Addressing informality and inequality

Globally, the informal (shadow) economy, and income inequality,are growing consistently - and significantly ('Informality' here, essentially, simply refers to allotherwise legal activity, but undertaken outside the official records for production and employment).
In the advanced countries, informality is limited and, related mainly to immigrants, it can be a social issue. In economic terms, greater attention focuses on the acceleration of inequality post the global 'liberalisation' that started in the 1980s. The deregulated, global 'free-market' is creating social stress. This shows up in declining returns to lower-skill workers, and in the shrinking of the state's capacity for maintaining liberal welfare policies.The loss of state revenue from reduced tax rates for the traded good sectors, necessary for international competitiveness, is being compensated, effectively, by regressive taxation on the middle-class.
The free market, or laissez faire economy, operates beyond the political and social control of the nation-state; its principal agents are giant transnational corporations, and its popular 'constituency' is its market - the global investor and consumer. In the 'liberalized' economy, the autonomy of individual countries, to put their own society's interests first, is compromised.
Nevertheless, democracy is expected to ensure that if the free-market becomes inimical to the social cohesion of a national electorate government will intervene to redress the social balance, and re-regulate the 'free market'. But, today, the free market reigns; in the upshot, disillusionment with ruling politicians has been evident in recent voting patterns, in a number of countries.
This article reviews global trends, for both informality and inequality, and also at trends for informality in Pakistan.
Global trends in inequality
From 1980 onwards, increased technology transfer between the developed world and emerging markets (Ems) has hastened the integration of global production and finance, which has decreased inequality between nations - but inequality has increased notably, within nations.
Leading EMs have grown considerably faster than the developed world. US per capita in 2014 was 4 times greater than in 1980 ($13k against $54k). In contrast, per capita in China increased 24 times ($350 to $8k) and in India and Brazil grew 8 fold, over the same period. Eurozone growth has been slower than that in US in this period (US 2.4 % pa, Eurozone 1.5%), and Ems' relative progress even more marked.
But inequality within nations has increased sharply. In the US, a recent study (Saez and Kopcjuk) shows that the average wealth of the top 0.1% of the population rose sharply, from 7% of the US wealth stock in the early '80s, to 22% now.In the meantime, the average wealth of the bottom 90% fell from 36% to 23% over the same period - so that 90% of the population, collectively, have the same volume of wealth as the top 0.1%. For the OECD as a whole, the income of the top 10% is 9.5 times greater than the that of the bottom 10%, versus 7 times in 1980.
However, once social transfers are accounted for in Europe, the Gini coefficient (a measure for inequality, where 0 is perfect equality, and 1 is total inequality), in general, improves from around .5, to around .3, or by roughly 40%. In overall terms, European inequality is noticeably less acute than that in the US (Gini .46).
Turning now to the EMs: inequality has increased rapidly.
The causes are common to most countries. While average per capita income has risen across the board, it masks highly uneven distribution.
High-growth from Globalization has skewed fast-rising income and profits towards a narrow sector of producers, that primary have been the engine for higher GDP growth.
The disaggregated picture shows far less dramatic general improvement. First, given the higher technology bias of modern manufacturing, wages have risen for skilled labour; but the increase in real terms has been negligible for less skilled labour, the majority of the labour pool. Then, rural migration has led to rapid and escalating urbanization in virtually all major EMs. This is compelled by falling labour requirements in the rural areas, from fragmentation of land-holdings, farm mechanization, and the replacement of rural artisanal production by factory-made packaged goods. Rural influx acts as a dampener on wage growth in the urban areas.
At the same time, Fiscal policy lowered direct taxes for the traded goods sector, but increased indirect taxes - with a negative impact on the purchasing power of lower-income groups.
So, GDP growth has certainly helped reduce poverty, but has accentuated inequality. China has reduced those living in poverty from 84% of its population in 1980 to 13% now, an achievement unsurpassed in history. However, its Gini coefficient has risen from 0.28 to .42, or almost by 50%, from 1980 to 2010; India's has risen from .31 to .36, by 15% over the same period. Regional inequalities in both countries are markedly high.
Inequality in the advanced countries is an emerging issue of the political economy. In two recent books - "Capital in the 21st century" by Thomas Piketty, and "A Fighting Chance" by Senator Elizabeth Warren (leading figure in US Democrat party), the writers attribute much of emerging inequality to the power of business groups and corporate wealth, over political authority. Declining middle-class purchasing power is an economic and social issue. If the democratic credo of 'one man, one vote' loses meaning, there will be political ramifications. The two writers offer suggestions for how the present trend can be checked.
Piketty's now-familiar 'r > g' illustrates that return on capital, 'r' has always grown much faster than the growth rate of output, or GNP (except, for special reasons, during the "Golden Age of Capitalism', roughly 1950 to 1980). The compounding effect of r>g creates huge disparity in ownership of national wealth.
Current trends validate Piketty's observations. Growth in the US/Europe has fallen to under 2% pa, but overall, return on capital has run much higher. There are simple reasons for this. For example,
The steady replacement of lower-skill labour with technology raises return on 'r', capital, while 'g' remains muted; there is an implicit transfer of income from wages to capital;
Corporate sales and profits can grow faster than domestic GDP, as sales are diverted to high-growth markets abroad, and production outsourced to low wage countries, boosting profits.
Wealthy individuals and institutions, advised by leading fund managers, invest their funds on a global pattern, also invest in high-yielding Private equity groups, Hedge funds, etc., usually with rates of return much higher than domestic growth.
Tax 'arbitrage' has become common, in global supply-chains and global sales. Giant corporations can reduce their domestic (home country) tax liabilitieson global revenue, through cross-border treaties, choice of domicile of holding companies, and manipulation of double-taxation avoidance to, in effect, produce double non-taxation (the much criticized use of Ireland as a revenue booking centre by Apple, Google et al is a prime illustration of tax avoidance). Individuals can use international tax-havens, which exceed 50 in number now. US' IRS reports that the effective tax rate for the 400 richest Americans, in 2009, was 18% - the same rate as that of an office secretary. The principal reason is that the 2/3rd of their income was in Capital gains, where the Tax rate is 15%.
So corporate and private wealth will continue to accumulate faster than increase in incomes from domestic growth.Piketty forecasts return on capital averaging 4.25% between 2012 and 2050, while growth rate of income (developed world) will average just over 1%.Compounding at 4.5%, wealth will double every 16 years; at 1%, in 72 years.
Piketty (like many commentators today) believes that Government action can change this. His suggested solutions include higher marginal tax rates (80% for the highest bracket), and global reporting of assets and income for all entities, which will be liable both to income tax, and to annual global wealth tax - besides higher inheritance taxes.
But will the influence of wealth on politics everywhere, really allow this to happen? In EMs, the power of crony capitalism may be a block; but equally, in the developed world, it will be the immensely wealthy corporate lobbies (in finance, pharmaceuticals, technology, etc) that will lead the counter-attack to any revision in tax policies or in re-regulation.
Senator Elizabeth Warren, in her much acclaimed "A Fighting Chance", a largely biographical book, expresses frustration with growing inequality in the US. She sees the US financial sector as the leading agent for the accentuation of wealth in the US, and notes that despite its bail-out by public funds, the financial sector is still working for wealth creation for its shareholders and executives, rather than for business development. In her view, the US has become a place where the rich write and rewrite the rules andprivate money influences political outcomes...the power of business lobbies and campaign finance is overwhelming (money spent in the Congressional elections in 2012 was about $ 7bn, versus just $1.5 bn in 1998). Her concern is that the US is not organized institutionally to challenge elite dominance, and she emphasizes that, with the Unions weak, powerful mobilisation of civil society and voters will be needed to stop middle-class stagnation turning into a decline.
Global informality
Moving on from the theme of inequality as a global issue to informality: the informal economy is generally estimated to be less than 10% of GDP in the developed world, and variously, 30% to 50% of GDP (i.e., 43% to 100% of the formal economy) in the developing world.
The quality of informality is different. In the developed world, it is mainly in the service sector (labour). In the EMs,it permeates all economic sectors, and can be inextricably linked with the formal economy. This happens, for example, when registered entities deal with unregistered suppliers or vendors, or when formal enterprises underreport revenue and labour employment statistics, to avoid taxes and/or social security payments.
More than the degree, the issue for the social economy is the direction, of the informal economy. Rising informality accentuates inequality.
Trends in Pakistan
Informality in Pakistan has been gauged as being between 30% and (in the most recent study in'12), 45 % of GDP (or 43% to 90% of the formal economy). The impetus to its growth in recent years has been accelerating urbanization,in which micro-enterprises mushroom, but another factor apparently responsible is transfer of capital from formal to quasi-informal/informal sectors.
This transfer of capital may be reflected in the falling rate of formal investment. Investment to GDP has declined to current levels of 12% of GDP, from 22% in 2006. Even if recent GDP growth has been slower compared with earlier years, businesses have been profitable, notably the FMCG and Financial sectors. Attractive business results in many sectors become evident in the sharp growth of KSE indices. So the capacity for expanding formal investment has existed, but was not transacted.
This also finds resonance in the fact that Private sector credit has fallen to 15% of GDP, from 28% in 2007; annual credit growth has been less than inflation, suggesting a contraction of formal credit in real terms. Also, Cash to Deposit ratio remains at 31%, an unusually high level by any standards, so cash transactions, a preference in informal markets, remain high.
Apparently capital diverted from the formal sector is playing some role in informal economic growth - which appears clearly in excess of official average growth of 3% since '07. The burgeoning Real-Estate project uptake in urban and peri-urban areas; the Stock-market acceleration; conspicuous consumption, via large-scale shopping malls and proliferating retail outlets; volume of foreign travel; the inward multiplier effect of record Workers Remittances; and the galloping growth of electric appliance, motor-cycle, and car sales, etc, for example, suggest faster rising consumption than official figures would suggest.
As the unrecorded economy grows, so does its real value. The irony is that mechanisms for 'big business' to move opportunistically between formal and informal markets exist, but enterprise value of the dominant low-income groups, is largely frozen, locked-up - given that it cannot interact with formal credit markets.
Such locked-up value stretches across the low-income economy, highly undesirable, from a public-policy perspective: it dampens the creation of jobs, while new job-creation has slowed down in the formal sector.
The reasons for low-growth of the formal sector are well-known. Briefly, profitability for much of Pakistan's large industry comes not from competitive strength, but through Government engineered protection from competition; through fiscal concessions (SROs); through oligopolistic cartels, and through Government guaranteed returns, such as in the Power sector, and in the Financial sector, where investment in high-priced Government borrowings (TBs/PIBs, Comm. Lending, PSEs) now approaching 60% of Bank exposure. In spite of effective Govt 'subsidy', or perhaps because of enervating dependency on it, formal sector growth continues to remain weak.
But irrespective of low GDP growth, the momentum of consumer power has been strong over the last several years - fed not by production growth, but by workers remittances; high agricultural prices; government subsidies, and government deficits. So, in the informal markets, growth has been strong, and is likely to continue strong - in informal services, micro-businesses, building activity and in thetrading economy.
A pressing need for Government now is to encourage initiatives that will help bring the informal sector 'in from the cold'. The most important step forward here will be new engagement with SME businesses by commercial banks, who have cut back SME lending, from 17% of total loans, to under 6% today. Other necessary concessions will be absolute simplification of registration steps, cutting back on regulatory and reporting requirements to the bare minimum, and reducing the tax regime for small businesses to a simple, single stage (low) tax.Finally, the rapid advance made in tele-banking, and the increasing momentum of microfinance banks will play a substantial role in increasing financial inclusion for the financially disenfranchised.
The informal sector, if avenues for formalization are opened, can build growth momentum, regularize and expand employment, and link forward into supply chains with the larger manufacturing sector. While we deal with the larger issue of reigniting LSM investment, via energy sector development and improving national logistics, the exigent need to empower smaller enterprise must be given due attention.
A pressing need for Government now is to encourage initiatives that will help bring the informal sector 'in from the cold'