Formalization vs. Disruption:

Did the initial shock to the informal economy caused by Demonetization (2016) and the subsequent compliance requirements of GST (2017) lead to permanent, positive formalization of MSMEs, or did it merely result in temporary business closures and stagnation in employment growth?

The impact of the 2016 Demonetization and the 2017 Goods and Services Tax (GST) on the informal economy and MSMEs is best described as a painful but ultimately permanent acceleration toward formalization, despite significant initial disruption and a complex trade-off with short-term employment stagnation.

The combined effect was an undeniable push towards a digital, traceable, and tax-compliant business environment.

Here is a breakdown of the dual impact:

1. The Initial Shock and Disruption (2016-2018)

The immediate aftermath was characterized by severe negative short-term consequences, primarily due to the suddenness of the policy changes and the informal sector's heavy reliance on cash and low-compliance operating models.

• Demonetization's Liquidity Crunch: The withdrawal of high-value currency notes paralyzed the cash-intensive, non-farm informal sector (e.g., small traders, construction, contract labor) because it relied on cash for daily wages, raw material procurement, and sales.³ This led to temporary, and in some cases, permanent business closures for the most marginal and least resilient enterprises.

• Initial GST Compliance Burden: The transition to GST required digital compliance (multiple monthly/quarterly filings), mandatory registration for many, and the adoption of HSN/SAC codes. This imposed a sudden increase in compliance costs (software, accountants, training) that disproportionately affected small enterprises with low digital literacy and limited resources.

• Employment Stagnation: In the immediate post-shock period, the informal sector, which historically generated the bulk of employment, saw a significant slowdown in job creation and potential job losses as businesses struggled to manage liquidity and the new compliance requirements.

The overall short-term effect was a sharp, adverse shock that disrupted supply chains and caused stress on working capital, particularly for small exporters and firms operating on low margins.

2. Permanent and Positive Formalization (The Long-Term Effect)

The structural changes introduced by the two reforms have created permanent incentives and disincentives that continue to drive MSMEs towards the formal economy.

A. GST's Structural Push (The Magnet)

The GST is the primary engine of long-term formalization for MSMEs that rely on business-to-business (B2B) transactions.

• Input Tax Credit (ITC) Mechanism: This is the most crucial formalization driver. Large, registered buyers cannot claim ITC on purchases from unregistered or non-compliant suppliers. This forces unregistered suppliers (MSMEs) to register under GST to retain their key clients and remain part of the formal supply chain, creating a traceable trail of transactions.

• Rise in Registered Businesses: The number of active GST taxpayers has significantly increased since 2017, demonstrating a concrete shift in business registration.

• Reduction in Informal GVA Share: Economic data suggests that the share of the informal economy in overall Gross Value Added (GVA) has steadily declined post-2016 (estimated at 23.7% in FY23 compared to $25.9\%$ in FY16), indicating that a large chunk of economic activity (approximately ₹26 lakh crore) has been formalized over seven years.

B. Demonetization's Digital Catalyst (The Enabler)

While temporary in its currency impact, demonetization's lasting legacy is the forced adoption of digital transaction methods.

• Digital Footprint: Demonetization compelled millions of people and businesses to open bank accounts and use digital payment platforms (like UPI and mobile wallets). This created a digital footprint for transactions that were previously cash-only, making income and business activity easier to track for tax authorities and providing verifiable data for formal credit.

• Access to Formal Credit: By transitioning from cash to digital, MSMEs gain a formal transaction history, which is essential for obtaining credit from formal financial institutions (banks and NBFCs). This is a vital, long-term benefit that addresses a chronic barrier to MSME growth.

C. Formalization of Labor (Job Quality)

Data from schemes like the Employee Provident Fund Organisation (EPFO) and the e-Shram portal reflect a growing trend toward formal employment:

• EPFO Registrations: Over $6.91$ crore new members joined EPFO between September 2017 and July 2024, indicating a massive shift of workers into the organized sector with access to social security and legal protection.

   

Conclusion

The relationship between formalization and disruption is complex:

• Disruption as a Filter: The initial shock served as a market cleansing event. It rendered unviable those MSMEs whose competitiveness relied purely on tax evasion and cash arbitrage, leading to their closure or absorption.

• Formalization as Structural Gain: For the survivors and new entrants, the reforms created permanent conditions (digital requirement, ITC compliance) that favor formal operation.

The net outcome is a permanent, positive shift toward formalization across economic activity and employment quality, realized at the cost of significant short-term economic pain and, likely, some irreversible loss of very small, marginal enterprises that could not adapt to the digital and compliance demands.