technology-intensive and higher skill-intensive sectors. Other countries that succeeded also moved with time from agriculture towards manufacturing and then to services. India has been a story in contrast—it has specialized in skill-intensive activities, and as agriculture

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_1

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declined as a share of GDP, there has been a commensurate increase in services with manufacturing being a stagnant share of the GDP. This has been attributed1 to two factors—that India emphasized higher education over basic education and that was the source of its pool of highly skilled engineers and managers, and that there were controls on the growth of the size of the private sector with policies favouring small-scale firms and anti monopoly laws which deterred the creation of large firms that are concomitant with the growth of manufacturing. India’s manufacturing firms are extraordinarily small in scale which restrains productivity gains as productivity is higher in larger firms, and a larger share of manufacturing is in sectors that require a larger scale of operations.2 The tragedy of India’s growth is that few jobs are being created in large firms and few of them in the formal sector. Whilst small and medium enterprises that constitute a part of the informal sector are a characteristic of fast-growing economies, it is a mistake to think that they have a causal impact on economic growth. In advanced countries there is some evidence3 that small firms have high innovation rates in skill-intensive industries, whereas large firms show a propensity for higher innovation in capital-intensive industries. In developing countries, however, productivity increases are usually driven by technology transfers from abroad, and large and exporting firms are usually the mechanism through which such technologies are adapted to local circumstances.4 There are other disadvantages of small firms that have been reported—they do not offer stable employment and non-wage benefits. Apart from job quality, whether small firms offer a greater quantity of employment is also not supported in the literature.5 In India, a large part of the debate has focused on labour market: the causes for the decline in employment growth since 1993–1994.6 Most business establishments including large firms which increased employment did not provide regular work but increased the extent of casual labour employed.7 This has been attributed in large part to the Industrial Disputes Act that makes layoffs, retrenchment, and closure illegal except with the previous permission of government for all firms with more than 100 workers as of 1982.8 The focus on labour laws has taken the discussion away from two other factors that have an important bearing on the size of firms and on the extent to which they set up in the formal sector. These factors are related to financial 1 See

Kocchar et al. (2006). OECD (2007), Fig. 2.5. 3 See Acs and Audrestsch (1987) for the US. 4 See Pack and Westphal (1986). 5 For instance, Davis et al. (1993) show that job creation and destruction are higher in small firms, but there is no relationship between net job creation and firm size. See Davis, Haltiwanger, and Schuh (1993). Also see Brown et al. (1990). 6 Employment growth was 1.55% during 1983 to 2009–2010 and was 1.27% during 1993–1994 to 2009–2010, due to a fall in employment growth especially in rural areas between 2004–2005 and 2009–2010. 7 In 2009–2010, casual labour as a share of total employment went up to 32.97% from 28.08% in 2004–2005 and this was mirrored by a decline in self-employment. 8 Those in casual work (paid for less than 240 days of work) are not considered workmen under the Industrial Disputes Act. 2 See

Introduction

3

development which eases financial constraints and funds the growth of firms9 and institutions of governance.10 In this paper, we will use the term judicial efficiency with respect to financial contracts to refer to institutions of governance. If a lender, for instance, is able to enforce a loan contract and recover her dues both when the borrower reneges on her commitment and when there is bankruptcy, then we consider judicial efficiency and the institutions of governance to be effective and this has an important impact on the growth of the formal sector. Kanbur (2009)11 argues that a central-determining factor in economic activity that is formal (or informal) is the nature and intensity of enforcement. He also makes a case for distinguishing between formality and informality in relation to regulation by the state. Thus, informality is not centrally about characteristics of enterprises (their size, nature of organization, etc.) or about the nature of employment (whether workers are provided benefits and whether the contract is for regular as opposed to casual work).12 Informality is a choice once government has instituted a regulation.

Taxes and Financial Intermediation The regulation that we focus on is that taxation distinguishes formal from informal enterprises. It is not that social security and labour regulations are unimportant. They do affect the cost of the contract between employers and employees and the decision to stay formal. However, the financial development that affects the decision to operate formally has not received the attention it deserves. The insight that we highlight is firms that need to grow require external funds, which in our setup are received from financial institutions that provide loans. However, once that happens firms must provide details about their assets to the financial institution. Revelation of assets is a signal of collateral which allows the financial intermediary to disburse a loan at a reduced cost of credit. Relatedly, once a firm accesses the financial sector it leaves a paper trail that facilitates tax enforcement. In developing economies, the availability of information to an external agent about a firm’s economic activities is limited. Information from outside a business establishment about the scale of activities is available to fiscal authorities from the recorded transactions that are made through the formal financial system which is a good source of checking the information that the firm may provide. Taxation and its enforcement are thus enhanced to the extent that firms use the formal financial system. If informal finance and cash transactions 9 Beck

et al. (2005) find that countries that are financially more developed have larger firms. See Beck, Demirgüç-Kunt, and Maksimovic (2005). 10 Kumar et al. (2001) find that countries which have more efficient judicial systems have larger firms. See Kumar et al. (2001). 11 See Kanbur (2009). 12 The National Commission for Enterprises in the Unorganised Sector, for instance, uses a definition for informal sector and also a definition for informal worker. Informal workers include those in the informal sector, exclude those in informal sector who have regular work with social security, and include those in the formal sector without employment and social security benefits.

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are used, they become difficult to monitor and tax. There is thus a link between taxation, formal financial intermediation, and the decision of firms as to whether to operate formally. Financial intermediaries are important to firms that seek external finance which is associated with an increase in the productivity of its operations. On the other hand, using formal financial intermediaries exposes the firms’ scale of operations which makes them liable to taxation. Firms will then only use the formal financial system if it provides significant value addition to them that exceeds the loss from being part of the tax net. India is a low tax economy compared to a number of developing countries. In fact, the OECD reports13 that the tax/GDP ratio for the level of per capita income is the least in India. The low tax ratio in international comparisons is partly due to the absence of social transfers for health, pensions, and unemployment covering the whole population. With social security contributions excluded from the international comparison, then India’s tax level is similar to that in China, Japan, Korea, Mexico, and the USA. This paper advances the position that financial development and taxation are related. Firms use the financial system that enables to improve their productivity such that it compensates for the tax revenues they are subject to. This means when financial development is low, taxation cannot be resorted to by the government in an intensive manner. Under some circumstances, reform of the financial sector increases the buoyancy of taxation.

A Theoretical Framework Consider an economy of entrepreneurs14 who are endowed with a capital asset Ai uniformly distributed in the interval [0, A]. This asset can be pledged as collateral with a bank for the purpose of obtaining a loan. To initiate a project, entrepreneurs require a loan L i which could be obtained from a bank or from the informal financial market. If they access a bank   then the entrepreneur operates in the formal sector and produces a gross output yf given by  y = f

ψKi with probability p 0 with probability (1 − p)

where Ki = Ai + Li . There is a fixed setup cost F of operating in the formal sector15 which includes the costs of compliance with various regulations, and so forth. If the entrepreneur operates in the informal sector then they have access to a technology that is not as productive. This stems from the inefficiency that is intrinsic to informal 13 See

OECD (2007). simplicity we consider the entrepreneurs to be risk neutral. 15 This along with a constant returns technology implies that there is a minimum scale of operations below which operating formally is never profitable. 14 For

A Theoretical Framework

5

operations due to the difficulties in obtaining technology, regular buyers, materials, and so on. Gross output when production operations are informal16 is  y = i

ψβKi with probability p,0 < β < 1 0 with probability (1 − p)

Let the cost of raising funds inclusive of the intermediation cost for the financial ˜ Financial intermediaries require collateral to give a loan intermediary be given by R. but can only recover a fraction φ of the collateral in case the project is successful or not. This is because if borrowers dispute the claim of the financial intermediary then the dispute is brought to the judicial system which is a cost that must be paid if the collateral is sought to be recovered. A lender can then obtain φAi units of collateral that has been pledged for the purpose of the loan. In case the project is successful lenders can at most recover a fraction α of the output. Thus, in the case of success, lenders obtain αψKi +φAi and in the case of failure, they obtain φAi . In a competitive credit market, the expected profits for a financial intermediary are zero and the terms of repayment, Ri , is set according to the following condition: ˜ i = pRi Li + (1 − p) min[Ri Li , φAi ] RL We can distinguish the following cases: Case I: The collateral is insufficient if the project were to fail, that is, φAi < Ri Li . In this case, ˜ i = pRi Li + (1 − p)φAi RL or Ri =

R˜ (1 − p) φAi − > R˜ p p Li

Case II: The collateral is insufficient to pay the lender if the project were to succeed. In this case, pαψKi + φAi < Ri Li . Then, there is a particular level of collateral given by Amin below which borrowers are excluded from credit by the financial intermediary. This is given by the condition: Amin =

˜ i pαψKi RL − φ φ

Case III: The collateral is sufficient to pay the lender if the project should fail, that is, Ri Li < φAi . Then, min[Ri Li , φAi ] = Ri Li and the zero expected profit condition ˜ For a borrower to get credit at such preferred terms she must have gives us Ri = R. 16 Without loss of generality, we are assuming that success and failure in the formal and informal sector have the same probabilities.

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Collateral insufficient if project succeeds

Collateral sufficient if project were to fail

Fig. 1.1 Access to formal finance

  ˜ i φ. In what follows, we presume that all borrowers collateral given by Ai > RL are financially constrained as they not have the collateral to finance a project at   do ˜ Hence, A = RL ˜ i φ (Fig. 1.1). the interest rate R. Thus, all entrepreneurs with collateral given by Amin = ˜ i RL φ

˜ i RL φ

−

pαψKi φ

< Ai
Amin . The cost is that the entrepreneur is subject to taxation and, of course, there is the opportunity cost of the income lost by operating in the informal sector. If an entrepreneur operates informally, the benefit is the tax saving. There is, however, a cost—a concealment cum transaction cost—which is that the collateral offered is difficult for the lender to sell in a secondary market and there is no recourse available to legal sanction. This cost increases with the size of operations and is represented by c(Ki ), where c(0) = 0, c (Ki ) > 0, c (Ki ) > 0.

The Role of Indirect Taxation We begin with a situation where the tax is a sales tax. The firm then receives a revenue of P per unit of output sold when the price to the consumer is P(1 + s), where s is the rate of indirect taxation. A reduction in the sales tax leads to a decline in the price to the consumer and an increase in the demand for the product. Thus, in the case where the project is successful, yf = θ (s)ψKi , where θ  (s) < 0. This occurs with probability p and setup cost F, an interest  involves   apart fromthe fixed  cost of Ri Li , where Ri = R˜ p − {1 − p}φAi pLi . The expected profit then is ˜ i + (1 − p)φAi . pPθ (s)ψKi − pF − RL

The Role of Indirect Taxation

7

Formal operations

Formal operations

E

Informal operations

E

Informal operations

Ai

Ai

Panel A

Panel B

Fig. 1.2 Indirect tax and formality

The alternative is to operate informally which means that the firm gets a revenue P(1 + s) per unit of output sold but incurs a cost c(Ki ) of operating informally. The ˜ i + (1 − p)φAi − c(Ki ). Comparing expected profit17 then is pP(1 + s)βψKi − RL the profits in the two scenarios in a diagram, a firm will operate formally to the right of point E in Fig. 1.2 where the diagram depicts the case of an entrepreneur with assets given by Ai > Amin . Whether the configuration is as depicted in Panel A or Panel B of Fig. 1.2 depends on the values of the parameters. If productivity when operating informally compared to formally is relatively high (β high), or if the cost of operating in the informal sector is low (c(.) low), or if the indirect tax is set at a high level (s high), or if the fixed cost of setting up in the formal sector is high (F high), then Panel A is the relevant panel for the purposes of analysis. The immediate question we ask is what does an increase in financial development do to the decision regarding whether to operate formally or informally. For our purposes financial development corresponds to a reduction in the cost of ˜ The outcome from financial development is depicted in Fig. 1.3. intermediation, R. In Fig. 1.3, Panel A, the profit from both formal and informal operations rises as represented by the dotted line curves. If the firm were at point E and operating informally, then it will shift to operating in the formal sector. By transferring this capital to formal operations, the firm saves c (.) and at the same time incurs a fixed course, there will be a shift factor θ (s) here in the informal sector as well, where θ  (s) > 0. We have omitted this because an increase in s increases the price received P(1 + s) in the informal sector and the overall impact of an increase in the revenue is captured by this term.

17 Of

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Formal operations

Formal operations E/ E

Informal operations Informal operations

E

Ai

Ai

Panel A

Panel B

Fig. 1.3 Increase in financial development

setup cost F which results in a reduction in capital. However, the productivity of capital is now higher in the formal sector and this increases the profit of the firm. In this situation capital intensity declines with an increase in formality. In Fig. 1.3, Panel B, financial development has no impact on the decision to operate in the formal sector. In such a situation, other policies such as improvements in productivity through upgrading marketing, skills, and so on would be beneficial.

Direct and Indirect Taxes Now, suppose there is both an indirect tax and a direct tax. In order to increase tax revenues, a direct tax at rate t(0 < t < 1) is introduced on profits earned in the formal sector. This will shift the kinked profit line down, and since it reduces profits in the formal sector it will induce an increase in operations in the informal sector. The intersection of the profit functions from operating in the formal and informal sectors is now to the right at point E/ as depicted in Fig. 1.4. The government may then consider reducing the burden on the formal sector by reducing indirect taxes to compensate for the impact of the direct tax. A reduction in indirect taxes increases the sales in the formal sector as θ  (s) < 0. This increases the profit from operating in the formal sector. At the same time, it reduces the price per unit of output P(1 + s) received from operating informally. This reduces the profit function in the informal sector. The new point of intersection is at point F in

Direct and Indirect Taxes

9

Formal operations

Formal operations

E E/ Informal operations

F

E

E/

Informal operations

F

Ai

Ai

Panel A

Panel B

Fig. 1.4 Substitution of taxes

Fig. 1.4. As can be seen, direct and indirect taxes are substitutes from the point of whether to operate formally or informally. Those firms that operate in the formal sector are capital intensive and are the focus of taxation. If the government requires tax revenues and yet is serious about containing disintermediation from the formal financial sector, it has to keep in mind the limits of taxation which pushes firms towards the informal sector. Moreover, the government can obtain required revenues and minimize disintermediation by reducing a tax as it raises another.

Availability of Formal Finance and Judicial Efficiency So far, we have been analysing the case where Ai > Amin . Suppose now that an entrepreneur has an endowment of capital Ai < Amin . Formal finance is then unavailable to this entrepreneur. Such an entrepreneur will

only operate formally using informal finance if pPψK{θ (s) − (1 + s)β} − pF > 0. This  requires that the fixed setup costs in the formal sector, F, are not large and that θ (s) (1 + s) is larger than β. If the relative productivity of the informal sector is high,18 then there is another limit to which the government may set indirect tax rates if it wishes to contain

the growth of informality. This limit is given by the requirement that θ (s) (1 + s) > β. Another way to induce firms towards formal operations, of course, is to improve 18 Values

of β closer to 1 increase the relative productivity of the informal sector.

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Expected profits

Formal operations

Informal operations

/ Amin

Ai

Amin

Fig. 1.5 Financial development at the lower asset margin

financial development. A reduction in R˜ will reduce Amin =

   ˜ i − pαψKi φ . RL

/ A reduction in R˜ will reduce Amin to Amin and for a sufficient reduction in R˜ operations in the formal sector will be profitable as depicted in Fig. 1.5 where the dashed lines are the economic possibilities when financial development has taken place and / reduced the value of Amin to Amin . Another option, of course, that ought to be stressed is for an improvement in judicial efficiency. This has two impacts: it reduces Amin , and second, it shifts upwards the profit functions in both the formal and informal sectors. A more efficient judicial system will amplify the impact of financial development and raise the incentive to operate formally. Hence, the overall message is that financial development has an important link with the size of the formal economy and also the levels of tax collection. An efficient judicial system plays a supportive role towards such an outcome.

Concluding Comments It is well known that there are deficiencies in the legal and regulatory environment in India which results in low credit extension to the economy. First, enforcing contracts is time-consuming and costly. In the Doing Business 2014 indicators India is placed at 186 out of 189 countries on contract enforcement. Enforcement of a contract19 dispute takes 1420 days and 39.6% of the amount of the claim goes to attorney and court fees. It is well known that the more easily that contracts can be enforced, the

19 The

South Asia average for days to enforce a contract is 24% lower at 1075 days and the cost is 30% lower at 27.7% of the contract claim.

Concluding Comments

11

higher is the level of credit provided to the private sector.20 Judicial inefficiency is an important determinant of high interest rate spreads and the low level of financial development. Collateral laws are an important second component of a weak legal regime that affects credit provided. Collateral is sought by lenders so as to incentivize borrowers to repay. However, the legal system that supports this requires that there are no significant delays in repossession and sale of collateral once a default has taken place. Collateral regimes retard the provision of credit because they do not have central registries for identifying and recording liens over collateral. In countries with strong collateral regimes a creditor can search electronically to find out if a borrower has pledged collateral to other lenders. Creditors usually shy away from extending credit if their lien does not have priority over those of other current and future creditors. Widespread sharing of credit information results in competition amongst banks, reduces the likelihood of defaults, and lowers the interest rate charged. India has a private credit bureau that covers 19.8% of adults. Lenders have an incentive to not share credit information as borrowers are then forced to go to the same bank each time they want a loan because other banks do not have their credit history. In such a situation there should be regulations that penalize banks for not sharing credit information with credit bureaus. The benefits it creates in terms of improving the flow of credit more than compensates for the cost of regulation that makes information provision mandatory. Finally, bankruptcy laws need to be revamped. In countries with large credit flows to the private sector laws require that the claims of secured creditors be satisfied first when a firm declares insolvency. In India, when a business is liquidated the claims of workers and tax authorities are met first. This makes secured lenders reluctant to extend credit, and when they do, they usually demand a higher interest rate in order to compensate for the increased risk they bear. Bankruptcy regimes also increase the reluctance of lenders to extend credit when bankruptcy proceedings are timeconsuming and costly. In India according to Doing Business 2014, it takes 4.3 years to complete insolvency proceedings and India is ranked 124 in this dimension. This causes uncertainty and delay to lenders who look to the recovery of their loans. The legal and other costs of bankruptcy amount to 9% of the value of the estate of the debtor and on average 25.6% of the amount is recovered.21 There is also scope to change bankruptcy laws so that creditors have greater control over the appointment of a manager or a receiver to manage the company after it enters into insolvency proceedings. As of now the incumbent management of the company has control rights when insolvency proceedings are on which reduces the likelihood of lenders being repaid. An improvement in judicial efficiency that increases the flow of finance to the private sector will also lead to a higher tax base that will fund state expenditures. Thus, it has the potential to reduce fiscal deficits at the same time. This is an important factor that it is also important to keep in mind so that credit is advanced to the private sector. 20 See 21 In

Levine et al. (2000). South Asia 29.1% is recovered and in the OECD it is 70.6%.

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A high fiscal deficit, for instance, reduces the significance that banks will place on private sector lending as they can earn acceptable returns from risk-free government lending. Many small enterprises are not in a position to compete with public debt in the portfolio of banks and reductions in such debt can improve credit flows to them. This is in addition to the higher interest rates that in any case accompany high levels of public debt that make taking out a loan unaffordable for many borrowers. In addition to fiscal authorities cornering credit, monetary authorities also need to consider reducing the high reserve requirements after considering the risk faced by the banking system. When there is a high probability of debtor defaults prudential considerations require the central bank to mandate that banks keep a greater share of their deposits in liquid assets. However, with deposit insurance in place the need for high reserve requirements requires some reconsideration as it reduces the funds available with banks to advance to the private sector. The liberalization of the taxation system22 in 1992–1993 and the financial sector in 1994 improved the efficiency of firms. However, for the formal sector to grow a focus of reforms on judicial efficiency will increase the flow of finance to the private sector and make the taxes available that fund the requirements of state expenditures.

Bibliography Acs, Z. J., & Audrestsch, D. B. (1987). Innovation, market structure and firm size. Review of Economics and Statistics, 69, 567–574. Basu, K., Dercon, S., Kanbur, R., & Svejnar, J. (2017, November). Regulation, Minimum Wage and Informality: Introduction to Symposium. Review of Development Economics, 21(4), 935–938. Beck, T. A., Demirgüç-Kunt, A., & Maksimovic, V. (2005). Financial and legal constraints to firm growth: Does firm size matter? Journal of Finance, 60, 137–147. Brown, C., Medoff, J., & Hamilton, J. (1990). Employers: large and small. Cambridge MA: Harvard University Press. Davis, S. J., Haltiwanger, J., & Schuh, S. (1993). Small business and job creation: Dissecting the myth and reassessing the facts. Business Economics, 29, 13–21. Kanbur, R. (2009). Conceptualising informality: Regulation and enforcement. V. V. Giri Memorial Lecture. Accessed at www.people.cornell.edu/pages/sk145. Kanbur, R. (2017, November). Informality: Causes, consequences and policy responses. Review of Development Economics, 21(4), 939–961. Kocchar, K., Kumar, U., Rajan, R., Subramanian, A., & Tokatlidis, I. (2006). India’s pattern of development: What happened, what follows? Journal of Monetary Economics, 53(5), 989–1019. Kumar, K. B., Rajan, R. G., & Zingales, L. (2001). What determines firm size? University of Chicago, CRSP Working Paper No. 496. Levine, R., Loayza, N., & Beck, T. (2000). Financial intermediation and growth: Causality and causes. Journal of Monetary Economics, 46, 31–77. OECD. (2007). OECD economic surveys—India (Vol. 2007/14) Paris. Pack, H., & Westphal, L. (1986). Industrial strategy and technological change: Theory versus reality. Journal of Development Economics, 22, 87–128. 22 The

personal income tax brackets were reduced to three with rates 20, 30, and 40% in 1992– 1993, and financial assets were removed from the imposition of wealth tax with the maximum rate of wealth tax reduced to 1%.

Chapter 2

Self-Employment and Human Capital

Introduction A characteristic of modern economic growth that Kuznets (1996) highlighted was the shift in the structure of production from small to large firms and from selfemployment to wage work. What accounts for the fact that in developing countries few people work for wages? The extent of self-employment in India is large—they constituted 56.5% of employment in 2004–2005 (NSS 2005). Casual workers constitute 28.3% of employment and regular workers are 15.2% of the employed. Yet academic work on self-employment is sparse. Most works on employment concentrate on wage employment and we know more about the conditions of such employment on the basis of whether it is rural or urban or whether personal characteristics such as membership of a certain caste or socio-religious group affects employability and wages. In contrast, almost nothing is known about self-employment. The National Commission for Enterprises in the Unorganized Sector (NCEUS 2007) acknowledged that employment is dominated by self-employment and identified three sub-categories of the self-employed in non-agriculture: (1) Own-account workers who work using their own labour power, (2) Unpaid family workers who contribute to family income but are not remunerated, and (3) Employers who hire less than 10 workers and thereby belong to the informal sector. The Commission emphasized that the self-employed are not necessarily and uniformly poor and include professionals such as doctors, architects, and lawyers with significant physical and/or human capital, and at the other extreme, street vendors and handloom weavers with little capital. The Commission also documents some of the characteristics of the self-employed such as weak access to credit, marketing, infrastructure, and technology. Whilst doing a socio-economic profile of workers the Commission makes the following observation: Lower level of education among the workers creates vulnerability at two levels. It first denies access to “good jobs” in the organized sector. Second, it confines the workers to mostly casual manual jobs. (NCEUS Sect. 2.22)

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_2

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The self-employed people in India as per the data have higher levels of educational attainment than do casual workers, but their educational attainments are lower than those of regular workers. It is this characteristic—the extent of human capital’s association with types of employment—that this paper attempts to unravel. The question that concerns is what does the amount of human capital have to do with the decision to allocate labour across self-employment, regular, or causal employment. In as much as educational attainment is a policy goal, its impact on the structure of employment decisions is of consequential importance. There are two sets of explanations that have been advanced to explain selfemployment. One argues that above market-clearing wages due to government or union-induced rigidities such as high firing costs and excessive benefits ration employment in the organized sectors and cause workers to shift their labour supply to the unorganized sectors. In contrast to this view that sees informal sector selfemployment as a less preferred employment option, a second view argues that people are self-employed by choice and not because of rigidities in the formal sector (Yamada 1996). This view emphasizes that the self-employed people work for themselves and so receive rewards for their human capital, physical capital, and entrepreneurial skills, whereas wage earners get a return only on their human capital. Thus, people with entrepreneurial ability choose self-employment as the sum of labour, and entrepreneurial income makes them better off than if they sought wage employment. Maloney (1999) also argues that rather than above market-clearing wages resulting in informality it is the reverse—the attractiveness of self-employment—that causes firms to pay above market-clearing wages. If the cost of benefits received in the organized sector is passed down to workers in the form of lower wages and workers do not value benefits as much as the fall in wages either because there are weak linkages between benefits and contributions or if the provision of social security and health benefits is inefficient, workers may seek jobs in the informal sector which pay only a monetary remuneration and no benefits. Rather than debate about whether self-employment is a less preferred rationed option or whether it is a preferred choice that causes firms in the organized sector to pay high wages, our approach is to consider the labour allocation decision between self-employment and wage employment in a standard choice framework. In this context we ask what effect does human capital have on the decision to be selfemployed or to engage in wage labour.

Labour Allocation We consider an agent (either an individual or household) that maximizes their utility U (Y, l) over income (Y ) and leisure (l) with the utility function having the standard properties.1 Income originates from two sources—self-employment income, Y SE , and wage employment income, Y w . Self-employment involves the production of an 1 It is a differentiable, quasi-concave, monotonic function with positive first-order partial derivatives.

Labour Allocation

15

output with the deployment of factors such as physical capital inputs (K) and labour SE which  OE in addition to self-employed labour (N ) may include engaging other labour . With the price of output normalized to unity and r and w the price of capital N and labour, respectively   Y SE = Q N SE + N OE , K , H − r K − wN OE

(2.1)

where H is the stock of human capital which is treated as a fixed factor. As argued by Rees and Shah (1986), education increases an individual’s human capital, which in turn increases the efficiency with which business opportunities are assessed. At the same time, as the acquisition of human capital increases managerial ability and the income from self-employment, it also raises the wage-earning capacity of the individual as the higher costs incurred in acquiring skills have to be compensated for with higher wages as argued by Mincer (1974). The income from wage employment then is Y w = w(H )N w w (H ) > 0

(2.2)

where N w is the amount of mandays of labour. The decision problem then is as follows: Max U (Y, l)

{N w ,N ,K }

such that Y = Y SE + Y w H = N SE + N w + l, N = N SE + N OE K ≥ 0, N ≥ 0, N ≥ 0, N w

SE

≥ 0, N

OE

(2.3) ≥0

The Kuhn-Tucker conditions are: N w : UY w − Ul ≤ 0, N w (UY w − Ul ) = 0 N : UY Q N − Ul ≤ 0, N (UY Q N − Ul ) = 0

(2.4)

K : UY (Q K − r ) ≤ 0, K UY (Q K − r ) = 0 If the agent is full-time self-employed (N w = 0), then the wage is less than the marginal product of labour in self-employment. Conversely, if the agent is fully in wage employment (N = 0), then the marginal productivity of labour in selfemployment will be less than the given market wage. We focus rather on the interior solution where the market wage is equated to the marginal product of selfemployment and the marginal rate of substitution between income and leisure. The first-order conditions then are Ul /UY = w = Q N and Q K = r. Comparative statics

16

2 Self-Employment and Human Capital

of the constrained optimization problem with respect to a change in the amount of human capital yields the following system: ⎡

w(UYY − UYl ) − UYl + Ull (wUYY − UYl )Q N ⎢ −Q NN ⎣0 0 Q KN ⎡ −(wUYY − UYl )(Q H + N w w H ) − UY w H ⎢ = ⎣ −w H + Q NH −Q KH

⎤ ⎤⎡

∂Nw ∂ H (wUYY − UYl )(Q K − r )

⎥ ⎥⎢ −Q KN ⎦⎣ ∂ N ∂ H ⎦

∂K ∂H Q KK ⎤ ⎥ ⎦

(2.5)

From this we obtain, ∂ N SE (Q NH − w H )Q KK − Q KN Q KH = ∂H Q 2KN − Q NN Q KK

(2.6)

The denominator of (2.6) is negative. In the numerator the second component (−Q KN Q KH ) is negative as well. Hence, the sign of ∂ N SE /∂ H depends on whether the marginal product of self-employment as human capital increases (Q NH ) is greater or less than the increment in the wage as human capital increases (w H ). The intuition2 for the response of N SE to a change in human capital is that beyond some threshold level of human capital H ∗ , as human capital increases the impact on managerial ability is large and the self-employed are able to increase the efficiency of production, thereby inducing them to allocate more labour towards self-employment. However, at even higher levels of human capital the wage in the labour market increases sufficiently with human capital increases and gives rise to a decline in the labour allocated to self employment. At some human capital level H ∗∗ , then all labour will be in wage employment and none in self-employment (Fig. 2.1). We thus have three regimes of employment. To the left of H ∗ the stock of human capital is meagre and with limited skills and capabilities an agent is able to participate only in a highly casualized labour market where most labours are casual labours. In the interval (H ∗ , H ∗∗ ) the level of human capital increases the income-earning potential from self-employment and causes the agent to become self-employed. After H ∗∗ , however, the extent of skills is higher, and the corresponding income from being in the labour market is much higher and agents with these higher levels of human capital will allocate all their labour to wage employment which will be more regularized employment. Self-employment is, therefore, a type of employment that diminishes with development as the human capital levels of a country increase. Kuznets finding that wage employment supersedes self-employment as economic growth proceeds is, therefore, contingent on the evolution of the stock of human capital which is the mediatory factor that results in this outcome. is true if the marginal product of self-employment as a function of human capital Q N (H ) is more concave than the wage function w(H ).

2 This

Concluding Remarks

17

Self Employment

N SE

H*

H**

Human Capital, H

Fig. 2.1 Labour allocation

Concluding Remarks Our results indicate that the high fraction of employment in the economy which is in the form of self-employment is related to the levels of human capital that the workforce is endowed with. As Sundaram and Tendulkar (2006) point out that even by the year 2000, there was still 65.5% of the total workforce (361 million people) who had zero or less than five years of schooling. If the stylized fact of development is that economies gravitate towards wage employment, then it is education that is the key that unlocks the economy on this trajectory. But we need to be cautious in presenting education as the panacea because the literature on the impact of human capital on growth does not find significant impacts (Pritchett 2001). This is because there is no single and context-independent relationship between education and output. For instance, if the expansion of education is pursued as a means to indoctrinating children into an economic ideology as occurred in Cuba, the impact on output is likely to be minimal. If, on the other hand, the expansion of education is linked to the increasing demand of a dynamic economy, then it is likely to be associated with economic growth (Lindauer and Pritchett 2002). In some sense, quality institutions in an economy are substitutes/complements for education policy. It is true that workers require business enterprises to exist if they are to find employment. The more the number of business enterprises are in existence, the more are the prospects of employment, and that is an incentive for workers to invest in the education that is required by firms. A policy of improving institutions such as reducing entry barriers, improving the protection of property rights, ensuring adherence to the rule of law, and so on can actually then raise the returns to education and cause workers to invest in education. Thus, just reducing the cost of acquiring education or providing a subsidy to education is an insufficient mechanism for the transformation of an economy towards a technologically vibrant

18

2 Self-Employment and Human Capital

and diverse economy. Governance reforms that improve the quality of institutions that foster the growth of enterprises can contribute to the transition of employment from self-employment towards wage employment by enhancing the returns to education.

Bibliography Knight, F. (1957). Risk, uncertainty and profit. New York: Kelley and Millman. Kuznets, S. (1996). Modern economic growth: Rate structure, and spread. New Haven: Yale University Press. Lindauer, D. L., & Pritchett, L. (2002). What’s the big idea? The third generation of policies for economic growth (pp. 1–39). Fall: Economia. Maloney, W.F. (1999). Self employment and labour turnover: Cross country evidence. Policy Research Working Paper 2102, April, The World Bank. Mincer, J. (1974). Schooling, experience and earnings. New York: Columbia University. NCEUS. (2007). Report on conditions of work and promotion of livelihoods in the unorganized sector. New Delhi: National Commission for Enterprises in the Unorganised Sector. NSS (2005) Employment and unemployment Survey, 61st Round. Pritchett, L. (2001). Where has all the education gone? World Bank Economic Review, 15(3), 367–391. Rees, H., & Shah, A. (1986). An empirical analysis of self employment in the UK. Journal of Applied Econometrics, 95–108. Sundaram, K., & Tendulkar, S. D. (2006). Changing structure of indian workforce, quality of employment and real earnings, 1983–2000. Mimeo. Yamada, G. (1996). Urban informal employment and self employment in developing countries: Theory and evidence. Economic Development and Cultural Change, pp. 289–314.

Chapter 3

Informal and Formal Employment in a Liberalizing Economy

Introduction Informality is an enduring characteristic of labour markets in developing countries. It has not been reduced significantly even if countries have experienced superior levels of economic growth along with low volatility. Informal employment is especially acute in India which is an outlier country in terms of the number of people employed informally. This is borne out by the large share of non-agricultural informal employment of 83.6% in India which is significantly higher than that of other BRICs countries—Fig. 3.1. Informal employment is so pervasive that in the public sector in India it is estimated that a third of all jobs are informal (Kolli and Sinharay 2011). For those in nonagricultural wage employment, more than three-fourths have no written contract, 70% are not eligible for paid leave, and 74% are not covered by social security benefits (Mishra et al. 2013). There is also a gender dimension—women are more vulnerable to informal employment and are more likely than men to be working in the most disadvantaged and marginalized segments of the informal economy (ILO 2013). With regard to economic sectors, workers in the trade and construction sectors in India are more likely to be in informal employment than workers in other sectors (ILO 2013). However, the share of informal employment is large and over 80% even in the transport and manufacturing sectors. Employees constitute 52.8% of informal nonagricultural employment in India, 37.9% are from among own-account workers and members of producers’ cooperatives, and the remainder 9.3% are contributing family workers (ILO 2013). Many workers in the informal sector work in dire conditions and in industries such as chemicals, leather tanning, and brick kilns and they are exposed to life-threatening chemical fumes and to injuries (NCEUS 2007). During the last two decades the per cent of workers in informal employment in India has remained stable—it was 92.6% in 1999–2000, 93.4% in 2004–2005, and 92.4% in 2011–2012 (IHD 2014, Table 2.5B). The bulk of informal employment is in the informal sector. However, a substantial number of workers in formal enterprises are informally employed in many emerging market economies (Fig. 3.2). © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_3

19

20

3 Informal and Formal Employment in a Liberalizing Economy

Fig. 3.1 Persons in informal Employment, percentage of non-agricultural employment

Fig. 3.2 Persons in employment in informal sector and in informal employment outside the informal sector, percentage of non-agricultural employment

In India informal employment within the formal sector—both in the industrial and services sectors—has grown to the detriment of formal employment. The proportion of informal workers in total formal sector employment has been rising from 41% in 1999–2000 to 48% in 2004–2005 and it expanded to 58% in 2011–2012 (Fig. 3.3). Not only has contract labour been increasing in factories but also within many services sectors such as financial services, real estate business, education, and

Introduction

21

Fig. 3.3 Percentage of informal workers in formal sector

health, and there has been an increase in informal employment. This raises an important question that requires to be addressed. Why is it that the pickup in economic growth in the last two decades and increased liberalization of the economy has been characterized by an increased importance of informal employment within the formal sector of the economy? The expectation is that as an economy develops there ensues a shift towards non-agricultural employment and towards formal employment with certain benefits such as sick leave and social protection. That this has not been the case is an important dimension of the trajectory of growth that requires an explanation.

Informal Employment in the Formal Sector It is imperative to delineate what this oxymoron is, which is called informal employment in the formal sector. This has most clearly been done by Ravi Kanbur (2009) in his V.V. Giri Memorial Lecture at the golden jubilee conference of the Society. After arguing that the informal and formal dichotomy has been associated with no clear definition but rather is “better thought of as metaphors that conjure up a mental picture of whatever the user has in mind at that time”, he stipulates that every characterization of these terms needs to “specify precisely the regulation concerned” (italics in original). Thus, formality and informality are dichotomies in relation to specific regulations. The definitions based on criteria such as size, degree of organization, or nature of competition are not useful. An activity is accordingly to be defined as formal when it is subject to government regulations and is complying with those regulations. Informality then is the binary

22

3 Informal and Formal Employment in a Liberalizing Economy

pair of formality and is a realm of economic activity that is constituted via negation to formality. In this way informal economic activity is of three types. There are activities conducted which are subject to regulation and are not complying (the evaders), those that are not subject to regulations because they have adjusted outside of its ambit (the avoiders), and those activities to which the regulations do not apply even without any adjustment (the outsiders) (Kanbur et al. 2012). Thus when there is a decision made that it is best to conduct an economic activity and to stay within the scope of a regulation there is a concomitant decision to be made of whether to comply or not with the regulation. Complying with regulation is a function of the enforcement of regulations that are known to be quite imperfect to say the least in the literature on economic development. A natural way to think of growing informal employment in the formal sector then is in terms of weak enforcement of regulation. Going forward we will consider the implications for employment of one of the most discussed regulations—that associated with employment protection. It is well known that labour laws that India has on the books are more severe than in most OECD countries. Two regulations that impinge on the decision as to whether to offer formal or informal employment contracts are those associated with job security under the Industrial Disputes Act of 1947 and the Contract Labour (Regulation and Abolition) Act of 1970. Both these regulations have been deemed to be associated with the rigidity and protection of employment. The Industrial Disputes Act of 1947 besides specifying conditions for lay off and retrenchment of labour (such as a notice period and compensation to workers) also stipulates the requirement of prior government permission if the enterprise employs 100 or more workers. The Contract Labour (Regulation and Abolition) Act prohibits the use of contract labour in the “core” and “perennial” activities of an enterprise. In markets that are subject to fluctuating demand, these regulations have been projected by employers as restricting their ability to have flexibility on tap in their employment decisions. Yet enterprises employing more than 100 workers have found ways to reduce their workforce and even to shut down (Deshpande et al. 2004). Contract labour has appreciably increased in organized manufacturing from 23% in 2000–2001 to 27% in 2004–2005 and 34% in 2011–2012 (IHD 2014). This is often attributed to a “‘relaxed’ attitude that the governments have tended to adopt in respect of compliance of labour laws” (IHD 2014, p. 40). In addition to regulation and enforcement, there is a need to identify from the perspective of an employer the characteristics of a job that would be considered by an employer to warrant formal employment and one that would call for informal employment. This aspect of formal and informal employment is not sharply delineated in the literature. Here we posit that a typical informal job would be one that is short-lived, relatively simple, and most importantly, easily supervised. In contrast, a representative formal job is relatively more complicated, and entails a fair degree of responsibility and need for independent initiative. As supervision is expensive for formal jobs it allows employers to monitor such workers periodically or imperfectly and they have to employ other mechanisms to contain problems of worker moral hazard. As in Shapiro and Stiglitz (1984) such employers may pay a wage in excess of that needed to attract labour so as to induce a discrete cost of job loss and

Informal Employment in the Formal Sector

23

elicit effort notwithstanding occasional supervision. In the context of employment protection regulation which makes firing difficult, employers would have to pay an additional amount to offset the reduction in effort induced by an increase in employment security. The analytical distinction between a formal and informal job then is that supervision is easy to do for an informal job whereas it can only be done irregularly for a formal job. Employees in formal employment accordingly receive a wage premium so as to induce an efficient level of effort supply as well as to counterbalance the effect of employment protection regulation. Such employees wage contracts would also typically be back loaded with deferred payments, including pensions and other benefits, so as to elicit effort over time (Lazear 1981). They would also include institutional safeguards such as severance payments in order to contain the possibility of employer opportunism that indulges in terminating the services of workers regardless of shirking (D’Souza 2008). In this paper we assume that formal employment contracts comply with such requirements of pensions and severance payments even as we side step the nuances of the time dimensions of contracts that are associated with eliciting effort. Employees in informal employment, in contrast, receive wages that reflect effort since that is monitorable, and employers take into account the enforcement cost of implementing such contracts given the regulation of employment protection. From the focal point of employment protection regulation, then, in the case of formal employment, such regulation affects the effort of a worker and firms’ influence that effort through selection of an appropriate wage. In the case of informal employment, an increase in the enforcement of regulation is akin to an increase in the marginal cost of informal employment (more on this below). Our approach is related to a series of papers that have focused on the impact of liberal economic policies on informal employment. Dasgupta and Marjit (2004) consider wages in the formal sector that are set by unions. The state is constrained to not allow job losses to arise in import competing industries as a result of liberalization. Since unions set wages above the market clearing level, firms attempt to evade such payments by resorting to informal contracts. Informal employment then increases as do directly unproductive expenditures made by the firm to reduce enforcement and allow the evasion of formal contracts. In Marjit and Kar (2012) wage rates in the two forms of employment are exogenously given. Firms are distributed along a continuum of formality with respect to adherence to legal mandates such that relatively productive firms hire both formal and informal workers, whereas firms with lower productivities hire only informal workers. In this setup informal wages do not change the level of employment but only its composition for firms that are relatively highly productive. They advocate this as a justification for enforcing labour laws strictly on large firms. In our setup that centres wage adjustment in the formal sector in response to employment protection, the costs of both forms of employment get affected by regulation, and the impact of a change in regulation results in changes in the types of employment within firms. Consider then a worker that an employer assigns to a formal job who is risk neutral and who maximizes utility that is additively separable in expected consumption (C) and effort (e)

24

3 Informal and Formal Employment in a Liberalizing Economy

U =C −e

(3.1)

Expected consumption is given by C = (1 − p)w + p B

(3.2)

where p is the probability of being caught shirking and being fired. B refers to the level of benefits that are experienced on being fired such as unemployment assistance. The probability of being caught shirking and being fired will in turn depend on the amount of effort put in by the worker which we take to be adjustable by a worker in response to the wage premium offered by the employer and the institutional extent of employment protection that is in place. Hence, effort is a continuous variable and defined in such a way that 0 ≤ e ≤ 1. Let θ represents the level of the employment protection regulation parameter. Higher values of θ indicate a more stringent employment protection regime. Then the probability of being caught shirking and being fired may be written as p = p(e, θ )

(3.3)

where pe < 0, pθ < 0, pee > 0, and peθ > 0. Hence, substituting (3.2) and (3.3) into (3.1), U = [1 − p(e, θ )]w + p(e, θ )B − e

(3.4)

A worker who is offered a job in formal employment will then choose the level of effort that maximizes (3.4) which gives the first-order condition: pe = −

1 (w − B)

(3.5)

Equation (3.5) implies the following effort function: e = e(w, θ, B)

(3.6)

where it can be shown with that ew > 0, eθ < 0, and e B < 0. The effort by the worker increases with the wage and is decreasing in the extent of employment protection regulation as well as the extent of benefits received after being caught shirking and being fired. An employer keeps a regard to the effort function of employees and chooses the extent of formal and informal employment as well as the wage to be paid to those who are formally employed so as to maximize profits. Let L F denotes the extent of formal employment in the firm, L I the extent of informal employment, and wF , wI

Informal Employment in the Formal Sector

25

the corresponding wages paid in the two forms of employment. The employer then selects L F , L I , and wF to maximize:  = F[e(w, θ, B)L F + L I ] − w F L F − w I L I −

θ L 2I 2

(3.7)

As argued above, in informal employment the issue of effort elicitation is not a consideration and so the wage wI is given since all labour is otherwise homogeneous. The parameter θ is the intensity of enforcement of regulation by government. We can think of this parameter as the outcome of the state’s response to a reduction in employment that ensues if regulation is perfectly enforced. Regulation in this view can be thought of as an aspiration that may not be perfectly enforced due to the ensuing political unrest stemming from unemployment. The state, for instance, may regulate that firms may not layoff workers but if that results in employers restricting job vacancies then it may instead look the other way as informal contracts are offered without job security. Alternatively, perfect enforcement may not be prevalent due to bribes paid to labour inspectors and bureaucrats. In that case the parameter θ is the applicable enforcement level after taking into account the costs of the side payments incurred by the employer to the inspector. Writing the enforcement cost as  θ L 2I 2 indicates that increases in informal employment are more easily subject to scrutiny by public authorities as well as public scrutiny (including by the media). The enforcement cost could be written more generally as θ (L I ) where θ  > 0 and θ  > 0. The quadratic form is employed here for simplicity. Since the level of benefits B is not the focus of this paper, it is censored in the ensuing analysis. The first-order conditions to the employers’ profit maximization problem are: ∂ = eF  − w F = 0 ∂LF

(3.8a)

∂ = F  − wI − θ L I = 0 ∂LI

(3.8b)

∂ = F  ew F L F − L F = 0 ∂w F

(3.8c)

Combining (3.8a) and (3.8c) gives us the famous efficiency wage  condition  that the elasticity of effort with respect to the wage is equal to one, that is, ew F w F e = 1 (Solow, 1979). Condition (3.8b) states another familiar stipulation that the marginal product is equal to the marginal cost of informal employment. A diagrammatic presentation of conditions (3.8a) and (3.8b) is depicted in Fig. 3.4. On the horizontal axis is the effective units of labour employed by the firm, eL F + L I . At point B in the diagram condition (3.8a) is satisfied, and condition (3.8b) is satisfied at point A. Hence, distance OC represents the extent of informal employment that is offered by the employer and CD is the effective formal employment eL F that is present.

26

3 Informal and Formal Employment in a Liberalizing Economy

wI + θLI

A

wF e

B

wI

O

F′

C

D

eL F + LI

Fig. 3.4 Equilibrium formal and informal employment

To find out the effect of an increase in the stringency of enforcement of employment security regulation, we totally differentiate the set of Eqs. (3.8a,b,c) to obtain

⎡ 2  ⎤ ⎤⎡ ⎤ ⎡ e F eF  ew F eF  L F dLF −e θ eF  L F + F  dθ ⎣ eF  F  − θ ⎦⎣ d L I ⎦ = ⎣ − eθ L F F  − L I dθ ⎦ ew F F  L F

2   0 0 ew F F + F ew F w F dw F − ew F eθ F  + F  ew F θ dθ (3.9) Then, dw F ew eθ F  + F  ew F θ

>0 = F2  dθ − ew F F + F  ew F w F

(3.10)

Thus in equilibrium an employer compensates for the unfavourable effect of an increase in the employment security regulation parameter, θ , by increasing the wage of those in formal employment with a view to prompt greater effort from such employees. The effect of the regulation parameter on informal employment is given by 1 eθ dLI = − L I + F dθ θ e

(3.11)

  The sign  of d L I dθ is ambiguous. It will be positive provided that eL I + eθ F < 0, which is the case on the condition that

Informal Employment in the Formal Sector

θLI θ < − eθ wI + θ L I e

27

(3.12)

The left-hand side of the above inequality is the share of marginal enforcement of regulation cost in the marginal labour cost of informal employment. The right-hand side is the partial elasticity of effort with respect to regulation enforcement. Thus, as long as the share of marginal enforcement cost in informal marginal labour cost is less than the partial elasticity of effort with respect to the employment protection legislation parameter, informal employment increases   with an increase in the parameter. That is, when condition (3.12) holds, d L I dθ > 0. Finally, the effect of the regulation parameter on formal employment is given by      eθ F  θ − F  − eF  L I F  L F eθ ew F w F − ew F ew F θ dLF   − =− dθ e e2 F  θ ew2 F F  + F  ew F w F

(3.13)

 Again the sign of d L F dθ is ambiguous. However, since the employer is concerned about effective labour employed, the effect on formal employment should be considered in conjunction with the effect on effort. The effect of the regulation parameter on effort by formal employees is given by   ew F ew F θ − eθ ew F w F F  de   = dθ − ew2 F F  + ew F w F F 

(3.14)

Yet again, the effect on effort is also ambiguous. This is because the intensification of employment protection regulation has the direct effect that it reduces effort. Employers offset this impact by raising wages so as to induce higher effort. As a consequence,     the overall effect on effort isambiguous. If de dθ  < 0, then it implies that d L F dθ > 0 in (3.13) provided that 

eθ F  θ − F  − eF  L I < 0.  is akin to the requirement for the following  This inequality to hold for the case d L F dθ < 0: F  eθ F  < (3.15) θ − F  eL I

    < 0, inequality (3.15) if −1 <  −1 <  F  θ − F  holds   Since θ − F  < eθ F eL I . This inequality −1 < eθ F  eL I is the F  same  as 0, and when this holds it is the case that d L dθ

I   (Eq. 3.12).Similarly, if de dθ > 0 and condition (3.15) continues to hold, then      the sign of d L F dθ is ambiguous. However, it is still the case that d L I dθ < 0. We summarize the impact of a change in θ on  L I , L F and e in Table 3.1. Table 3.1 demonstrates that when d L I dθ < 0 holds, which is the case of an increase in informal employment as employment protection regulation is liberalized, then profit maximization is associated with ambiguous impacts on effort and formal employment. Interestingly, there is the possibility of an aberrant effect where

then sign of

dLF dθ

de If dθ > 0, then dLF dθ < 0

ambiguous

then sign of

dLF dθ de If dθ > 0, then dLF dθ < 0

dLI dθ < 0 de If dθ < 0,



then

dLF dθ



>0

de dθ

> 0, then LF sign of ddθ ambiguous

If

eθ F F −1 < θ −F 0 and eθ F  + eL I > 0

N.B.: The second row indicates values implied by the inequalities stated in the first row. The values in the second row plugged into Eq. (3.11) gives the sign         of d L I dθ. The values in the second row along with either de dθ > 0 or de dθ < 0, plugged into Eq. (3.13) gives the sign of d L F dθ in the final rowN.B.: The second row indicates values implied by the inequalities stated in the first row. The values in the second row plugged into Eq. (3.11) gives the sign         of d L I dθ. The values in the second row along with either de dθ > 0 or de dθ < 0, plugged into Eq. (3.13) gives the sign of d L F dθ in the final row

ambiguous

dLI dθ < 0 de If dθ < 0,



dLI dθ > 0 de If dθ < 0,



F θF −1 < eeL < θ −F  < 0 I

   eθ F  θ − F  − eF  L I < 0 and   eθ F  + eL I > 0



F < −1 < θ −F  < 0

   eθ F  θ − F  − eF  L I < 0 and   eθ F  + eL I < 0

eθ F  eL I

Table 3.1 Impact of change in enforcement of regulation on formal and informal employment and effort expended in formal employment for different parameter values

28 3 Informal and Formal Employment in a Liberalizing Economy

Informal Employment in the Formal Sector

29

liberalization is associated with a decline in formal employment and an increase in effort expended by workers engaged in such employment as depicted in the final row of Table 3.1. In such a situation effort must rise by such a magnitude so that higher output can be produced by employing a lower amount of formal employment as workers are much more effective in their performance on the job. The employer for the case of formal employment seeks to hire effective labour as cheaply as possible. By hiring a worker the employer obtains e(w, θ ) unitsof effective labour at a cost of w F . The cost per unit of effective labour then is w F e. In effect  for this category of employment the employer is minimizing the effective  wage w F e. The effect on w F e of a change in the regulation parameter is given by    d wF e wF = − 2 eθ > 0 dθ e

(3.16)

An increase in the stringency of employment protection regulation then raises the effective wage. This is as would be expected. An increase in the regulation parameter adversely affects effort and employers respond by increasing the  wage. However, since employers are choosing the wage w F so as to minimize w F e, they respond to a tightening of employment protection regulation by raising the effective wage. We summarize the impact of a reduction in the effectiveness of employment protection regulation in Fig. 3.5. In recent years it has been documented that the permission to retrench workers under Chapter VB of the Industrial Disputes Act have Panel A Case: θLI > − θ eθ wI + θLI

wF e

(wF /e)/

A

e

B A/

Panel B Case: θLI < − θ eθ

wI + θLI

wI + θLI

wF e

B/

A

O

F′ LI LI /

wI + θLI

B

(wF /e)/

A/

wI

e

eLF + LI

wI

B/

F′

O LI / LI

eLF + LI

Fig. 3.5 Effect of reduction in effective employment protection regulation on informal and formal employment

30

3 Informal and Formal Employment in a Liberalizing Economy

been given more easily by state governments (Reddy 2008; Shyam Sundar 2008). Given that the impact on informal labour employment is ambiguous (vide Eq. 3.11), there are two possibilities that the theory throws up. In Panel  A of Fig. 3.5, the impact of a reduction in effective regulation is to shift down w F e to the dashed flat line (Eq. 3.16) and for the w I + θ L I line to swivel to the position of the dashed upward sloping line. There is an increase in informal employment to L I / in Panel A as the share of marginal enforcement cost in informal marginal labour cost is greater than the partial elasticity of effort with respect to the stringency of regulation (condition (3.12) holds). In Panel B of Fig. 3.5, the converse presents itself and informal employment declines to L I / . It is our contention that Panel A of Fig. 3.5 represents the recent scenario in India with respect to the growth of informal employment within the organized sector as portrayed in Fig. 3.3. A reduction in effective regulation from the result in Eq. (3.15) reduces the effective wage to (wF /e)/ as depicted in Fig. 3.5. This along with a decline in the marginal cost of employing labour in informal contracts increases informal employment in Panel A. Even though informal employment has risen, the impact on effort and formal employment is ambiguous as depicted in Table 3.1 on the basis of Eqs. (3.13) and (3.14). We believe that liberalization with respect to the organized sector was a transformation from a regime of blunt effort and relative formal overemployment to a regime where formal employment was blunted and effort required on the job got raised. It is conceivable that with liberalization employee effort has risen substantially so that the output can be produced with about the same labour employed in formal contracts because all workers work that much more effectively. Thus, a rise in e that is sufficiently high can be associated with a decline in L F such that eL F rises along with a decline in enforcement of employment security regulation. At the same time, the wage paid for formal employment, w F , declines despite the rise in effort. A decline in the average wage paid to formal and informal employees as well as a decline in formal employment along with the rise in output due to an increase in the intensity of effort is consistent as well with the decline in the share of labour in output that has been found to be the case in India. The share of wages in value added in organized industry for instance has been declining progressively since liberalization. In the 1980s the share of wages was 45% of value added and this declined to 25% by 2010– 2011 (IHD 2014, p. 109). In terms of our model this is explained by a substitution of formal employment for informal employment, along with a stagnation of real wages, and an increase in the intensity of work effort.

Conclusion Informal employment is severe in India and accounts for 83.6% of non-agricultural employment. Though a large part of informal employment is in the unorganized sector, a significant number of workers in organized enterprises are informally employed. Importantly, informal employment within the formal sector has been growing at the expense of formal employment. This is not what one would envisage

Conclusion

31

to be the case for an economy that has experienced an improvement in the rate of economic growth that has been accompanied by liberalization. This paper provides an analysis of this phenomenon. Formal employment is taken to be that employment offered by employers which is imperfectly monitored and which entails a reasonable measure of independent initiative by the employee. The effect of employment protection regulation for formal employment is that it influences the amount of effort that such workers impart on the job. Even though employers may comply with such regulation the degree of enforcement of such regulation affects the extent of effective labour supplied through the impact on the choice of effort by such workers. The other type of employment that employers may offer are informal employment contracts for jobs that are easily supervised and for which the extent of effort put in is verifiable. Contracts for such jobs would provide employers the flexibility to change employment in accordance with economic conditions but for the presence of employment protection regulation. Employers then seek to evade regulation by incurring a circumvention cost associated with offering informal employment opportunities. In formal employment contracts then even though employers are complying with regulation they take into account the impact of the enforcement of such regulation on effective employment (effort per worker rather than just labour supply). In informal employment contracts employers directly evade the effect of regulation. Workers obtain utility from the expected wage and disutility from effort. Worker effort is shown to increase with the wage offered and to decrease with the stringency of the enforcement of employment protection regulation. Employers take the effort choice of those employed in formal employment contracts into account whilst maximizing profits. They select the magnitude of formal employment, informal employment, and the wage to be paid to those who are offered formal employment. A reduction in the enforcement of regulation is shown to decrease the wage paid to formal employment as well as to reduce the effective wage (wage per unit of effort). Under certain plausible conditions such as that the share of marginal enforcement cost in informal marginal labour cost is greater than the partial elasticity of effort with respect to employment protection regulation, informal employment is shown to rise. The effect on the extent of formal employment and effort is ambiguous. However, a reduction in formal employment that is accompanied by an increase in the intensity of effort raises effective formal employment. Liberalization of the economy accompanied with a blind eye towards compliance with labour laws then results in a rise in informal employment, an increase in the effort required by those in formal employment accompanied by limited adjustment in the number of persons so employed, and a decline in the share of wages in value added.

Bibliography Auer, P., & Jha, P. (2009). Labour market reforms in India: Barking up the wrong tree?”. Indian Journal of Labour Economics, 52(1), 71–82.

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Chen, M. A. (2006). Rethinking the informal economy: Linkages with the formal economy and the formal regulatory environment. In Guha-Khasnobis, Kanbur, and Ostrom (eds.), Linking the formal and informal economy (pp. 75–92) Oxford: Oxford University Press. Dasgupta, I., Marjit S. (2004). Evasive reform: Informalisation in a liberalised economy with wagesetting unions. Working Paper No. 04/06, Centre for Research in Economic Development and International Trade, University of Nottingham. Deshpande, L. K., Sharma, A. N., Karan, A. K., & Sarkar, S. (2004). Liberalisation and labour— Labour flexibility in Indian manufacturing. New Delhi: Institute for Human Development. D’Souza, E. (2008). Labour market institutions in India: Their impact on growth and employment. ILO Asia-Pacific Working Paper Series. Guha-Khasnobis, B., Kanbur, R., & Ostrom, E. (Eds.). (2006). Linking the formal and informal economy—Concepts and policies. Oxford: Oxford University Press. IHD. (2014). India labour and employment report 2014—Institute of human development. New Delhi: Academic Foundation. ILO. (2013). Women and men in the informal economy: A statistical picture. Geneva. ILO. (2014). Informality and the quality of employment in G20 countries. Report prepared for the G20 Labour and Employment Ministerial Meeting, Melbourne, Australia. Jhabvala, R., Sudarshan, R. M., & Unni, J. (2003). Informal economy centrestage—New structures of employment. New Delhi: Sage Publications. Kanbur, R. (2009). Conceptualising informality: Regulation and enforcement. Indian Journal of Labour Economics, 52(1), 33–42. Kanbur, R., Lahiri, S., & Svejnar, J. (2012). Informality, illegality and enforcement: Introduction. Review of Development Economics, 16(4), 511. Kannan, K. P. (2009). Dualism, informality and social inequality: An informal economy perspective of the challenge of inclusive development in India. Indian Journal of Labour Economics, 52(1), 1–32. Kolli, R., & Sinharay A. (2011). Share of informal sector and informal employment in GDP and employment. Journal of Income and Wealth, 33(2). Lazear, E. (1981). Agency, earnings profiles, productivity, and hours restrictions. American Economic Review, 71, 606–620. Maiti, D., & Sen K. (2010). The informal sector in South Asia. Special Issue of Indian Journal of Labour Economics on the Informal Sector in South Asia, 53(2). Marjit, S., & Kar, S. (2012). Firm heterogeneity, informal wage and good governance. Review of Development Economics, 16(4), 527–539. Mishra, P., Newhouse, D., Topalova P. (2013). “Informality of employment in India: Stylized facts and policy implications”, economic survey 2012-13. Ministry of Finance, Government of India, Chapter 2, pp. 46–48. Muralidharan, T., Bino Paul, G. D., & Murti A. B. (2014). Should real wages of workers go up in Indian manufacturing? Economic and Political Weekly, XLIX(30), 153–162. NCEUS. (2007). Conditions of work and livelihood in the unorganized sector. National Commission for Enterprises in the Unorganized Sector, Government of India, New Delhi. Reddy, D. N. (2008). Labour regulation, industrial growth and employment: A study of recent trends in Andhra Pradesh. In T. S. Papola (ed.), Labour Regulation in Indian Industry Series (Vol. 5). Institute for Studies in Industrial Development and Bookwell. Shapiro, C., & Stiglitz, J. E. (1984). Involuntary unemployment as a worker discipline device. American Economic Review, 74, 433–444. Shyam Sundar, K. R. (2008). “Impact of labour regulation on growth, investment and employment: A study of Maharashtra”, institute for studies in industrial development, European union, and international institute for labour studies. New Delhi: Bookwell. Solow, R. M. (1979). Another possible source of wage stickiness. Journal of Macroeconomics, Winter, 1, 79–82. Unni, J., & Sharma A. N. (eds.) (2013). Informal employment in India and China. Special Issue of the Indian Journal of Labour Economics, 56(4).

Chapter 4

Migrants and Informal Casual Labour Markets

In this chapter, we focus on internal inter-state migration and its associated casual employment.1 The principles of the freedom to migrate are recognized by the Constitution of India and are stated in clauses (d) and (e) of Article 19(1) of the Constitution. The Constitution does not permit discrimination on the grounds of place of birth (Article 15) and assures citizens of equality of opportunity in public employment (Article 16).2 Yet migration is often reported to be low across states in India. Even though internal migrants represent a large fraction of the population of the country (30% in the 2001 Census),3 two-thirds of these migrants are intra-district migrants and more than half of them are women migrating for marriage.4 As pointed out by Kone et al. (2018), inter-state migration is slightly above 1% of the population in India, whereas it is 3.6% in Brazil, 4.7% in China, and almost 10% in the USA. Bell et al. (2015)5 compare internal migration across countries between 2000 and 2010 and show that India ranks last in a sample of 80 countries. The 2011 Census puts the figure at 50 million for internal migrants who migrated for economic

1 Prof.

Papola’s work in this area is represented in Papola (1975) and (1981). Supreme Court in Charu Khurana versus Union of India and Others (Civil Writ Petition No. 73/2013) laid down that restrictions based on residence for the purposes of employment were unconstitutional. The petitioner, a make-up artist, was denied membership of the Cine Costume Make-up Artists and Hair Dressers Association on the ground that she had not resided in Maharashtra for five years. As the union had a monopoly over accreditation of make-up artists in the state this affected her ability to work. The court held that provisions of the rules relating to gender and domicile were in violation of Articles 14, 15, and 21. See Ministry of Housing and Urban Poverty Alleviation (2017)—“Report of the Working Group on Migration”, January. 3 Using provisional tables from the 2011 Census, the Economic Survey (2017) suggests the share of migrants for economic reasons rose from 8.1% of the workforce in 2001 to 10.5% which still suggests that the country is characterized by low internal migration. See Economic Survey (2017), Chapter 12, “India on the move and churning: New Evidence”, Department of Economic Affairs, Ministry of Finance. See also Tumbe (2018). 4 Kone et al. (2018). 5 Bell et al. (2015). 2 The

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_4

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reasons. And the Economic Survey of India in 2017 estimated the figure to cross 100 million.6 Short-term seasonal migration for work is known to be not captured well by national data systems and the estimates here vary from 80 to 140 million.7 There are, for instance, several well-known migration-sensitive labour markets in construction, head loading, textiles, recycling, and small manufacturing in large cities in India. Our focus is on the relatively low inter-state migration for economic reasons, which is surprising as we know that migrants with factor endowments that are different from those who are current local residents of a region can produce complementarities in production that increase the incomes of the region. Migrants can also play a role in an economy that has labour and skill shortages in particular segments of the economy such as in Kerala. Migration also has spillover effects—it results in a more diverse society which ought to be valued, but at the same time, it can result in a greater population density and more congested habitats. Congestion that is accompanied by run down and unhygienic conditions of living as well as high rents usually results in migrants who are males, and has the upshot of a gender dimension to migration. Residents in a locality also tend to view migrants as impacting the public finances of the region. It could well be that migrants receive more in public services and benefits than they pay in taxes and are a drain on the public finances. To the extent that these workers do not depend on the welfare state they are net contributors to the economy. Residents are also typically divided about the benefits of migrants to their society depending on their valuations of the gains and losses to them as economic agents. Employers may benefit from the increase in the supply of labour, and middle-class households may benefit from the lower price of household services provided by the migrants and their families. Local residents with comparable skills to those of migrants may find that they have to compete for jobs in the labour market. If they feel the pinch to their household budgets due to this, there could develop the rhetoric of migrants taking away the jobs of the locals who are sons of the soil. A migrant receiving region may also attribute to the migrants as coming from a different cultural milieu and view their presence as impacting the cultural identity of their region. If that translates into a situation where questions are raised about shared norms and mutual obligations in a society, it could quickly result in migrants being viewed as having adverse effects on the society.8 In response to these concerns local governments may prioritize the interests of local residents over those of migrants. To the extent they do so they do not take into account the benefits to the families of migrants who may have stayed back in their homes and the remittances that are made to them. Local governments and political parties will consider the relative benefits of diversity and complementary 6 See

Tumbe (2018), page 35. Aajeevika Bureau at https://www.aajeevika.org/labour-and-migration.php. Also, Srivastava (2011). 8 In some instances there may also be disquiet about the potential impact that migrants may have on perceived crime and security. 7 See

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endowments that migrants bring with the considered harm to local residents in terms of competition for jobs and the dilution of the cultural climate of the region. The reception of migrants in a region will then be based on the relative weight given to the different interests that are affected by their presence and the way in which those interests are organized to influence policy. In particular, if migrants have comparatively low skills and thereby lower earnings, then there may very well be a pressure to restrict their access to welfare benefits in order to reduce the impact of the fiscal costs of providing such services for current local residents. Migrants also do not have a voice as they are denied the right to vote in a region by restricting their ability to avail of an election card and they must return to the source region to cast their vote. To that extent they are treated as temporary residents unlike the permanent host region residents and they do not have equal status. Migrants then become a form of second-class citizens who find it difficult to settle in the region and they tend to diversify their risk by having part of the family stay back in the source region rather than join them at the destination. Not surprisingly, Kone et al. (2018) find that migration in India is hindered due to entitlement programmes that are implemented at the state level. They find that access to subsidized food through the public distribution system and admission to public hospitals or school admissions is governed on the basis of identification, such as ration cards, that are accepted only by the home state. They find that the relative share of unskilled migrants moving out of the state is lower in those states with greater participation in the public distribution system. The Unique Identification Documentation does promote a system to document identification at a nationwide level but it has not yet been used extensively to access the PDS. Also, some states provide universal access to subsidized food such as Tamil Nadu. But many states do not extend the PDS to migrants as part of the subsidy is borne by the state on the basis of its own poverty line and list of poor households.9 Instances of destination states cooperating with source states in sharing responsibilities towards migrant workers are rare.10 The response to these issues has been to focus on rights and the inalienability of those rights in an attempt to constrain policy makers in a region to be inclusive in their approach towards migrants. However, there is a tradeoff here that we should caution ourselves about. Think of a region that allows rights for migrant workers such as workrelated benefits, access to public health facilities and education, a living minimum wage, and so on. Some of these raise the cost of public provision of services that require to be financed through higher local taxes. To the extent that policy makers are sensitive to residents who would not prefer bearing this fiscal burden of such rights, there would be an attempt to underprovide or not provide such public benefits. Some rights would impose a direct additional cost on the employer. This raises the cost of 9 It

is reported that 27% of rural households and 15% of urban households are fully dependent on PDS grain. 10 See the Memorandum of Undertaking between Odisha and Andhra Pradesh regarding cooperating with regard to migrants working in brick kilns in Andhra Pradesh in Appendix 4 of Ministry of Housing and Urban Poverty Alleviation (2017)—“Report of the Working Group on Migration”, January.

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employing such workers and any increase in cost will be met with a lower demand for workers. If instead the costs to employers of such workers were lower they would employ more of them. Limiting the rights of migrants could possibly entail reduced costs to employers and some extra migrants employed. Ceteris paribus, with equal rights migrant labour will not be preferred to resident workers. There is an analogy here between higher wage costs that reduce employment and more rights for migrants that similarly can have an adverse impact on their employment. Of course, we must keep in mind that it is only those rights that generate a marked increase in labour costs that will induce employers to reduce the vacancies that they would want to fill up with workers. Granting equal access to the welfare state for low-skilled migrants may create fiscal costs that are not offset by the benefits from employing them. In that case we have to consider that improving rights and labour standards will promote the welfare of existing migrants and possibly make it difficult for others to migrate and work. We may have to consider the possibility that restrictions on rights or welfare measures to lower skilled workers is a requirement to have migration in some cases. Those welfare measures that result in net costs for destination regions may be subject to some restrictions of access in order to advance the cause of migrants.11 There is a policy tradeoff between welfare rights and openness to migration.12 Of course, the core civil and political rights13 cannot be traded off but there may be restrictions on rights to public benefits or permanent residence.14 There is still a role for other sorts of policies to control against events such as misleading information by middlemen regarding the terms of contract, not having identity documents confiscated, or nonpayment of dues for work already undertaken. In short, there is a room to think about rights not as trumps but as an expression of weighing the benefits to migrants and to the host population. Many migrants do tradeoff for better economic outcomes with some restriction on their rights. Of course, this is not desirable but it may very well be in the short-term interest of the migrant. Migrants do rationalize the tradeoffs when considering employment in a destination which often involves poor working conditions, no written contracts, and no paid holidays, and the psychological costs of being separated from their families. Information about conditions in the destination may not be perfectly available to a potential migrant but compared to the poverty at home it may still be a better option for the person to migrate.

11 In the case of inter-state migration, the cause of migrants can be advanced even without restrictions on welfare measures if one introduces a role for the central government. A central planner can take into account both the costs for destination regions and the benefits for source regions. The rights restriction on migrants in destination regions might be an inferior option in such a situation. 12 Bell and Piper (2005) find that NGOs representing domestic help workers in Hong Kong and Singapore are reluctant to promote equal rights in apprehension that it may lead to a cut down in admissions to that country. See Bell and Piper (2005). 13 Individuals must be protected against violence, theft, and fraud and security of contract should be assured amongst other aspects of such rights. Individuals should also not be forced to do compulsory labour or be subject to inhumane or degrading treatment or subject to arbitrary detention. 14 I am thinking of those states which have restrictions on ownership of property by non-locals.

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37

We may consider a scenario where an employer is bargaining with a worker about the terms of an employment contract. The worker has rivals who are also looking for employment and these rivals are good substitutes for the worker the employer is currently negotiating with. The worker i has an opportunity cost of working for the employer15 given by αi > 0 and the employer obtains an output valued at v > 0 by employing a worker.16 Suppose also that the two are considering to allow non-wage benefits in the negotiation and the benefit they are considering is the provision of a paid holiday that comes at a cost c > 0 to the employer17 and is valued at μi > 0 by the worker. There are potential other workers x ∈ X the employer could consider contracting with and their opportunity cost of work is αx , whereas their valuation of the benefit is μx . Both employers and workers are taken to be interested in the surplus from the contract. If benefits are provided then the employers surplus is Seb = v − c − wi . The surplus to the worker is Swb = wi − αi + μi . The total surplus then is S b = v − c − αi + μi . The surplus to the employer if the benefit is not provided in the contract is Se = v − wi and the benefit to the worker is Sw = wi − αi . The total surplus then is S = v − αi . Then not having the benefit included in the contract is welfare enhancing if S > S b , or, c > μi . One condition then for the benefit not to be part of the contract is because from the employer’s stance the cost of providing the benefit exceeds the value of the benefit to the agent and the surplus from not having the benefit as part of the contract increases. Now consider the case where c ≤ μi and providing the benefit in the contract increases the surplus from the contract. However, the employer may also contract with other workers x ∈ X who are all substitutes for worker i. The surplus from the contract that provides benefits with these other workers is S b = v−c−αx +μx . It is worth it for the employer to contract with these other workers if v −c−αi +μi < v −c−αx +μx . That is, it is beneficial to contract with x rather than i if αi − μi > αx − μx , or the net opportunity cost of worker i is greater than the net opportunity cost of another worker x who the employer may contract with. The highest benefit will occur for that worker x whose valuation of the benefit is μx = c. Hence the employer will contract with the worker with the lowest net opportunity cost given by αx −μx = αx −c. The employer fills a job vacancy with the person who is the lowest cost to the establishment. That person obtains a wage given by the opportunity cost of work αx and the benefit is not a part of the contract as the value of the benefit equals the cost to the employer of providing the benefit and no surplus is to be gained by entering into a contract with a role for benefits. In case the worker with the lowest net opportunity cost values the 15 The worker i may be a local who is not willing to work in a certain sector and has a high opportunity cost of doing so. In the foundy industry in Ahmedabad and Rajkot only migrants are employed as locals consider the work to be hard, and often employers pay higher than minimum wages to migrants for the job. 16 There is a gender dimension to migration as well, especially amongst construction and brick kiln workers, and gender-based wage discrimination is important but not our focus here. 17 We could take this to be net of any circumvention costs if the benefit is a mandated one.

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benefit at μx > c, then the benefit gets degraded to that level. Essentially benefits have been bid down by competing workers till they reach a level at which no worker is in a position to obtain the benefit and the employer does not provide the benefit. Workers who place a low value on benefits are relatively more competitive and they have the ability to replace those with a higher valuation. The process will continue till benefits cease to exist. There is, of course, a role here for collective action in hindering this slippery slope where benefits decline that we would like to emphasize. It is advantageous for efficiency that workers have sufficient voice to affect their working conditions. We think of voice here in the spirit of Hirschman (1970)18 as an effort directed at a higher authority to achieve a change in organizational processes and performance. Though, our experience of informality suggests that workers have become conditioned to take insecurity as a norm for work. Often they internalize limited voice by framing their current working conditions as being due to broad economic forces that are marketdriven and which employers are unable to change. Workers then do not expect much in terms of workplace benefits from their employers and perceive their condition as one in which employers demand dedication and hard work and in return provide a paycheck and no job security and discourage voice. We believe that despite this there is a place for collective voice worker organizations. Such organizations have advantages that they should strive to make employers realize—for instance, that workers who find their voice represented are less likely to quit and more likely to invest in skills that improve productivity. Our belief is that workers want to identify with and contribute to those organizations they work in that respond to their expressed interests.19 In a developing economy context, the issue that arises is how do you have a labour market that is flexible so that jobs are being created whilst ensuring that those jobs do not impact the well-being of workers. In this regard core labour standards have been proposed in the form of freedom of association, the elimination of forced labour, the abolition of worst forms of child labour, and the elimination of discrimination in employment. A stream of work has gone down the route that labour standards require effective state enforcement mechanisms. If the labour inspectorate and tribunals are under-manned, if workers do not have the capacity or the proficiency to represent their case before the appropriate authority, or if they fear reprisals and job loss in case they complain, or if there is corruption, then it may not be easy to safeguard labour standards. In light of this, some have argued that state capacity needs to be improved and some have maintained that deregulation is called for. Later I will argue that despite breach of law and imperfect enforcement there is still a role that such defective systems fulfil which is that they can be resorted to as a reference point in 18 Hirschman

(1970).

19 We partially subscribe to the view that to improve working conditions for informal workers worker

organizations need to take advantage of their capacity to disrupt production or services. This view is expressed by Eaton t al. (2017). They also emphasize that such organizations need to have a long term strategy based on moral considerations and that they need to enhance their associational power by cooperating with other labour organizations. See Eaton et al. (2017).

4 Migrants and Informal Casual Labour Markets

39

negotiations between workers and employers which has certain valuable efficiency properties. Core labour standards, however, are advanced as universal whereas migrants and the poor may view the important issues in their lives somewhat differently. Some of the issues that migrants prioritize are around occupational health and safety, sexual harassment and physical abuse, timely payment of wages, and maximum hours of work. For the working poor, the conditions of the work environment are often a priority consideration when they are considering the work offer and the pay that they will receive. It is well known that migrants in jobs like brick kilns and mines or powerlooms have higher earnings than what is available in their villages. Yet they live in squalid conditions with lack of privacy and personal security, their living conditions are unhygienic, they face harassment and abuse, and the pay does not offset these abysmal circumstances that they face. To be sure they are in need of labour standards. However, those standards must be applied keeping in mind the circumstances and concerns of those that get impacted by them. We know that it is not wise to impose a hard ban on child labour if the families who get affected cannot feed themselves, or to require that female workers get equal payment or workers be allowed to associate if they are going to be the earliest to be laid off or fired with no operative remedy through legal recourse. Labour standards must be imposed after considering the implications for those who will be affected by those standards. Regulations may be difficult to comply with, resulting in evasion or the regulation results in the activity being adjusting so as to be outside its ambit—there is avoidance. There are many known cases of establishments that subcontract work to home-based workers for instance, who are then treated as self-employed and not employees and thus outside the scope of employee-related legislation. The short point is that labour standards are desirable, but if they impact the employment of migrants and the working poor adversely, then the insistence on those standards should be considered judiciously. We have for long known about the effect of the demand for parity between foreign and domestic workers acting as a barrier to trade. Whilst paying foreign workers the prevailing local wages protects local workers and makes them more amenable to accepting competition, it is also advanced as a way of protecting foreign workers from being taken advantage of. However, such an obligation of imposing a uniform wage prevents a developing country from obtaining the benefits of comparative advantage and it reduces the benefits from trade. Whilst equal wages are akin to non-discrimination, it at the same time diminishes the cost advantage of a foreign worker.20 By not pushing for equality of treatment with regard to employmentrelated entitlements, we may be Pareto improving if it allows comparative advantage to flourish. Similar arguments are applicable in inter-regional migration. We should recognize that migrants may be willing to accept limited access to some rights and

20 Of course, ILO conventions such as 97 and 143 do call for migrant and local workers to receive the same wage for the same work. Such conventions may result in restricting the movement of labour.

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public benefits if it allows them to advance other advantages such as access to employment and an increase in incomes for their families. When considering migration as a choice we may fare better if we put in the balance the interests of the destination region with the interests of migrants. Whilst resorting to universalism of human beings is an ideal we should strive for, in an imperfect world it may be worth making a distinction between the rights and entitlement of migrants and residents. I realize that this is in practice not an easy path to take as it requires us to balance non-discrimination with the possibility of exploitation. What prompts this position is that it has the potential to promote human development. I am advocating that we may do better in a world which is run according to second best policies.

Informal Casual Labour Markets A large number of migrants across regions in developing countries are casually employed on a daily basis in the informal labour market. We now restrict our attention to the aspect of contracting in the casual informal labour market that results in the wage and the duration of employment.21 In most instances this type of labour contract is oral and is struck as a bargain in a central market place that serves as a focal point where potential employers meet with potential employees. Sometimes there is a middle man or labour contractor or jobber or mukadam who acts as the go-between the persons who offer their labour service and employers who are looking to fill up a vacancy. The type of labour service undertaken is mostly unskilled and often involves manual labour. Some other characteristics of this phenomenon are that earnings are low and the hours worked per day are usually longer than the standard eight-hour work day, and this type of employment is irregular and provides for uncertain incomes. Many of these workers are often referred to as the working poor. The paucity of research on the employer–employee match in the daily urban casual labour market has been commented on by Iversen and Torsvik (2010),22 who review the role of social networks and intermediaries in the recruitment and control of workers in such types of employment. They claim that networks (usually relatives and co-villagers) are a cheap source of information provision about job openings, indicating that labour market information that flows through such networks is akin to a local public good. In addition, they claim that recruiting through networks provides a screening mechanism whereby information is provided ex ante on skills or qualities such as discipline and work ethic that are otherwise hard to obtain. Workers here are presumed to have superior information about relevant work qualities of individuals who belong to a social network. Finally, recruiting through networks reduces behavioural risks as surveillance and peer pressure is likely to be stronger in

21 Much of what we stipulate holds for informal casual wage negotiations that involves local workers

and employers and not just for negotiations involving migrant workers. 22 Iversen and Torsvik (2010).

Informal Casual Labour Markets

41

networks. Such workers are less likely to be absent from work and are more likely to be loyal to the workplace. This literature overlooks an important characteristic of such labour contracts— that they are characterized by search costs where potential employers and workers must incur a fixed search cum negotiation cost when they bargain and agree on an informal contract over the wage and the hours of work that is to be undertaken. For migrants the costs of taking a loan to facilitate the travel and relocation costs as well as the on-the-ground costs of subsistence are sunk costs that may be taken to constitute a part of the search costs. In many urban contexts, workers gather at some focal point such as a busy market place or crossroad in the morning and meet with potential employers who negotiate the type of work to be performed, the wage, and the number of hours that the worker has to work. Working days are usually long— between 12 and 14 h in many instances—and the wage and working conditions are usually negotiated.23 The market wherein the bargain takes place is a flexible labour market where workers can be replaced by the employer at a minimal cost to the employer. In most of such contracts workers report that they have been cheated and face harassment. Guérin et al. (2015) who survey migrant workers into the sugarcane and brick making sectors find that more than half of such workers (55.8% in 2014) report they have been cheated and all workers report that they have been harassed. A useful framework to understand these issues is provided by the transactions costs literature (Williamson 197924 ). This literature maintains that all contracts are unavoidably incomplete. In our context two factors are important when considering informal sector employment contracts—one is that the contract must be able to specify what constitutes satisfactory performance of the terms of the contract, and the other is that the contract must be enforceable. These requirements for complete contracting are severe and rarely satisfied in this context. Though the type of work required to be performed (say head loading) is discussed in the employment bargain, there is no stipulation of the conditions that would be taken into account to arrive at an understanding of whether the work had been performed satisfactorily and the associated rights and responsibilities of the two parties involved in the bargain. As a result, a third party cannot verify whether the terms of the contract have been adhered to and whether the parties have acted according to the particular courses of action that were negotiated. In the head loading instance, there is no measurement system that records whether the worker has transferred the requisite number of parcels without damage and within a given timeframe. This inability to verify whether the terms of a contract have been fulfilled in turn makes it difficult to enforce a contract via an impartial arms-length third party inspection. The employer then has an incentive to hold up the worker by requiring that she works for longer hours or requires her to take up other responsibilities that were not negotiated in the first instance. The worker who has already committed her day towards working for that employer is forced into undertaking these additional responsibilities so as to enable her to obtain the agreed to wage which she would have to otherwise forgo at a significant personal cost. It 23 Amongst

the many articles on these aspects see Guérin et al. (2015). (1979).

24 Williamson

42

4 Migrants and Informal Casual Labour Markets

is not surprising then that workers report they have been harassed or cheated. As Williamson has famously argued, once a party is in a relationship-specific situation where it is unable to recover any dues stemming from its investment of time or other assets if it does not continue to do business with the contracted party, there is the distinct possibility of a holdup. The trading partner that causes the holdup attempts to renegotiate the terms of the contract in order to extract some more of the surplus produced in that relationship so as to improve its returns from the relationship. Formally, we consider a static situation where potential employers and workers enter the market and negotiate an informal contract over the wage to be paid for the labour services per day and the number of hours per day during which work is to be performed by the worker. For simplicity we focus on daily wage casual workers. Workers who work for n hours in the day produce an output given by the production function F(n), where the other factors of production that are complementary with labour have been suppressed as they are not central to what we want to focus on.25 The employer also has to bear a fixed exogenous search cost θe of bargaining and attempting to match workers with the job vacancy he currently has. These costs are the time costs of search for a worker and the negotiation and contracting costs that cannot be recovered constitute a sunk cost. The profit to the employer from finalizing a work contract with the worker where he agrees to pay a wage of w is given by  = F(n) − wn − θe

(4.1)

With θw the sunk costs of the worker before she engages with the employer in the work bargain, the value to the worker of engaging in the work contract may be written as V = wn − c(n) − θw

(4.2)

Here c(n) is the cost to the worker of providing labour for n hours. We assume that c(n) is convex and that c/ (n) > 0 and c// (n) > 0. The employer and the worker determine the wage and the number of hours of work through bargaining. The solution to these is given by finding out the Nash bargaining solution that is written as max[F(n) − wn]α [wn − c(n)]1−α {w,n}

In the above Nash bargain the threat points have been set as zero to indicate that if the employer and worker do not agree to a contract then there is no employment relationship that is entered into. Also, since θe and θw are sunk before the contract is finalized, they are not part of the bargain with respect to the wage and hours of work. The solution to the bargain is given by

25 The

production function has the standard Inada properties.

Informal Casual Labour Markets

w=

43

1 [αc(n) + (1 − α)F(n)] n

(4.3)

and F / (n) = c/ (n)

(4.4)

From (4.3) it turns out that if workers have high bargaining power (α = 0), then, wn = F(n). From (4.1) this situation would result in a loss to the employer given by −θe . Analogously the value to the worker of the employment contract is −θw if employers have high bargaining power (α = 1), and the worker will be better off being excluded from the labour market. The bargain results in a negotiated wage and hours of work that does not ensure the employer and/or worker will be recompensed for the ex ante search costs. The wage bargain in the casual labour market then may result in no trade taking place and this market is therefore ex ante not efficient. With regard to hours of work both employers and workers are interested in maximizing the social surplus of the economy given by F(n) − c(n) − θe − θw as that expands the economic pie that can then be shared between them. Both employers and workers realize that without a positive n there will be no output and this in turn would mean no profit or wages. The value of n that maximizes the amount of output that can be shared between them through a bargain is given by Eq. (4.4), or F / (n) = c/ (n).

Wage Regulation Suppose now that the social network or the middleman, who by virtue of their prior experience know about these transaction costs, indicate a “regulated” wage to the parties contracting that ensures the sunk costs faced by the parties are covered. This “regulated” wage could also be introduced by government via a legislation. This “regulated” wage could be a living wage as defined by some minimum wage or any wage that forces employers and workers to commit ex ante to the payment that requires to be made in order for the employment contract to materialize. The mukadam may set such a wage in order to obtain worker buy-in to the contract. The mukadam may also collect the wage up front to ensure it is a binding cost the employer bears which is not negotiable ex post. Since the market bargain may result in no trade the “regulator” would be interested in introducing a wage that would ensure that it is efficient for both sides to agree to an employment contract. This occurs by setting a higher wage provided that employers earn positive profits and workers valuation of the transaction is also positive. With the regulated wage given − by w this requires the following:

44

4 Migrants and Informal Casual Labour Markets

  −  −  −   = F n w − w n w − θe > 0 and  −   −  − V =w n w − c n w − θw > 0 Hence, the regulated wage bill must lie in the following interval to ensure that the employer and worker contract  −   −    −  − F n w − θe >w n w > c n w − θw   −    −  As long as the social surplus F n w − c n w − θe − θw is positive an informal contract between employer and worker will take place as long as neither side bypasses the wage set by regulation. Nonetheless, the total surplus will not be at a maximum as the wage cost has gone up. Let us consider the possibility that the regulator’s wage is accepted by both parties and they contract to the payment of wages accordingly. The number of hours worked is not subject to inspection without the “regulator” incurring a prohibitive cost—t requires real-time continuous inspection—and so workers and employers will continue to bargain over the hours of work. The bargain is now given by    −  −  − α  −  −    − 1−α w n w −c n w max F n w − w n w {n}

(4.5)

This results in the bargain over the number of hours of work to be performed to be according to the following equation 

  −  −    −  −  −  / w w F n − F n w −wn w α − −   −  = −  −    −  (1 − α) w −c/ n w w n w −c n w

(4.6)

Since the right-hand side must bepositive   −   −  for  and V to be positive, it implies − − / / that either w> F n w , or w< c n w . In either case since F / (n) = c/ (n) the total surplus will not be maximized. We have a situation that has the “regulator” remove an ex ante inefficiency where trade may not have occurred but in the process has reduced the total surplus ex post. The regulated wage being stipulated at the time when employers and workers connect to contract, each side has an incentive to maximize their return from the contract. Employers would like to maximize the number of hours worked and workers would like to minimize the number of hours worked. Opportunism will kick in. If employers

Wage Regulation

45

have not paid the wage up front then they can hold up workers by “recontracting” that they put in more hours of work before they compensate them. At this point we are confronted with the tradeoff between ex ante efficiency and ex post efficiency. Agents realizing the existence of this tradeoff could consider the possibility of continuing to negotiate over wages and hours of work with each other. The difference is that the “regulator” has proposed a wage which is now a reference frame for the bargain. If the bargain is not successful then the two parties could fall back on the regulated stipulation. If it is successful then there is a negotiated wage and work schedule that is agreed upon and the regulated wage is not the consequence. The regulated wage is the contingent contract the parties can engage in given that it is the recommended contract and keeping that in reserve the parties negotiate to see if they can come up with an alternative contract that they may prefer. If they are not able to recontract then they resort to the reserve contract as specified by the “regulator”. The bargain is now undertaken with respect to a new threat point and we now write the bargain for the wage in terms of the following: Max {w} [F(n)

− wn − {F[n(w)] − wn(w)}]α [wn − c(n)

−{wn(w) − c[n(w)]}]1−α

(4.7)

The solution to this is given by  −    −     −  − + (1 − α) F(n) − F n w wn =w n w + α c(n) − c n w

(4.8)

This solution is ex ante efficient. Suppose workers have all the bargaining strength, or, α = 0. Then,  −    −  − wn =w n w + F(n) − F n w Combine this with Eq. (4.1),  = F(n) − wn − θe , and we obtain,   −  −  −   = F n w − w n w − θe This is the condition for ex ante efficiency in the case where the “regulator” sets the terms of the wage contract. Similarly, in the worst-case scenario for workers, α = 1, the solution (4.8) is  −    −  − wn =w n w + c(n) − c n w In this case then, V = wn − c(n) − θw

46

4 Migrants and Informal Casual Labour Markets

or  −   −  − V =w n w − c n w − θw which is the condition for ex ante efficiency in the case where the “regulator” has stipulated the contract. Similarly, solving the bargaining for the number of hours worked, Max {n} [F(n)

− wn − {F[n(w)] − wn(w)}]α [wn − c(n)

−{wn(w) − c[n(w)]}]1−α we obtain, F / (n) = c/ (n) Thus both workers and employers are at least as well off under the case where the negotiation takes place in the shadow of the terms of the regulated contract as under the contract that is suggested by the “regulator”. With the regulator’s contract framing the negotiation process any renegotiation will not lead to hold ups. The renegotiation is ex ante efficient as well as ex post efficient. A response to the evidence that regulations do not bite is that they should be removed. For instance, it is widely reported that minimum wages are not paid. A response to this is that there is inefficient enforcement and state failure. Another response is that with regulation of the wage there is the possibility of some of those who could potentially obtain jobs not finding them as employers reduce job vacancies in response to the regulation. This has implications for socio-economic unrest and a state that is sensitive to that may come to look at the regulation as an aspiration and not enforce it. In the approach that we take here there is yet another possibility—the regulation helps frame the context for bargaining between employers and workers, minimizes hold-ups, and promotes both ex ante and ex post efficiency, even when the regulation is not meticulously adhered to. When wage payment regulations are enforced, employers have an incentive to increase the number of hours worked and the social surplus is not maximized. If regulations are circumvented, then negotiations could reduce opportunism and enhance ex post efficiency. It is desirable that there is the possibility of enforcement of the regulation in our approach if either party seeks such enforcement. Otherwise in the background of the regulation both parties negotiate in a manner that reduces holdups and improves efficiency.

Conclusion

47

Conclusion Internal migration for economic reasons across states in India appears to be low by international standards. An inference we could draw from this is that the complementarities in production from migrants and locals are not a strong enough pull factor compared to the congestion of habitats and other factors that deter migration. Locals who have comparable skills may not welcome such competition for jobs even though employers would benefit from the increase in the supply of labour. The sociopolitical response to this is to prioritize the interests of local residents over those of migrants. If migrants are of low skills and have low earnings, then their contribution to fiscal resources of the receiving region would be lower than their potential usage of public services and welfare benefits and their drain on public finances is also a source of conflict. In such cases, with equal rights, migrants will not be preferred to local residents in the filling of vacant jobs. There is a tradeoff between welfare rights and openness to migration. Migrants usually consider these tradeoffs of poor working conditions, unwritten and unenforceable contracts, unpaid holidays, separation from the family and living as second-class citizens in the destination region, and all considered still migrate. In this they tradeoff some rights with the benefits of higher incomes. Given state capacity and the available fiscal resources the receiving region may make a distinction between the entitlements to migrants and to residents. Some discrimination may be acceptable to the migrant if it promotes entry into the region and their ability to make a living. Such informal contracts that migrants enter into may even be exploitative. In the context of low-skilled workers in the informal sector, the requirements for complete contracting are severe. It is difficult ex ante to specify what constitutes a satisfactory performance of the contract (as it is difficult to record and measure performance) and accordingly it is difficult to enforce the contract via a third party. This leads to opportunism as the employer holds up the worker by requiring further responsibilities to be undertaken that were not negotiated in the first place. This could be in the form of longer hours of work and the worker who has committed the day to work for the employer is forced into undertaking the additional work before receiving their wages. Once parties are in a relationship-specific situation and are unable to recover any dues stemming from their investment of time and other assets if they do not continue to do business with the contracted party, there is the possibility of holdup. This results in a renegotiation of the contract in order to extract more of the surplus produced in the relationship by the employer who holds up the worker. When workers and employers negotiate the wage and the duration of the work, they do not take into account the sunk costs of search and the negotiation may result in an outcome where the market is ex ante not efficient and trade may not take place in the market. We then consider a middleman or “regulator” who sets the wage in a way that both sides find it attractive to buy into the contract. The “regulator” sets a wage that ensures that both employers and workers valuation of the contract is ex ante efficient. Even though the “regulator” may be able to observe the payment of wages, she is not able to enforce that a certain number of hours of work be performed. Accordingly,

48

4 Migrants and Informal Casual Labour Markets

there is opportunism on this front and workers can be required to “recontract” where they put in more hours of work before they are compensated. There is thus a tradeoff between ex ante efficiency and ex post efficiency. A wage set by a ‘regulator’ such as a mukadam or middleman becomes a reference frame and a status quo point from which bargaining over the surplus takes place. Both employers and workers can now choose to go by the regulated contract that is subject to opportunism or to bypass this and negotiate keeping the regulated contract as the fallback position. We show that such a contract is ex ante as well as ex post efficient. Regulations are good if incentive compatible to both parties who seek their enforcement. Otherwise in the backdrop of the regulation, both parties may negotiate in a manner that reduces holdups and improves efficiency. On the condition that the employer and worker participate in an informal bargain, a “regulator” can structure the negotiation process by setting an appropriate wage and ensure the negotiation does not lead to a holdup. The negotiation is limited by the option of going back to the regulated wage since it is not realized results in both parties contracting efficiently. This is an instance of a “regulation” that when not followed may lead to efficiency. The “regulation” helps the parties to avoid the obstacle stemming from holdup and serves like a protective belt that keeps them from resorting to opportunism. Contracting parties are reluctant to engage in holdups when they realize that their participation in the market via negotiations can result in outcomes where they are not taken advantage of.

Bibliography Bell, D. A., & Piper N. (2005). Justice for migrant workers? The case of foreign domestic workers in Hong Kong and Singapore. In W. Kymlicka, and H. Baogang (eds.), Multiculturalism in Asia, pp.196–222. Oxford University Press. Bell, M., Charles-Edwards, E., Ueffing, P., Stillwell, J., Kupiszewski, M., & Kupiszewska, D. (2015). Internal migration and development: Comparing migration intensities around the world. Population and Development Review, 41, 33–58. Eaton, A. E., Schurman, S. J., & Chen, M. A. (2017). Informal workers and collective action: A global perspective. Ithaca: NY, Cornell University Press. Guérin, I., Venkatasubramanian, G., & Kumar, S. (2015). Debt bondage and the tricks of capital. Economic and Political Weekly, vol. L Nos. 26 & 27, pp. 11–18. Hirschman, A. O. (1970). Exit, voice, and loyalty—Responses to decline in firms, organizations and states. Harvard University Press. Iversen, V., & Torsvik, G. (2010). Networks, middlemen and other (urban) labour market mysteries. Indian Growth and Development Review, 3(1), 62–80. Kone, Z. L., Liu, M. Y., Mattoo, A., Ozden, C., & Sharma, S. (2018). Internal borders and migration in India. Journal of Economic Geography, 18, 729–759. Papola, T. S. (1975). Labour market, wage structure and labour mobility: A study in Ahmedabad, India. In S. Kanappan (ed.), Labour Markets in Developing Countries. Geneva: International Institute for Labour Studies. Papola, T. S. (1981). Urban informal sector in a developing economy. New Delhi: Vikas Publishing House.

Bibliography

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Srivastava, R. (2011). Labour migration in India: Recent trends, patterns and policy issues. The Indian Journal of Labour Economics, 54(3), 411–440. Tumbe, C. (2018). India moving: A history of migration. India: Penguin Viking. Williamson, O. (1979). Transaction cost economics: The governance of contractual relations. Journal of Law and Economics, 233–261.

Chapter 5

Wage Disparity and Human Capital Accumulation

Human Capital, Technology, and Development Increasingly, there is recognition that the acquisition of human capital is central to development and growth. The acquisition of skills not only makes people more productive, but in an era of rapidly changing technology it also makes them more adaptable to technological progress. A lot of attention in the literature has thus been devoted to whether markets provide sufficient incentives for investments in skills. It is often argued that when people face credit constraints, they cannot finance education by borrowing, so the government should intervene to relax credit controls, provide educational vouchers, or loan guarantees. Similarly, the signalling literature emphasizes market failure in that even if education is acquired, it cannot be perfectly signalled to potential employers. Related to this is the issue of the acquisition of training which is linked with occupational qualifications in Germany and to life-long employment in Japan, but in most other nations it is left to the individual to acquire the skills associated with training and education. Indeed, by and large, skill formation is viewed as a supply-side policy that sometimes makes the state responsible for giving people the opportunity to get educated or trained, and a policy that leaves the individual and firms as responsible for the employability of that human capital. This paper explores the consequences of the view that increase in human capital enables more technological change because more skilled workers enable the introduction of more sophisticated and productive machines. The technological change in turn influences the demand for skilled workers and affects the return on the acquisition of human capital. With technological change and the acquisition of skills having mutually reinforcing effects that enhance the returns to skilled labour and to investments in technology, the gap between skilled and unskilled workers can increase which results in disparities that have political and social consequences. In India, part of the inequality that is being witnessed over the last decade may be attributable to this factor. Deaton and Dreze (2002) for instance point out that whilst poverty declined in the 1990s in India, inequality has increased between rural and urban areas, and per capita expenditures of the high-income groups have increased faster © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_5

51

52

5 Wage Disparity and Human Capital Accumulation

Table 5.1 Distribution of workers by level of education

1983–1984

1993–1994

1999–2000

Illiterate

57.5

48.5

44.1

Primary

24.3

24.9

23.5

Middle

8.9

11.4

13.8

Secondary and above

9.3

15.1

18.6

304.3

396.9

451.1

Education stock

Source Chadha (2004) N.B.: Years of education for primary level is taken as 5, for middle 8, and for secondary and above as 12, whilst calculating education stock

than for other groups. They conclude that “the rate of increase of economic inequality in the nineties is far from negligible” (p. 3740). The poor human capital base which is labelled as the Achilles heel of the Indian economy by Chadha (2004) shows a gradual decline in the proportion of illiterate workers and a corresponding increase in the proportion of educated ones over the last two decades (Table 5.1). A summary statistic that we employ to capture the stock of education or human capital  (L) in the economy is given in the last row of the table and is computed as L = li si , where li is the share of persons in the labour force with ith level of schooling, and si is the average years of education received in the ith level of schooling. The growth rate of the education stock in the decade between 1983–1984 and 1993–1994 is 2.7% which reduced to a growth rate of 2.2% between 1993–1994 and 1999–2000. This is barely above the labour force growth rate, and as Chadha points out the still high proportion of illiterate workers is a cause for concern. In addition to the usual reasons advocated for this low attainment such as political economy and credit constraints, we propose that the complementarity between technology and skilled labour and the interaction of this with the externalities associated with education provide an additional insight into the nature of the accumulation of human capital.

The Process of Accumulation Strictly speaking, to understand the problem we need to consider at least two time periods. In the first period people invest in human capital, and in the second they work and spend. Many would even insist that other assets are included in the setup so that agents can have claims on physical capital in addition to human capital. Introducing time periods and different assets makes the problem more dynamic and results such as multiple equilibria may be derived. We opt to forgo this and instead take human capital to be a discrete variable—people are either skilled or unskilled. An unskilled worker is taken to own 1 efficiency unit of labour and a skilled worker owns ρ (ρ > 1) efficiency units of labour. Total labour input in efficiency units is given by L = ρ L s + L u , where L s is the number of skilled individuals in the

The Process of Accumulation

53

labour force, and L u is the number of unskilled individuals in the labour force. More realistically, skilled and unskilled labour are imperfect substitutes but we bypass this generality which does not damage our results. Given that some individuals may not be employed the total labour force, L, can be divided according to whether an individual is skilled or unskilled. Thus, Ls + Lu = L

(5.1)

 Let x = L s L be the proportion of skilled workers in the labour force and  (1 − x) = L u L be the proportion of unskilled workers. Production is assumed to be given by Y = AL α = A{ρ L s + L u }α Or α  Y = A {ρx + (1 − x)}L

(5.2)

We can then derive the demand for unskilled labour as  α−1 − wu = α A {ρx + (1 − x)} L

(5.3)

Given perfect substitution between the types of labour we must have ws =ρ wu

(5.4)

This is the condition for employment under profit maximization which states that the relative wage depends on the relative productivity of the two factors. The productivity of skilled workers, however, is determined by the technology in the economy. Reciprocally, technological change is influenced by the proportion of skilled workers in the economy as the accumulation of human capital is favourable to innovation. Hence, ρ = ρ(A),

ρ > O

and A = A(x), A > O We could postulate simple functional forms for the above:

54

5 Wage Disparity and Human Capital Accumulation

ρ = ρ + θ A,

ρ > 1.

And A = 1+γx

(5.5)

  − α−1 ws − wu = {ρx + (1 − x)} L     A (x){ρx + (1 − x)} + A(x) ρ  A x + ρ − 1

(5.6)

Profit maximization then yields

On the demand side firms are willing to pay higher wages to skilled workers as the stock of human capital increases because this increases the adoption of new technology which makes skilled workers more productive. The graph of Eq. (5.6) is depicted in Fig. 5.1 as the solid upward sloping line. An increase in the sensitivity of the productivity parameter for skilled workers, ρ  = θ , shifts the graph to the dashed line and the gap in wages between skilled and unskilled workers is widened for any stock of human capital. Also, an increase in the sensitivity of the technology parameter, A = γ , shifts the graph up even more to the dotted line and widens the gap between skilled and unskilled wages further. We now turn to the supply side. The dividend to investing in an education is the wage differential between skilled and unskilled workers. Again, we are ignoring the presence of unemployment which could be factored in—the expected wage differential would then represent the return to education—but again to extract the essence of

ws wu

x Fig. 5.1 Wage disparity and labour demand

The Process of Accumulation

55

the problem we ignore this factor. Also, for simplicity, the acquisition of education is treated as being instantaneous. There are two costs associated with acquiring an education. There are direct costs that depend on how many individuals are being educated. As efficient class size is more than one student in a class, education is a public good with the characteristics of collective benefit and shared costs. Increases in class size may affect educational effectiveness in which case education becomes a contestable public good. Education also results in externalities as social benefits arise from more educated fellow citizens. The direct costs thus decline with the proportion of individuals who are skilled, that is, c = c(x) and c (x) < 0. We specify c(x) = ψ + x −β where β is a measure of the publicness or externality generation associated with education and ψ is a direct flat cost. Additionally, individuals differ in their cost of acquiring education as more able individuals or better endowed individuals with lower credit constraints incur a lower cost associated with their endowment e which is uniformly distributed and e ∈ (0, 1). Equating costs and benefits, ws − wu =

ψ + x −β e

The individual who is indifferent between becoming skilled and  remaining unskilled would be that individual whose endowment is e∗ = ψ + x −β (ws − wu ). Given that e is uniformly distributed we must have x = (1 − e∗ ) and so we may write ws − wu =

ψ + x −β 1−x

(5.7)

This is graphed in Fig. 5.2 where we witness that the disparity in wages initially declines due to the decrease in educational costs as more individuals benefit from fixed facilities or due to externalities. As more individuals acquire an education, the opportunity costs of doing so begin to kick in and this requires an increase in the wage differential between skilled and unskilled workers so that a greater supply of skilled labour may be forthcoming. Any increase in the externalities or capacity of facilities for education β shifts the curve up to the dashed curve. An increase in the direct flat cost ψ also shifts the curve up to the dotted curve. The increase in the externality prolongs the decline in wage disparity, whereas the increased direct cost shortens the decline in wage disparity. Putting together demand and supply we get the situation depicted in Fig. 5.3. As can be seen, there are two equilibria denoted by points A and B, with the former being a case where the proportion of skilled workers in the labour force is low and the latter represents an economy with a highly skilled labour force. Some outcomes caused by parametric changes can now be depicted in this framework. An increase in the relative productivity of skilled workers due to technological change (an increase in ρ  = θ ), or an increase in technological change due to an increase in the availability of skilled labour (an increase in A = γ ) shifts the demand curve up to intersect the supply curve at points C and D. As C is to the north-west of A, for an economy that is poorly endowed with skilled labour to begin with, any increase in the productivity

56

ws

5 Wage Disparity and Human Capital Accumulation

wu

x Fig. 5.2 Wage disparity and labour supply

ws wu D

F

C

B

E A

x Fig. 5.3 Parametric shifts in demand & supply

The Process of Accumulation

57

of skilled labour due to technological change or in the impact of skilled labour on the introduction of new technology results in a reduction in the acquisition of human capital and an increase in the disparity between skilled and unskilled workers. In this situation the unskilled workers are relatively productive in the production of goods and services and the feeble technology-driven demand for skilled labour raises the return to skilled labour relative to unskilled labour and simultaneously causes a substitution for skilled with unskilled labour that is abundantly available. If there is an increase in the direct cost of education or in the externalities or public good properties associated with education as we saw shifts the supply curve upwards to intersect the demand curve at points E and F. For the case where the initial proportion of skilled workers is low as point E is to the north-east of A, this results in an increase in the acquisition of human capital. The increase in the direct cost requires higher wage disparities for each level of skilled labour supply and that raises the return to investing in education which causes a rise in the supply of skilled labour. As unskilled labour is abundant this keeps the unskilled wage low, and the higher wage required to be paid for eliciting larger investments in skills is made available by the productivity and technology-driven demand for skilled labour. An increase in the cost of education paradoxically raises the investment in education but this occurs due to the complementarity between investment in education and technological change which causes the wage disparity to rise along with the stock of skilled labour in the economy.

Concluding Remarks Rising wage disparity and inequality is inevitable in the early stages of development when the proportion of skilled labour in the labour force is low. However, if at this juncture in the development trajectory technological change is not sufficiently strong to raise the productivity of skilled labour relative to unskilled labour, then the rising wage disparity is accompanied by a reduction in the incentive to invest in education and the economy does not witness an increase in the proportion of skilled labour. On the other hand, rising wage disparity is associated with an increase in investment in education when the increased cost of eliciting that investment is paid for through the productivity enhancement that occurs. The lesson that emerges is that the cost of education is not a deterrent to investment in education in the early stages of development if the skills produced in the education sector can trigger off changes in technology that raise the returns to education strongly enough so as to pay for the cost. This points to the need to ensure that the quality of skills imparted in education is of a standard that it provides an impetus for initiating technological change. Enhancing the complementarity between skills and technology is the key to the motor of development.

58

5 Wage Disparity and Human Capital Accumulation

Bibliography Acemoglu, D. (1998). Why do new technologies complement skills? Directed technical change and wage inequality. Quarterly Journal of Economics, 113, 1055–1089. Banerjee, A., & Newman, A. F. (1993). Occupational choice and the process of development. Journal of Political Economy, 101, 274–298. Chadha, G. K. (2004). Human capital base of the Indian labour market: Identifying worry spots. Indian Journal of Labour Economics, 47(1), 3–38. Chiu, W. H. (1998). Income inequality, human capital and economic performance. Economic Journal, 108, 44–59. Deaton, A., & Dreze, J. (2002, September 7). Poverty and inequality in India—A re-examination. Economic & Political Weekly, 3729–3748. Psacharopoulos, G., & Woodhall, M. (1985). Education for development. Oxford: Oxford University Press.

Chapter 6

The Pervasiveness of Self-Employment

Introduction Why is self-employment so pervasive in developing countries like India? Table 6.1 reports data for the distribution of workers by category of employment in the last 25 years and reveals that the share of self-employment currently is as much as 53% of the total workforce. The proportion of self-employed workers to total employment in rural areas has declined from 63% in 1977–1978 to 56% in 1999–2000 but in the past quarter century the proportion in urban areas has remained constant at around 42%.1 The self-employed workers are engaged in a wide range of economic activities from engagement in high-income services such as doctors, lawyers, consultants to engagement in more traditional activities such as artisans, craftsmen, small retail outlets, and tiny industries. The traditional view sees the self-employed as the core of the informal sector (Maloney 2003) that comprises the disadvantaged residual of segmented labour markets. The above market-clearing wages due to government or union induced rigidities, including high firing costs and excessive benefits force rationed workers in this view to shift their labour supply to the informal sector where remuneration is lower, work conditions more irregular, and benefits are absent. In contrast to this view of the informal sector as a less-preferred employment option that provides meagre earnings, it has been argued that people in the urban informal sector are self-employed by choice and the proliferation of such employment is not inefficient (Yamada 1996). Emphasizing that the self-employed work for themselves and so receive rewards for their human capital, physical capital, and entrepreneurial skills, whereas wage earners get a return only on their human capital. Yamada argues that people with entrepreneurial ability choose self-employment as the sum of labour

1 The

Task Force on Employment Opportunities attributes this to the decline in the proportion of farmers cultivating their own land due to fragmentation of holdings which has converted marginal cultivators into casual agricultural labour.

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_6

59

60

6 The Pervasiveness of Self-Employment

Table 6.1 Distribution of workers (usual status) by category of employment (per cent) Year

Category of employment Self-employment

Regular salaried

Casual

1. Rural areas 1977–1978

62.6

7.7

29.7

1983

61.0

7.5

31.5

1987–1988

59.4

7.7

32.9

1993–1994

58.0

6.4

35.6

1999–2000

56.0

6.7

37.3

1977–1978

42.4

41.8

15.8

1983

41.8

40.0

18.2

1987–1988

42.8

40.3

16.9

1993–1994

42.3

39.4

18.3

1999–2000

42.1

40.1

17.8

1977–1978

58.9

13.9

27.2

1983

57.4

13.9

28.7

1987–1988

56.0

14.4

29.6

1993–1994

54.8

13.2

32.0

1999–2000

52.9

13.9

33.2

2. Urban areas

3. Rural and urban combined

Source Government of India (2001)

and entrepreneurial income that makes them better off than if they sought wage employment. In another set of papers, Maloney (1999a, b) argues that often minimum wages are not binding and unions direct their attention more to the maintenance of employment rather than to wages as firms voluntarily pay wages above the market-clearing level so as to deter workers who they find difficult to monitor from shirking or to raise the opportunity cost to workers from leaving so that training and recruitment costs are not lost. Rather than above market-clearing wages causing. Informality, Maloney argues the reverse—that it is the attractiveness of selfemployment that causes firms to pay above market-clearing wages. If the cost of benefits is partially passed down to workers in the form of lower wages and workers do not value benefits as much as the fall in wages either because there are weak linkages between benefits and contributions or if the provision of social security and health benefits is inefficient, then they may seek jobs in the informal sector with entirely monetary remuneration. Further, the paucity of openings for promotion may cause workers to seek self-employment. Firms pay efficiency wages to prevent workers from leaving with their training and opening a business in the informal sector. Whilst accepting that high firing costs and non-wage benefits may reduce the

Introduction

61

size of the formal sector, Maloney argues that poor LDC education systems that force training costs on individual firms and low technological progress in the formal sector that restricts wage and employment growth there probably have a larger impact on the size of the informal sector. It would be the case that some individuals voluntarily consider the informal sector as a preferred destination for employment especially after they have accumulated sufficient human and financial capital in formal sector jobs that makes it attractive to quit and open their own enterprise. It is also true that individuals with higher entrepreneurial abilities will face a lower cost of production and find it more profitable to be self-employed rather than earn a fixed wage. However, given the large proportion of the workforce that is self-employed earn meagre incomes, it is a stretch of the imagination to characterize self-employment as a preferred activity that is voluntarily chosen. In the same vein, it is difficult to ascertain ex ante for an individual as to how good an entrepreneur he actually is until his business is actually running, and it is too much to expect risk aversion to be low at low levels of income. The size of the informal sector and low average incomes earned in self-employment rather suggest that for a large number of self-employed their presence in this type of occupation is involuntary, and as a result, a lack of opportunities accumulate human capital due to capital market imperfections or poor education systems. Moreover, given the uncertain stream of incomes earned in the informal sector, strategies for insuring against risk are often evolved to mitigate the impact of the risk. This involves among other strategies accessing at below market cost the financial or human capital resources available through one’s social network such as a brother who is a lawyer or a cousin who has an accounting practice. The causes of the involuntary element and the uncertainty reduction mechanisms in self-employment have often been observed to be prevalent. Given the high failure rates of enterprises in the informal sector, it is common for them to engage in informal strategies for managing risk (Maloney 2003). Maloney reports sociological work documenting how small informal sector firms are anchored in social networks of family that allow them to enforce implicit contracts and insure against risks. Social capital has long been considered to be a mechanism for alleviating problems of contractual enforcement and imperfect information (Coleman 1990), and communities are effective monitors of the behaviour of its members and providers of local public goods as their members, not outsiders, have crucial information about other members’ behaviours, capacities, and needs. Social capital may be defined as those expectations for action within a collectivity that affect the economic goals and goal-seeking behaviour of its members (Portes and Sensenbrenner 1993)— the emphasis here being on those social structures that facilitate individual rational pursuits. Portes and Sensenbrenner emphasize four types of economically relevant expectations—value introjection, reciprocity transactions, bounded solidarity, and enforceable trust. Value introjection refers to the moral character of economic transactions that are guided by value imperatives learned during the process of socialization. It prompts individuals to behave in ways other than naked greed—one’s (duties and) obligation towards the content of his professional activity which cannot be contracted. Reciprocity transactions refer to that aspect of behaviour where selfish

62

6 The Pervasiveness of Self-Employment

ends are pursued rather than the higher group morality of value introjection behaviour. With social life comprising many transactions where favours, information, approval, and other such intangible valued items are given and received, the accumulation of such “chits” based on previous good deeds to others that are backed by the norm of reciprocity constitutes the social capital of reciprocity transactions. Bounded solidarity is a result of situational circumstances that leads to the emergence of principled group-oriented behaviour that results in mutual support which is quite different from the introjection of established values or from individual reciprocity exchanges. The lower the chance of exit from a situational circumstance (such as being rationed in the labour market), the stronger is the forging of solidarity amongst members of the group, and the higher the appropriable social capital based on this solidarity.2 A solidary community represents simultaneously “a pool of reliable low-wage labour and a potential source for start-up capital” (Portes and Sensenbrenner 1993, p. 1329). Finally, there is the source of social capital that is enforceable trust where individuals subordinate their present desires to collective expectations or group goals not due to value convictions but to the anticipation of the long-term advantages associated with good standing in a collectivity. In this case individuals behave in a more instrumental fashion out of an anticipation of rewards or punishment, but unlike reciprocity the behaviour is not oriented to a particular other but to the web of social networks of the entire community. In a community the probability that members who interact today will interact in the future is high and this is a strong incentive to act in socially beneficial ways now to avoid retaliation in the future. Communities monitor the behaviour of their members and render them accountable for their actions. However, as enforceable trust is guided by instrumentalist expectations, its strength depends to what extent the community is a source of rewards such as social approval or business opportunities. The greater the economic opportunities available outside than those available through membership in the community, the lower is the enforceable trust that it is possible to generate in a community. Bounded solidarity and enforceable trust foster the development of social capital that can be used by group members. Individuals that belong to communities and groups recognize each other as familiar. People that know each other or about each other can place each other and are able to generate interpersonal trust and understanding. Those already in established networks get easier access to others that recognize these networks. Moreover, being rooted in a network embeds the individual in a cluster of relationships where people share perspectives and resources and feel they are similar, thereby creating ties that help locate suppliers, clients, workers, and capital for the enterprise. In self-employment enterprises the hiring contract, the code of conduct, and how the place is run are based on culture. Very often these enterprises are family based (Maloney 2003) with the family furnishing labour and pooling financial resources. Labour that belongs to a community or network can be trusted to not indulge in opportunism. Also, because they have a greater stake in the success of the business such workers tend to be more productive than others when hourly 2 Individuals enact emergent sentiments of loyalty towards others like themselves and such behaviour

can be independent of reward or punishment.

Introduction

63

wages are low. Self-employed enterprises thus hire or work with those with whom they have real or symbolic ties. In such enterprises class interest is downplayed and access is limited to those with the recognized background. The employer–employee bond is culturally based and jobs are governed by particularistic rules known to everybody. Rather than well-defined job parameters, mutuality and helping features are emphasized in whatever tasks are assigned or required to be carried out in the enterprise. This mutuality allows the flexibility of deploying labour and works well in attenuating coordination problems in the enterprise. From a labour economics perspective this is akin to the posting of a bond to guarantee performance. A self-employed enterprise has a high chance of failure and any person shirking exposes everyone in the enterprise to the possibility of closure. To overcome this, it is necessary to create incentives that encourage co-employees to monitor one another so as to prevent failure of the enterprise. Making each person individually responsible for the success of the enterprise is achieved by making their employment serve as collateral against the failure of the organization. This high liability induces individuals to monitor the effort of their colleagues as others actions expose them to the risk of losing their jobs. However, the cost of posting this bond is low as information about others honesty and competence via social networks makes it unlikely that the bond will have to be forfeited. Also given the ties that bind individuals together in a self-employed enterprise mutuality is prevalent and this results in individual’s preferences being altruistic. Thus, individuals do not pursue the satisfaction of their selfish preferences but take into account the preferences of everyone else in the enterprise but this altruism is at the same time instrumental (bounded solidarity) behaviour given that opportunistic negligent action by others is costly for an individual. The implications of such behaviour and the incentive to accept the joint liability for the success of the enterprise requires further elaboration.

Efficiency Wages and Self-Employment In the efficiency wage literature, the opportunistic behaviour of a worker is prevented by paying a higher than market-clearing wage and by the threat of firing if the worker is detected to be shirking (Shapiro and Stiglitz 1984). If w is the wage and e the level of effort on the job, then the utility function of an individual can be stated as ∞ U=

e−r t {w(t) − e(t)}dt

(6.1)

t=0

For simplicity we allow effort to be minimal, e = 0, or the individual can choose to provide a greater than zero level of effort, e > 0. The firm can detect with probability p whether a worker is shirking (e = 0). Following Shapiro and Stiglitz (1984), let Ui be the expected value of discounted lifetime utility from the present onwards of a worker who is in state i, where i = E, S; E representing positive effort when

64

6 The Pervasiveness of Self-Employment

e > 0 and S the shirking associated with e = 0.3 An assumption we make about Ui , i = E, S, is that the transitions among states are Poisson processes4 so that the Ui s do not depend on a worker’s prior history or on how long he has been in his current state. Also, as we focus on steady states, the Ui s are constant over time. If we think of the expected present value of lifetime utility as an asset, then the asset’s price is U E when the worker exerts effort and is employed and U S when he shirks. For this asset to be held by risk neutral investors with required rate of return r , the return on the asset, rUi , must equal the dividend per unit of time plus any expected gains or losses per unit of time. When the worker exerts effort and is employed, dividends per unit time are (wˆ − e) where wˆ is the efficiency wage. Thus,5   rU E = wˆ − e or UE =

wˆ − e r

(6.2)

For a worker who decides to shirk the dividend is the wage as no effort is provided. To find the capital loss on the asset when he shirks we proceed by denoting by p the probability that it will be detected that he shirked and he will be fired in which case in the next period he will find employment with probability (1 − q) giving an expected utility p(1 − q)U S . If it is not detected with probability (1 − p) that he shirked, then his next period expected utility will be (1 − p)U S . The capital loss associated with shirking will be {1 − [(1 − p) + p(1 − q)]}U S or pqU S . Thus, the expected returns to shirking equals the dividend minus the capital loss as given by rU S = wˆ − pqU S or,

3 For simplicity we are ignoring state i = Q where Q is the unemployed state. We also do not allow for the possibility that there is an exogenous rate at which jobs end. 4 If the worker begins working at time t , the probability of being detected as a shirker at some 0  later time t is P(t) = e−b(t−t0 ) , b > 0. This implies P(t + τ ) P(t) equals e−bτ and thus that it is independent of t. 5 Alternatively, we could use dynamic programming to derive the same result. Consider a worker who is employed and exerting effort at time 0. If time is divided into intervals of length t and a worker who loses his job during an interval cannot begin to look for a new job until the beginning of the next interval, we can write the value of employment at the beginning of an interval, U E (t), as t  −r t U E (t) = e (wˆ − e)dt + e−r t U E (t). The first term is utility during the interval (0, t), t=0   ˆ 1 − e−r t + e−r t U E (t) or, and the second term reflects utility after t. Thus, U E (t) = w−e r ˆ w−e ˆ U E (t) = w−e r . Hence, U E = lim U E (t) = r which is the same as Eq. (6.2). t→0

Efficiency Wages and Self-Employment

65

US =

wˆ r + pq

(6.3)

The efficiency wage which firms must pay to induce workers to provide a high level of effort is given by the solution to U E ≥ U S , or,

r wˆ ≥ e 1 + pq

(6.4)

Because wˆ will be higher than the market-clearing wage there will be unemployment and some individuals will be rationed out of the labour market. In the above setup those who are rationed search for jobs and find one with probability (1 − q). However, apart from finding jobs in the formal sector there is the option of taking employment in the informal sector. Prima facie it would seem that the informal sector would also have to pay efficiency wages that satisfy condition (6.4) above. But this ignores that the informal sector taps into social capital and comprises units where members of the extended family, ethnic group, or social network are employed. Given the ties that bind co-workers as argued above, they maximize their joint utility function given by U = Ui + U j

(6.5)

Again, for simplicity we presume a two-person enterprise, where Uk = wk − ek , k = i, j. The self-employed enterprise comprises individuals who behave benevolently by directly considering the interests of others in the enterprise as a result of the social relationships that they are embedded in. For such an enterprise to be viable social capital must be able to provide the benefit that the enterprise finds it profitable to pay efficiency wages that elicit effort but which are less than those paid so as to discourage shirking as given by condition (6.4). The informal sector enterprise must have an advantage in utilizing the predisposition to cooperation that communities have deployed to regulate their common activities such as solidarity, trust, reputation, personal pride, and reciprocity. The informal sector extracts this advantage by stressing mutual and joint liability for the success of the enterprise in the sense that if one member shirks then all members of the enterprise are affected as joint performance is the strength of the enterprise. The individuals in a self-employed enterprise participate in a joint contract that promotes more effort by all as only by reducing the costs of shirking do they have an advantage over individual contracts in the formal sector that pay efficiency wages to deter shirking. By stressing joint liability the selfemployed enterprise is able to add value compared to the alternative contracting that targets the individual alone outside his social setting. The utility of the self-employed enterprise when both members put in effort and w S E is the efficiency wage payable is rU ES E = 2(w S E − e)

66

6 The Pervasiveness of Self-Employment

or U ES E =

 2  SE w −e r

(6.6)

If one individual finds it convenient to shirk we would expect that the second would also follow suit as the success of the enterprise is contingent on none 2 shirking. The joint probability of shirking is (1 −  capital  p) and the2 associated  2 loss of the enterprise will be 1 − (1 − p) + 1 − (1 − p) (1 − q) U SS E = pq(2 − p)U SS E , where (1 − p)2 U SS E is the utility of non-failure of the enterprise  2 and 1 − (1 − p) (1 − q)U SS E is the utility when the self-employed enterprise fails and both get employment in the formal sector. The shirking utility associated with the self-employed enterprise will be given by rU SS E = 2w S E − pq(2 − p)U SS E or U SS E =

2 wSE r + pq(2 − p)

(6.7)

The efficiency wage necessary to ensure no shirking is again U ES E ≥ U SS E , i.e.,  2  SE 2 w −e ≥ wSE r r + pq(2 − p) or

w

SE

r ≥e 1+ pq(2 − p)

(6.8)

Comparing (6.8) with the wage paid under individual contracting as given by (6.4), it is obvious that w S E < wˆ provided p < 1. If p = 1 in both types of organizations there is no advantage of a self-employed enterprise with joint liability over individual contracting in a formal sector enterprise. It is possible for p = 1 in the self-employed enterprise and for it to be viable provided the observability in the formal enterprise with individual contracting is imperfect and the probability 

of detection there is less

r SE than unity. In such a case, wˆ ≥ e 1 + pq and w ≥ e 1 + qr still gives wˆ > w S E . In a self-employed enterprise opportunism by workers is mitigated via the mutualism and joint liability that motivates the members of the enterprise which decreases the costs of shirking. It now needs to be checked if this is profitable for the individuals involved. To do this suppose two persons who are rationed in the formal sector and have access to the same source of social capital decide to self-employ themselves by starting an enterprise. If U Q is the utility associated with unemployment and (1 − q)

Efficiency Wages and Self-Employment

67

is the probability of finding a formal sector job, then, rU Q = (1 − q)U E − qU Q or UQ =

(1 − q) UE (r + q)

(6.9)

The total utility of the two individuals when currently unemployed is U Q Q where U Q Q = 2U Q =

2(1 − q) UE (r + q)

(6.10)

If instead they start their own self-employed enterprise with a lower efficiency wage w S E , their utility will be rU ES EE = 2(w S E − e) or U ES EE =

2(w S E − e) r

(6.11)

Self-employment is worthwhile provided U ES EE ≥ U Q Q , or, 2 SE (1 − q) 2 (w − e) ≥ (wˆ − e) r (r + q) r or (w S E − e) ≥ (wˆ − e)F(q, r )

(6.12)

 where F = (1 − q) (r + q) = F(q, r ). It can be checked6 that ∂∂qF < 0 and ∂∂rF < 0. This implies that higher unemployment (q) and higher discount rates (r) will make the individuals more willing to accept the lower wage of the self-employed enterprise. If the two individuals are both employed in the formal sector and get utility from this employment of U E each as given by (6.2), then it is never worth to go in for selfemployment (with utility U ES EE ) even if they are connected with social ties because in that case they would get lower wages. This is because the total utility of selfemployment, U ES EE , is less than the total utility of individually contracting in a formal sector job, 2U E , as can be seen from examining that U ES EE < 2U E implies 6 ∂F ∂q

=

−(1+r ) (r +q)2

and

∂F ∂r

=

−(1−q) . (r +q)2

68

6 The Pervasiveness of Self-Employment

2(wˆ − e) 2(w S E − e) < r r or w S E < wˆ which is true. If on the other hand, one individual is employed in the formal sector and enjoying utility U E and the other is currently unemployed with utility U Q , then their total utility would be7 U E Q = U E +U Q . It can be verified that U ES EE ≥ U E Q provided (w S E − e) ≥ (wˆ − e) 21 (1 + F). In this case too like when both were unemployed, self-employment and the accompanying wage reduction for one of the individuals is worthwhile if the unemployment rate or the rate of discount is appropriately high because the reciprocity that the two individuals bestow on one another allows them to earn a higher joint income and enjoy higher total utility. When unemployment rates or the discount rate is relatively high, then we have the possibility that workers trade off the low chance of finding employment and their high preference for the present with the reduction in the wage that is made possible as due to their social relations they are able to control the costs of shirking.

Conclusion Self-employment is pervasive and is the predominant form of employment in India. There are two sets of explanations that have been advanced to explain this. One argues that rigidities in the labour market due to government or union influence segment the labour market into formal and informal segments, with the self-employed forming the core of the informal sector. Other explanation sees the self-employed as choosing this form of employment so as to earn the return from this entrepreneurial capital as well as their human capital. With the informal sector being more attractive, firms pay above market-clearing wages in the formal sector so as to retain workers and reap the benefits of the training and recruitment costs incurred. This paper, in contrast, argues that given the sheer size of the informal sector and the low average income earned there, it makes more sense to consider employment here as a second preference option. Moreover, at such low levels of income it is difficult to imagine individuals willing to assume the risk that accompanies entrepreneurship. It is argued that the accessibility of resources available through one’s social network mitigates the risk of entering into self-employment and allows the enforcement of an implicit contract where co-workers monitor opportunism and thereby make self-employment an economic proposition that can survive by paying

7U

EQ

= UE + UQ = UE +

1−q r +q U E

 = 1+

1−q r +q

 U E = (1 + F)U E .

Conclusion

69

lower wages than formal sector firms. These lower wages in the self-employed enterprise are acceptable over queuing up and searching for a formal sector job due to high unemployment rates or high discount rates of individuals. In the presence of high unemployment and high discount rates social capital is a resource that enables individuals to compete effectively by controlling wage costs through imposing joint liability for the failure that goes with opportunism. The resulting self-employment is a second preference and does not earn individuals the high incomes of the formal sector but it cushions them from the third best option facing them which is unemployment and possible destitution. Of course, there are relevant downsides that are important but which in this article we ignore. For instance, workers in self-employment may gain a short-term advantage of income but lack recourse to legal protection. Self-employment through social relations survives by maintaining low wages and there is no scope for union organizing. Individuals who depend on social capital for socio-economic achievement can become caught in a web of obligations and individual sacrifices that interfere with their potential pursuit of economic opportunities which causes them to indefinitely be tied to lower wage self-employment rather than to invest in human and financial capital so as to access the high returns of the formal sector. These and other such important issues require more research and consideration.

Bibliography Coleman, J. S. (1990). Foundations of social theory. USA: The Belknap Press of Harvard University Press. Government of India. (2001, July). Task force on employment opportunities. New Delhi. Maloney, W. F. (2003). Informality revisited. World Bank Policy Research Working Paper 2965, January. Maloney, W. F. (1999a). Does informality imply segmentation in urban labour markets? Evidence from sectoral transitions in Mexico. World Bank Economic Review, 13, 275–302. Maloney, W. F. (1999b). Self-employment and labour turnovers: Cross-country evidence. Policy Research Working Paper 2102, April, The World Bank. Portes, A., & Sensenbrenner, J. (1993, May). Embeddedness and immigration: Notes on the social determinants of economic action. American Journal of Sociology, 98(6), 1320–1350. Shapiro, C., & Stiglitz, J. (1984). Equilibrium unemployment as a worker discipline device. American Economic Review, 74, 433–444. Yamada, G. (1996). Urban informal employment and self employment in developing countries: Theory and evidence. Economic Development and Cultural Change, 289–314.

Chapter 7

Secure Livelihoods

Introduction As the traditional economic and social order undergoes transformation and societies develop, there emerges a perceived need for social security to provide for those who lack an income (due to disability, old age, death of a breadwinner, maternity, workrelated injury, unemployment, etc.) or who have medical needs. Programmes of this type in developing countries that are publicly administered are not usually extensive and they cover mainly a small part of the population—the organized sector, where the structure of enterprises facilitates the collection of taxes and contributions, as well as the administering of schemes. As a result, the extension of these schemes, such as those governed under enactments like the Employees’ Provident Fund (& MP) Act, the Workmen’s Compensation Act, the Employees’ State Insurance Act, the Maternity Benefit Act, and the Payment of Gratuity Act, to outside the ambit of the formal sector is not viewed as operationally feasible.1 To the vast majority of the population who belong to the informal or unorganized sector especially, it is argued that designed social insurance schemes like welfare funds financed by taxes or a cess are required (Subrahmanya 2000), as well as social assistance programmes financed by government revenue, targeted to the poor (Guhan 1994). Social security for the unorganized sector is increasingly receiving the attention of academics, policy makers, multi-lateral organizations, and NGOs, and the writing on the subject is fast approaching the status of a growth industry (Van Ginneken 1997, 1998; Jhabvala and Subrahmanya 2000, 2000; Seeta Prabhu 2001; Mahendra Dev 1999; Unni and Rani 2001). The consensus in the literature is that the definition of social security needs to be broadened from the focus on addressing only contingencies

1 Judicial

pronouncements have upheld the applicability of the EPF and ESI Acts to home-based workers in beedi rolling, carpet manufacturing, and other cottage industries. Yet it is difficult in these situations to firmly establish an employer/employee linkage and employers have large incentives to evade. Unorganized sector work by nature does not result in steady and regular employment.

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2020 E. D’Souza, Conceptualizing the Ubiquity of Informal Economy Work, SpringerBriefs in Economics, https://doi.org/10.1007/978-981-15-7428-3_7

71

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7 Secure Livelihoods

to encompassing programmes that enable individuals to attain a reasonable standard of living. Those programmes providing employment, income, and assets required to reach a basic standard of living have been termed as economic security programmes, whereas those associated with needs such as health care, child care, old age, pensions, and food have been termed as basic needs programmes, and these two types of programmes are viewed as being mutually reinforcing. For instance, it is argued that child care facilities can increase the hours worked as well as the productivity of women workers, and the increased income earned provides economic security which in turn becomes the means by which people can satisfy their basic needs. Social security in an economy with a large unorganized sector and is thus seen to be a part of a comprehensive poverty reduction programme which has a promotional component of improving endowments and exchange entitlements, as well as a protective component that protects individuals from contingencies such as illness and disability. Social security programmes for the unorganized sector are thus meant to provide adequately to beneficiaries—with the adequacy of provision being a replacement (mainly partial) of previous earnings due to the occurrence of a contingency, or the provision of a minimum or standard level of benefit to all. In this light, they involve redistribution from those better off to those worse off—social equity, and the provision of benefits to people equal in expected discounted value to their contributions or taxes—individual equity. The standard level of benefit advocated can be viewed as a general income support policy into which the contingency-related social insurance policy dovetails once regular benefits from it have been exhausted because coverage and benefits will have limits imposed by the availability of finance. The explicit objective of the aspect of social security policy in promoting social equity is poverty reduction and not so much the correction of large income or wealth inequalities. The case for this needs to be spelt out as the literature cited above does not make out a case but treats it rather as an obvious objective. The equity foundations for social security for unorganized workers are largely skipped over although some justifications are done by making an appeal to rights, needs, or desert-based arguments. A desert-based argument, for instance, is made by Bhatt (2000), who argues for income security and social protection because workers and producers are the main contributors to the wealth of nations, and hence provision of such security to them will add to social product. Rights and needs-based arguments justify social security on the grounds that they allow a decent or minimum standard of living.

Equality of Opportunity If the reduction of absolute poverty is the valid concern then it is the task of public policy to assure that most of the population is above the poverty line and that no vulnerable groups (the elderly, children, disabled, etc.) suffer from income deprivation. However, if observed income and wealth inequality reflect to a large extent individual differences in effort, ambition, and risk taking, then, in as much as these

Equality of Opportunity

73

are due to individual responsibility, it is not required of social policy to alter the resultant income inequality.2 The crucial distinction is that social policy is concerned with the equality of opportunities and not the equality of outcomes (income, wealth) as individuals are not deemed to be responsible for the opportunities they face which are largely due to circumstances beyond their control (Roemer 1996). It is the individual’s responsibility, however, to transform favourable opportunities into positive outcomes. The role of social policy is to compensate individuals for the disadvantage inherent in their circumstances. In this perspective equality of opportunities reduces to equality in access to wealth-creating factors, or the capacity to earn incomes is the target of social policy. If workers in the unorganized sector constitute individuals who share the same set of circumstances (irregular income and low-quality employment) and workers in the organized sector are another type who share a different set of circumstances, then equalizing opportunities across these two types of individuals in society implies that the distribution of the income-earning capacity is the same for both these types. The stress is not on the capacity to earn incomes being the same for both types (which is an equal outcome scenario) but on the equal distribution of that capacity so that individuals irrespective of their type do not face differential circumstances that are beyond their abilities to influence. Once the circumstances have been delineated, differential effort and risk taking will result in different achievements of income and wealth which is acceptable as it does not violate the notion of social equity as equality of opportunity. A significant source of inequality is social exclusion3 which refers to the multidimensional character of deprivation due to the disadvantages relating to the precariousness of work, income, gender, ethnicity, and participation—it thus refers to exclusion in the economic, social, and political sphere due to power relations, culture, and social identity. It is recognized that the dimensions of social exclusion are different in each society (deHaan and Maxwell 1998) and that vulnerability of some groups of people in a society results from barriers to upward mobility that can take many forms such as discriminatory treatment by institutions of justice, religious and cultural marginalization, and lack of political representation. Well-being then is not merely economic but can also result from social and political marginalization which is due to the low voice and socio-political power that certain groups have in society. Social exclusion makes it very difficult for certain social groups to access resources such as education, information, credit, employment opportunities, and legal protection that enable upward mobility. In India, one of the dominant forms of social exclusion is caste which is fixed at birth. This social institution often denies access to common property resources as happens when lower castes are prevented from entry into temples or forbidden to use village wells because these castes are deemed to be polluted. Till until recently children of lower castes were even denied entry into 2 There is, of course, the issue of the circularity between resources and preferences—richer individ-

uals may be more willing to take risks which are thought of as belonging to the realm of personal responsibility—which complicates the argument. We sidestep this here but see the footnote 9 where a difference is made between risk preferences and risk behaviour. 3 Rodgers pioneered the work on social exclusion at the International Institute of Labour Studies at the ILO. See Rodgers et al. (1995).

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schools—a social restriction on human capital acquisition, and on social occasions lower castes are sometimes made to eat separately. In the labour process literature, workers in the unorganized sector have also been characterized as suffering from social exclusion—the exclusion being from the process of economic development. This is because the people working in this sector have been viewed as surplus labour—limited industrialization and labour demand along with the increasing demographic pressure and landlessness which resulted in increasing labour supply are the reasons for the rise of unorganized sector. Unorganized sector workers are thus those who are excluded from modern economic development. This perspective, of course, has been questioned by Marxist scholars (Breman 1996) who do not see the unorganized sector as part of a dual economy, but rather as a product of capitalist development—unorganized workers are thus not excluded from development, but subsumed under its logic. However, as pointed out by Breman, lack of mobility and segmentation characterize urban labour markets in India where certain economic functions are associated more with particular social groups than others. Such a non-market phenomenon impedes equality of opportunity as it implies that some groups are “included” and others “excluded” and thus calls for policy to mitigate such inequality. The provision of social and economic infrastructure must accordingly be tied to a delivery mechanism that entails equal access to goods and services such as basic health and education. In economic terminology we can think of wealth-creating assets and the environment in which they are generated as the conditions circumscribing households who act given these conditions to produce income and other aspects of well-being which are constitutive of livelihoods. The goal of social policy, as we conceive it, is to promote equality of opportunity so as to enable households to achieve secure livelihoods. The wealth-creating assets that households are endowed with unequally are various forms of capital: physical capital, financial capital, human capital, and social capital. Physical capital encompasses land, housing, livestock, jewellery, farm implements, and other production durables that constitute tangible assets which allow production and that have the potential of begetting income. Financial assets constitute assets with higher liquidity and lower carrying costs that allow households to make intertemporal adjustments of income that can be used for consumption, production, and investment. There are three types of financial capital services that are useful to distinguish. Savings services allow the depositing and accumulation of small amounts of capital over time, which in many cases earn a positive rate of return. Credit services allow a borrower to obtain a lumpsum now but repayments of the principal and interest have to be made at some future point of time. Insurance services allow clients to pay a premium in return for a future payout that is contingent on the occurrence of a risk whose timing is unknown. Human capital includes health, education, and nutrition that are embodied in individuals and which translate into skills and abilities that are potential sources of labour, managerial, and entrepreneurial incomes. Social capital refers to the features of social organization such as informal reciprocal networks, norms, and trust that are found within communities and extended families and which facilitate coordination for mutual benefit or enable redistributive transfers to occur.

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The focus of equality of opportunity on wealth-creating factors that has been adopted here is a recognition that it is assets—broadly defined to include physical, financial, human, and social assets on which more shortly—which are commandeered by individuals and households with the objective of achieving certain levels of income and well-being. Second, there is an emphasis on multiple dimensions to the achievement of income and well-being so that an over emphasis on economic aspects without reference to the social and political dimensions of well-being will not promote an understanding of what we are seeking to comprehend. Third, the treatment of social security in the established literature describes a favourable social security system mainly in terms of outcomes achieved in various aspects of wellbeing, such as in education, nutrition, and health. The strategy in the literature has been to identify what constitutes well-being, and the vector of attributes that constitute well-being is selected on a notion of what is an essential component of basic needs or a decent standard of living. The literature then measures whether the achieved elements of the vector of well-being in society is sufficient to meet the basic needs of the individuals or households that comprise it—insufficiency being a measure of insecurity. In contrast to this emphasis on outcomes, the approach we take here is different in that social security or insecurity is not a state where income and wellbeing is insufficient for basic needs, but rather, is a process where due to certain mechanisms and institutions, individuals and households are able or unable to attain satisfactory incomes and well-being. In trying to transform wealth-creating assets into incomes and well-being (see Diagram 7.1), agents in the economy face a stochastic environment which makes them subjects of various types of risky situations such as drought, illness, or disability and the institutions through which the conversion of assets into earnings is transacted can enable or hinder the efficiency with which such actions by agents are performed. The end result of these actions by agents in the face of various risky conditions and institutions that facilitate or constrain their ability to generate returns from various activities is what at first blush can be thought of as is done in the literature as the achievement of economic and social needs, but which on reflection would be more appropriate to think of as promoting the attainment of increased power over their own lives now and in the future. For these reasons, this essay’s point of departure is that the issue of social security is best intellectually tackled through the lens of secure livelihoods. Secure livelihood as defined here refers to the extent of empowerment of households as determined by the opportunities available to them to make a living mediated through various market and non-market institutions in the face of stochastic conditions when they act by deploying various forms of capital—physical, financial, human, and social—at their command so as to earn a return in the form of income or well-being. We now proceed to elaborate on this definition.

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7 Secure Livelihoods S to c h a s tic E v e n ts

Id io s y n c ra tic / C o v a ria te

L o w /H ig h F re q u e n c y

In te n s ity

P re c a u tio n a ry S tra te g ie s

A u to c o rre la te d / N o n -S ta tio n a ry

A d ju s tm e n t S tra te g ie s

C a p ita l

P h y s ic a l

F in a n c ia l

H um an

S o c ia l

In s titu tio n s M a rk e t

N o n -m a rk e t

In c o m e

W e ll b e in g

L iv e lih o o d

Diagram 7.1 How Shocks and Institutions link wealth creating assets to Livelihoods

Stochasticity and Institutions Households have endowments of various forms of capital identified at their disposal—their opportunities—which can be transformed into different forms of income that can be thought of as returns to these types of capital. Transfers and remittances, for instance, are returns to social capital, and credit as a form of financial capital is a current return on the potential value of assets. These incomes deriving from various types of capital allow households to attain other aspects of well-being such as low levels of infant and maternal mortality. Income and well-being is mediated through institutions such as markets and non-market ones with norms within households regarding the allocation of resources. The livelihood of households is then insecure if various types of capital assets they have are subject to erosion or the institutions that enable the transformation of these assets into aspects of income and well-being function poorly and ineffectively. Secure livelihood, which is our preferred way of viewing social security, is then not only about the availability of various types of capital assets at the command of households but also about the erosion of these assets through various random shocks and the inability to earn the full potential return on these assets due to institutions that support and help generate incomes from these assets but not providing an enabling environment.

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The capital assets of households are subject to erosion due to stochasticity— various types of eventualities that are probabilistic in nature and beyond the direct control of households. These stochastic events are of four different types, each of which yields variable and unpredictable returns from capital and so affect the security of livelihoods (Morduch 1999a). One type of stochastic fluctuation can be characterized by frequency of occurrence. Certain types of shocks to human capital, such as minor illnesses for instance, can occur very frequently whereas other shocks are relatively rare. High-frequency downside shocks have the potential to erode capital and can be quite damaging. Second, there is the intensity of occurrence of a shock, more intense shocks being more serious or damaging to the asset base of households. For instance, a shock of high frequency but minor incidence to health such as insect bites will have a smaller impact than one with a low frequency but serious impact such as a coronary attack. Third, shocks need not be independently distributed over time—they could be autocorrelated. For instance, a monsoon failure may result in drought and malnutrition which in turn raises the probability of occurrence of further erosion of human capital as children are pulled out of schools and made to work to supplement the reduced income. Droughts also affect the maintenance of the land and the consequent poor soil conditioning and run-offs can have adverse impacts much after the climate returns to normal. Some shocks may be non-stationary. For instance, if somebody becomes permanently disabled or loses productive assets, then these can have permanent effects on their capacity to generate incomes. The fourth type of random shock does not vary over time but across individuals. These are either idiosyncratic, i.e., they are due to factors that are specific to individuals in isolation such as accidents, injuries, and illnesses, or they are covariate and affect a group who are linked geographically or by some shared risk characteristic such as a drought, floods, or an epidemic. Households are in the know that these shocks occur but have no idea as to the timing of their occurrence due to the probabilistic nature of these shocks and so have no control over the likelihood of occurrence. These shocks affect the variability of income and well-being and households undertake precautionary strategies to smooth the returns to forms of capital. In short, households make attempts in advance to minimize the impact of adverse income shocks (Morduch 1995). This can be thought of as a precautionary motive of savings. The aim of such a motive is the desire to be able to procure a minimum level of consumption in the unknown future when an unknown amount of reduction in income or increase in expenditures (such as for medical needs or social obligations) could occur.4 Traditionally, savings is defined to include changes in assets—monetary and physical—such as food, jewellery, inclusive of other consumption and production durables, and adjustments are made for changes in debt. This focuses on savings and investment by households on financial and physical capital only. It does not include the other important component of savings and investment in human capital such as education and in social capital such as 4 This

motive for saving is different from the accumulation motive where the aim is to accumulate assets for a planned and foreseeable expenditure such as financing the acquisition of real estate or a dowry.

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investments in networks of family and friends that provide a safety net as well as other services. As the aim of precautionary savings in various forms of capital is to minimize downside risk and to reduce the variance of income, the strategy also entails a lowering of the expected income as lower risk is generally associated with lower returns.5 Precautionary savings is a type of buffer stock that can be liquidated in the event of a transitory income shock. Physical assets that are used for precautionary savings are usually jewellery, livestock, and food. These types of savings are subject to risks like inflation, disease, and rotting and status; cultural norms and prestige play an important role as well in the accretion of such assets. Financial savings are mainly in the form of cash due to the demand for liquidity and accessibility in times of sudden need. These savings earn a negative real interest but are demanded due to the desire for quick liquidity and low transactions costs dominating the desire for a positive return when the consideration is to make timely expenditures when a random shock occurs. A form of precautionary saving in human capital is to have more children who form a reserve army of labour that can be used whenever there is an unexpected shortage of family labour due to illness or failure of exchange entitlements. Another extreme form of income smoothing via labour market activity is tied labour involving a longterm contract between employers and employees at low but steady wages and greatly reducing the risk to workers of facing low consumption in slack seasons (Bardhan 1984). Incomes are also diversified through off-farm activity with some household members in wage employment. Precautionary savings can also be in the form of social capital through investing in personal relationships with extended family and friends that give private transfers as gifts or loans in times of need. Social capital is also built up via household members migrating and remitting incomes. Once adverse shocks occur, households deploy various strategies to insulate consumption from the reduction in the return to various forms of capital. Households respond to declining income by adopting expenditure-minimizing strategies of changing dietary habits, cutting down purchases of non-essential goods, and incomeenhancing strategies including sending children and women to work. Adjustment strategies are typically adopted in a hierarchical manner with priority given to those which have low long run costs and entail easily reversible actions. For instance, reduced incomes by those who have a large proportion of their consumption expenditure absorbed by food expenditures is often adjusted to by a modification of food consumption. Consumption rationing in this case is achieved by diversifying food consumption—forgoing income elastic components of food expenditures such as on meat or fish, and compensating by consuming coarse cereals or in some cases even wild foods. Apart from the composition of food, absolute food consumption may also be reduced when the shock is large through having fewer meals per day as well as smaller servings of food. After the exhaustion of this type of strategy, households 5 Income

smoothing also occurs via using variability reducing inputs and production techniques. Inputs such as fertilizer may be used less intensively to reduce the level of investment tied up in risky activities and land may be devoted more to safe, traditional seed varieties than riskier high-yielding varieties.

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adjust through strategies that have greater long run implications for their asset base. This involves drawing down savings in various forms of capital and even selling assets. It should be mentioned that housing is an important physical asset and it is often overlooked that it can cushion households in times of adversity. Housing is often used as a base for home-based enterprises such as front-room shops involved in retailing and preparing meals, to tailoring and dressmaking. Housing is also used for extending personal relationships and generating social capital. Young households without their own assets often reside in parental households giving them access to cheap housing, freeing additional time for potential productive work as elders help with child rearing activities. Of course, congestion and the side effects this can create on health, etc. as a result of, for instance, latrine sharing are costs of such activities. Another common practice of adjusting to shocks is to withdraw children from school—drawing down human capital—so as to release resources for the priority of purchasing food. Social capital is also called on through borrowing from friends and relatives as well as moneylenders and requests made for remittances from the extended family. As the circumstances become extreme, assets such as jewellery, livestock,6 and farm implements can be sold, children can be sent to work and to beg, and female members of the household join the labour force through work in petty trade and services in the informal sector as domestic servants, street sellers, and as scavengers. Girl children are usually called to take on child care and other household responsibilities so as to release their mother for work. The intra-household distribution of the burdens of adverse shocks are known to be very unequal. As shown by Behrman (1988), seasonal variation in nutrition is more marked for girls than for boys in India, and Rose (1999) demonstrates how during adverse rainfall shocks in India girls’ survival probabilities fall relative to boys’, with girls being 40% more likely to die than boys in a year of bad rainfall. Various adjustment strategies adopted by households in the face of seasonality and calamity in terms of diversifying sources of income and drawing upon communal and social relationships and physical assets have been excellently and exhaustively documented in the work of Agarwal (1991). The opportunities available to households to attain various levels of income and well-being are affected apart from stochastic factors, also, by institutions—market and non-market—that facilitate or hinder their ability to transform their various stocks of capital into aspects of livelihood. This transformation of assets into the returns that constitute the income and well-being aspects of livelihood are mediated through markets, where goods and services are transacted, and non-market institutions, such as the government supplied public services of health, and education. The availability of information about and imperfections in markets and the nature of government intervention that promotes or hinders participation in markets through ensuring property rights and enforcement of contracts are crucial aspects for the promotion of secure livelihoods. Often the transformation of assets into incomes, for instance, does not allow the full potential returns to assets to be earned due to the 6 Rosenzweig

and Wolpin (1993) find that sales of bullock in India are motivated by the need to smooth consumption.

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constraints in factor markets. A well-known example of this is in the credit market where despite a good prospect of future revenues from an activity credit may not be forthcoming due to a collateral constraint. Much of the same constraint on the options available to households operates when, for instance, the timely availability and quality of inputs are not assured. Thus, an important precondition to promoting secure livelihoods is investments by government in technology development and transfer, road infrastructure, and improving the performance of commodity markets. Assets are not profitably invested in many cases due to the lack of complementary services such as agricultural extension and access to services that prevent disease, and due to inadequate access to input and output markets and infrastructure. The generation of income and well-being can be negligible if the necessary complementary infrastructure and markets as well as health and other social services are not in place. Social and economic infrastructure are crucial inputs to enhancing the household returns to types of capital. Social services such as education ensure that people gain skills and knowledge, whereas economic infrastructure such as health care, water, transport, and electricity ensure that households use their skills and knowledge productively. When there is a decline in public investment in infrastructure, such as during structural adjustment programmes, not only does the quality of services that households can obtain suffer, but also they are forced to allocate a greater proportion of their incomes to needs such as water, transport, and energy. This has negative impacts on well-being. The consequences of poor social and economic infrastructure are visible in many instances; for instance, when it requires more time for women to carry out such tasks as fetching water which reduces the time available for income-generating activities. Declining quality (stock-outs in drugs, and teaching materials, declines in staffing in health centres and schools) and increasing expensiveness of services result in less health care and poor sanitation which affects the productivity of human capital. The retreat of the state from the provision of social and economic infrastructure affects the capacity of households to earn incomes not only in the present but also over the longer term as children are pulled out of schools because fees become prohibitive and pushed into augmenting incomes so as to maintain consumption. Schooling not only directly improves labour productivity and so reduces poverty but also has beneficial impacts on household productivity through its positive effects on hygiene and health, nutrient intakes, as well as on the number of children and their schooling, all of which enhance well-being (Behrman 1990). In addition, supportive economic policy environments that do not result in inflation or currency crises, and sustainable fiscal policies are important to converting assets into secure incomes and livelihoods.

Credit-Cum-Insurance Services It is often argued that the perfect vehicle for the management of adverse shocks is the family and hence transfers mediated through other institutions such as the state may actually just substitute for such mechanisms and not add to income generation (Cox

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and Jimenez 1995). Rosenzweig (1988), however, finds from a survey of villages in rural South India that transfers respond to less than 10% of the size of typical income shortfalls. This should be expected as reciprocal transfers would be more possible in more well-to-do households (which need such transfers the least) and in situations of covariant risk such as during a monsoon failure both parties to a reciprocal transfer would be pushed to subsistence, making it difficult to share the adversity. Also, as pointed out by Morduch (1998), when incomes of participants grow at different rates, richer households would have incentives to opt out of informal insurance mechanisms to shield themselves from repetitive redistribution to others. In fact, recognizing such effects, communities may put restrictions on the accumulation and saving strategies of households so as to foreclose the possibility of households isolating themselves from communities and their social demands as and when they find their obligations due to their relative resource abundance are decidedly higher than their receipts from the community. Banerjee and Newman (1998) also argue that cities have greater earning opportunities but weaker informal reciprocal insurance mechanisms, whereas villages have group-based informal insurance mechanisms but low-earning opportunities. Thus, the bulk of the population can stay put in villages, and informal insurance can be a drag on economic development. Given the constraints of social capital in coping with shocks and its inability to assure households of secure livelihoods, a key concern for policy is to develop programmes aiming at expanding household access to human and financial capital. Households have a high potential for savings, credit, and insurance services that allow them to face adversity as well as to generate better returns on assets. The savings rate in the unorganized sector of 18% is by no means low and comparable to the savings rate of 25% in the organized sector (Pradhan et al. 1999). It is noteworthy that the pattern of savings in the unorganized sector is different than that in the organized sector. Households in the unorganized sector save more in the form of physical assets,7 constituting 75% of gross savings, whereas in the organized sector savings in physical assets comprises just 34.5% of that sector’s gross savings. The pattern of financial savings is also instructive. In the unorganized sector 66% of financial investment was in deposits and small savings in commercial banks and post offices, whereas in the organized sector such deposits accounted for 48% of total financial investment with provident fund/PPF accounting for the second major form of financial savings with a share of 34%. Interestingly, for the year 1994–1995 when the study was conducted by the NCAER, it was estimated that approximately 37% of the population lived below the poverty line.8 About 97% of these poor people belonged to the unorganized sector and only 3% to the formal sector. Of those poor in the unorganized sector, 81% lived in rural areas and 19% in urban areas. Significantly, the poor in the unorganized sector dissaved in the aggregate with a savings rate of 7 Physical

assets include gold, jewellery, house property, and consumer durables. per capita monthly income (and not consumption expenditure) poverty lines for rural and urban areas were estimated as Rs. 228 and Rs. 305, respectively. The rural poverty line was found by inflating the 1987–1988 figure given by the Expert Group and the urban line by inflating the poverty line for 1973–1974.

8 The

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−4.5%. This is in stark given that the overall savings rate of the poor was 13.8%. Negative savings is therefore a distinguishing feature of the poor in the unorganized sector. Given the lack of access to the services of financial intermediaries unorganized sector savings is in the form of physical capital, cash, and by investing in social capital through the provision of gifts and loans to those from whom they may be prospective future borrowers. Active financial markets for savings, credit, and insurance services can help households overcome adverse circumstances more easily and protect their consumption whilst at the same time not eroding their prospective future earnings unlike strategies such as drawing down the stock of human capital via withdrawing children from schools, or distress sales of physical assets. In what follows, we stress on this fact that strategies for intertemporal income and consumption smoothing that are not affected through financial markets for credit and insurance but through adjustments in the stock of physical, human and social assets are second-best arrangements. It will be argued that credit-cum-insurance provision is a more effective first-best mechanism for managing risk and the smoothing of incomes. Financial markets, however, must not have high transactions costs and strict collateral requirements or involve considerable waiting time and must provide liquid, flexible savings services that can be dipped into to cushion shortfalls in incomes. Households that do not face credit constraints will reduce their precautionary savings in other forms of capital that diminished their future earnings potential as the other savings were in low-risk, liquid assets, that could easily be converted into incomes. Households investing in liquid assets tend to invest less in production durables like farm implements and tend to make smaller illiquid investments in human capital such as sending a child to school. When earnings are irregular as in the unorganized sector, and lumpy, savings are highly demanded as an income smoothing mechanism. Credit facilitates the stabilization of consumption over time and thus enables households to absorb more risk than is possible in the absence of credit. In the absence of credit households adopt risk-reducing behaviour such as diversifying income generation or tending to favour established technologies over adopting newer technologies and do not exploit the potential for productivity increases. Differential access to credit institutions results in differential risk behaviour and hinders the adoption of capital accumulation strategies by households in the unorganized sector that maximize their income-earning potential.9 An advantage of good credit services is that if appropriately managed, it can substitute for insurance services. All households in the unorganized sector insure against risk (Zeller 1995) by, for example, undertaking mixed cropping (deployment of physical capital) and paying a premium in the form of additional work, or entering into implicit coinsurance with friends and relatives (social capital) with the premium being the reciprocal help given in difficult times. These indirect insurance systems may be effective as we argued earlier in covering for idiosyncratic risks such as illness, accidents, or old age, but are also 9 Binswanger

and Sillers (1983) found risk preferences to be fairly homogeneous across income groups in LDCs but there were differences in risk behaviour as observed in the adoption of new technologies. They attribute this to differential access to production credit.

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grossly ineffective against covariant risk such as weather risks which affects everybody simultaneously. Formal insurance, on the other hand, is not an easy financial service because of the presence of incentive problems—agents can behave opportunistically. Credit contracts are free from a major problem in insurance contracts— unlike an insurance contract it does not dilute the incentives of the insuree, and the lender does not require to know the effort level or the output of the borrower. Also, when random factors resulting in uncertainty are correlated across households, then, insurance is not viable, but as long as these random factors are not autocorrelated— correlated across time—a credit service can serve as a good alternative as it enables risk pooling across time. Credit contracts need to be tailored, however, to the specifics of the conditions faced by households in the unorganized sector. A weakness of credit contracts from the point of view of the unorganized sector is that they economize on information—the nature of a contingency is irrelevant to a lender who mainly bothers about expected yield and maturity so as not to have an asset-liability mismatch amongst other motives. In the unorganized sector, credit contracts should have the flexibility of tending towards insurance contracts by relenting on a part of the repayment due whenever there is an unforeseen negative shock to a borrower. The credit contract, in other words, should be contingency based and allow rescheduling of repayments—a credit-cum-insurance contract. Such systems are more successful as has been the case with SEWA which allows pregnant borrowers to reschedule loans or the Association for Social Advancement in Bangladesh that requires borrowers to buy life insurance so as to safeguard the repayment of loans in case of the death of the borrower. The Grameen Bank requires borrowers to contribute to an emergency fund in the amount of 0.5% of borrowings. This fund provides insurance in case of default, death, and disability. An important institution that can provide credit-linked insurance services is the microfinance institution10 (Morduch 1999a, b, 2000) as it uses local, member-based knowledge and monitoring (peer monitoring) to determine loan amounts, interest rates, and rescheduling possibilities. Small communities or social groups reduce the cost of information collection and contract enforcement as in such situations information is common knowledge. Moreover, as local communities have very low exit rates due to other communities being tightly knit and having high entry barriers, contracts are more or less self-enforcing. It needs to be kept in mind, however, that the tradeoff between incentives (opportunistic behaviour) and risk-pooling is never easy. Credit substitutes for the lack of insurance when there is an inability to diversify risk across households in space by pooling risks across time. Such an arrangement faces viability problems, however, when contingencies are correlated across the population as the covariance of income risk will then result in a covariance of default risk. A well-run cooperative credit type scheme would in such a situation not be successful and tend towards bankruptcy unless it kept high reserve ratios, had

10 Under

this rubric are included group lending programmes (such as Grameen Bank), credit cooperatives, and rotating savings and credit associations.

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easy access to donor grants, or, it pooled risks over a range of economic activities that are complementary from a risk point of view. Microfinance institutions are also subject to capture with collusion being often reported between credit officers and clients. Todd (1996) describes how a loan officer at Grameen Bank in collusion with borrowers delayed the recording of interest payments. The loan officer used a complicated system of double accounting and used the on-time payments of some borrowers to cover up the repayment defaults by others. The loan officer was able to increase the collective credit rating of borrowers as well as earn a promotion. This is a problem of delegation that any financial institution faces when lenders and borrowers collude against the interests of the financier. Many microfinance institutions have not been successful despite the wide publicity given to such institutions.11 As is usual, institutional design is crucial and there have been success stories from which much can be learned (Desai and Namboodiri 2000). When high-intensity large covariate risks occur the ability of households and community finance organizations to deal with them is seriously in doubt as when happens during massive drought and famines. In such cases of disaster, the state provides implicit insurance through social assistance programmes via transfers that replenish the asset base of households (mainly health and nutrition-related services, and occasionally actual asset transfers such as housing after a flood or earthquake). Microfinance-type institutions can take over once the ability to economically engage in productive activities is restored as the incomes generated re-enable households to save and repay loans and accumulate sources of capital and make intertemporal decisions. A convenient way to think about this is to consider the following two types of situations. Let y denote household permanent income, c current consumption, and w the value of the vector of attributes that enables minimum effective well-being of households (basic needs). Then, in the situation where c < w < y, households’ potential livelihood is affected by contingencies and they are unable to borrow against future income. A credit-cum-insurance service will be an effective tool in this situation. In another type of situation, the fundamental capacity to transform assets into wellbeing is impaired so that c < y as well as w < y. Here, it will not be possible to borrow against future income and tax or cess financed social assistance by the state is warranted. State programmes of social assistance face problems of targeting, have high delivery costs due to administrative and staffing problems, and often are slow in implementation which reduces the effectiveness of response to events. Microfinance institutions can offer credit-cum-insurance services largely financed by clients and enable households to undertake first best precautionary strategies to avoid the effect of shocks and adjustment strategies to cope with shocks once they occur. Some of the ways in which this has occurred in India has been documented in Jhabvala and Subrahmanya (2000) and van Ginneken (1998). Of course, as stressed earlier, if the complementary economic and social infrastructure such as the availability of water, roads, electricity, health services, and schools are not available or their quality is low 11 Morduch

(1999) reports that currently less than 1% of microfinance institutions worldwide are financially sustainable, and most of them, including Grameen Bank, receive high subsidies.

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and functioning is ineffective, then, easing the access to financial services by unorganized sector households may not be of much use. The challenge of development policy in securing livelihoods is in creating and providing the necessary social and economic infrastructure so as to enable community-level institutions to function and so promote the empowerment of households.

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