Trade reforms and informal economy in India: a CGE analysis.


Informality is multidimensional and generally lacks clarity in its description. The ambiguity of the terms has constrained research on the macroeconomic aspects of the informal sector. This also means the linkages of this sector with other economic agents have not been largely examined so far. The current study intends to conceptualise the term 'informal economy' by taking into account firms and workers not protected by any legislation. The objective of the current macro analysis is to define the macro aspects of the informal sector to enable a measurement of this sector's contribution to the economy. This is done first through the construction of a Social Accounting Matrix (SAM), and second, by using a Computable General Equilibrium Modelling approach to examine the economy-wide impact of trade reforms. To understand the macro aspects, we consider two major perspectives through which we conceive the informal sector: small-scale production, which is identified as the 'unregistered' part in national statistics; and informal 'factor ownership', i.e., workers involved in casual work and own-account workers. The informal sector is directly relevant to poverty analysis as most workers in this sector live in poverty. There are a large number of case studies that have conducted reviews of the linkage between adjustment and poverty during the 1980s. These have analysed the impact of policy changes in developing countries on poverty and inequality. Case study analysis cannot generally trace exact linkages between any policy changes such as trade or fiscal reforms and the welfare changes, as these cannot be statistically tested. The results seen after a policy change could just as well be due to other reasons and no direct linkage may be traced without any quantitative connection. Sometimes, there is no impact of a policy change due to miscellaneous factors. As well, conclusions reached through analyses using qualitative studies cannot be taken as generally applicable and should be limited to the specific group interviewed. The inability of descriptive studies to provide a robust causality between impact and result has made research in modelling approaches more demanding. There are few instruments that can relate macroeconomic policy and microeconomic behaviour. The Computable General Equilibrium Models (CGEM) is one such tool used to address these concerns. Such models have been applied to a range of policy questions in a number of economic fields over the last ten or so years. They include public finance and taxation issues, international trade policy questions, and evaluations of alternative development strategies and the implications of macroeconomic policies. Such models can use information from micro studies to design aspects of their behaviour. Here we have used information from case studies of the rice and garment sector to inform our assumptions. These field studies have shown that many formal firms employ workers on a casual basis. Accordingly, we have designed the formal sector innovatively in the model such that it hires both regular (formal) and casual (informal) workers. Field work shows that there may also be price differences in the formal and the informal sub-sectors of an industry; so here we have treated the two sub-sectors as distinct with different production processes and pricing mechanisms. The prices of the formal part of an industry are formulated by incorporating production taxes. The informal parts do not have any such wedge. We have attempted to put all the information collected from primary and secondary data in a structured format with explicit connections amongst the major activities and income generation processes in the economy. Lastly we design a general equilibrium model that is able to examine shocks and analyse the economic ramifications or \"transmission\" of these shocks. Originating from changes in government policy the shocks which are simulated have differential impacts on sectoral production, types of incomes, consumption and trade. Our findings show that trade reforms cause wages of casual workers to increase with full flexibility in both the labour markets specified in the study (namely formal and informal). This is because casual labour intensive sectors expand (conforming to the typical Heckscher-Ohlin conjecture) under tariff reduction as erstwhile-protected sectors contract. However, when we impose wage rigidity in the formal labour market, the results differ. Specifically, when the demand for formal labour declines in these circumstances, some formal labour is laid off which then seeks employment in the casual sector, swelling the ranks of casual workers and bidding down their wages. The study shows that the very bindings, which result in greater expansion in the informal sector, namely the wage rigidity causes the informal sector wages to contract. A positive outcome could be obtained for the casual workers letting them attain the benefit from informalisation, if the informal sector workers are protected through minimum/decent wage legislation.


47 pp.

Trade reforms and informal economy in India: a CGE analysis.

Published 1 January 2004