Can Digital Platforms Address Demand Constraints on Informality?

VAT in the Indian state of West Bengal. It finds that the direct impact of the VAT reform on informality was quite limited. The estimates imply that, if the cascading sales tax had been replaced by a VAT while keeping the tax rate the same, only 0.3 percent of informal firms would have registered.27 This muted impact arose because of the prevalence of outsider-type firms in the informal sector. For such firms, a lower tax burden did not generate a major incentive to formalize.

Chapter 3 also finds that, even though the switch from the sales tax to the VAT did not have a major impact on formalization, it did have a significant positive impact on total output, profits, and wage income by reducing distortions caused by double taxation. A switch to a VAT system while keeping the tax rate the same would have increased formal sector output by 12 percent and reduced informal sector output by 2 percent, the latter predominantly through indirect channels.

Although the direct response of informal firms to tax policy changes may be restrained, the existence of a large informal sector may influence how formal firms respond to changes in tax policy. For instance, widespread informality may enable formal firms to evade the tax increase. Greater competition from informal firms may make the demand for the goods of formal firms more price elastic, thereby rendering the revenue more sensitive to tax rates. Widespread informality may thus dilute the impact of changes in tax rates. Should this be a major consideration in the design of tax policy?

Chapter 4 makes a new contribution to the limited evidence base on this question in the context of the multiple tax rates prevailing in India’s GST system. These multiple rates exist mainly because, in addition to raising tax revenue, the GST is used to improve the equity of the tax system by imposing lower tax rates on necessity goods (such as fresh produce) and higher rates on luxuries.

Using detailed data on product-level GST returns from the state of Karnataka and exploiting the natural policy experiment generated by the multiplicity of GST rate changes, chapter 4 estimates the sensitivity of reported sales to the tax rate and considers whether the presence of informal firms affects this sensitivity.28 The estimated elasticity is high. Firms report 2.6 percent fewer sales when the tax rate they face increases by 1 percent. This finding suggests that the inefficiency caused by multiple rates may be sizable. However, the elasticity of the reported sales to the GST rate is not significantly higher in sectors with a large share of informality, suggesting that there is no efficiency rationale for applying lower tax rates in sectors with more informality.

Digital platforms can help informal firms transcend constraints posed by limited access to markets. More generally, digital technologies shift the cost-benefit balance of investing, growing, and becoming more visible among informal firms. E-commerce platforms provide an infrastructure of marketing, warehousing, and commercial relations at no

cost to firms that participate. The requirements of registration with tax authorities to operate on these platforms do not offset these benefits; in some cases, as shown by the emerging evidence presented in chapter 5 and other recent studies, informal firms actively formalize soon after joining the platforms.

Yet, digital platform technologies are not a silver bullet. Not all informal firms have smooth access to online platforms. Moreover, such platforms mainly address the demand-side constraints on small firms. The heterogeneity of the informal sector means that not all informal firms or workers would necessarily benefit from easing only market access. Small businesses also face other constraints, such as those related to credit, skills, access to technology, and managerial expertise.29 Among firms in which the relevant constraint relates to such factors, supply-side interventions addressing these constraints might be more useful.

E-COMMERCE CAN IMPROVE GOODS MARKET ACCESS TO THE INFORMAL SECTOR

The market share of e-commerce in South Asia is small, but it is growing rapidly. For example, the share of online channels in total retail sales expanded from 1.6 percent in 2015 to about 5.0 percent in 2020 (IBEF 2021). This trend accelerated during the COVID-19 crisis. Total e-commerce revenues in Bangladesh thus reportedly rose by 70 percent to 80 percent during 2020 (Hasan 2020). In addition to retail, digital platforms are also increasingly active in other service industries, such as in transportation and domestic services and in agriculture. The Collabrex digital platform in Pakistan, for instance, connects farmers to markets. Such industries have large informal sectors. However, there is a dearth of rigorous evidence on the impacts of these developments on the informal sector.

Digital platforms reduce transaction costs related to search, replication, transportation, tracking, and verification (Goldfarb and Tucker 2019), which may be especially important for small and informal firms. By joining an e-commerce platform, small firms can gain access to a large customer base without incurring prohibitively expensive investments in marketing and distribution channels. As their online transactions grow, they may become better able to prove their creditworthiness to banks through verifiable digital records of sales and payments. This may improve their access to credit (Klapper, Miller, and Hess 2019). Joining a platform may also enable productivity growth in small firms by improving the access of the firms to information on new technologies and business practices and helping them generate data to track their revenues, costs, and other performance indicators.

Chapter 5 uncovers new evidence on this issue by analyzing previously unexplored data from a large e-commerce platform in India.30 The chapter describes the impacts on small and informal firms of joining such a platform by analyzing information from transactions on the platform (quantity, prices, and the locations of individual sales over a period of four years), in combination with data from a survey on the businesses and entrepreneurs selling on the platform.

The analysis in chapter 5 suggests that e-commerce platforms can help firms grow by enabling access to a wider market. Most of the firms selling on the platform analyzed are located in the major metropolitan areas of Delhi and Mumbai, but they are selling to a much more spatially dispersed customer base. The states of Karnataka, Maharashtra, Tamil Nadu, and Uttar Pradesh (mostly postal codes outside greater Delhi) account for the largest shares of sales, and none of them have shares of more than 15 percent of total purchases. Businesses selling on the platform experience a steady increase in sales and in the number of postal codes to which they sell. They also experience an expansion in the number of product types sold.

Informal firms on the e-commerce platform are generally doing as well as their formal counterparts on the platform in terms of growth. There is no difference between formal and informal firms in the growth rates of the monthly number of sales transactions, total revenue, number of products offered, and geographic reach (as measured by the number of postal codes to which they sell).

Informal businesses even outperform formal businesses in some dimensions of productivity on the platform. On average, a formal business has 34 fewer sales per employee than an informal business with similar characteristics, and the revenue per worker of the formal business is nearly one-half the corresponding revenue of the informal firm. This suggests that informal businesses have relatively more to gain than formal businesses by joining a platform. It may be that joining the platform allows smaller businesses to gain access to a larger market without any of the overhead costs—such as those involved in advertising and building networks of sales agents—that larger businesses may have already incurred.

The platform also provides a relatively stable source of demand, a feature that may be especially desirable to informal firms because of their limited cash buffers. More than 65 percent of the firms on the platform experience almost no months with zero sales. Large month-on-month fluctuations in sales are also relatively rare; 32 percent of the firms experience no month in which their sales dropped 50 percent relative to the previous month.

These positive findings have potential implications beyond e-commerce. Digital platforms are also increasingly active in South Asia in markets for low-skilled services, such as transportation, food delivery, personal care, and domestic help. For example, there are numerous ride-hailing and food delivery apps operating in the region. The personal care and domestic help services industry, too, is seeing the entry of apps, such as the Hellotask platform in Bangladesh that connects domestic help workers and potential employers.31

Such platforms could enhance earnings among low-skilled workers in South Asia’s informal sector. The market for personal or domestic services is predominantly local and informal, and there are almost no modern firms supplying such services. Digital platforms could ease frictions in these markets by making it easier to match demand and supply and by enabling workers to build a reputation for good work. For instance, in a randomized experiment involving data entry operators on an international online

task platform, providing a rating and feedback to inexperienced workers on the platform almost tripled their income and reduced their level of unemployment (Pallais 2014). Although encouraging, such evidence is mostly from high-income country contexts and may not translate to informal labor markets in South Asia.

Flexibility is another potential benefit of digital platforms that deserves more careful examination in South Asia. In the United States, Uber drivers are found to benefit significantly from the flexibility in work hours that the service enables and are even willing to earn less as long as they get to choose when they work. It is estimated that this flexibility is worth more than twice the surplus they would earn in less-flexible arrangements (Chen et al. 2019). Flexibility in choosing when and where to work could be particularly valuable to women in the informal sector who may be struggling to balance work with childcare responsibilities and undertaking long, unsafe commutes to and from work.

Whether online lending platforms can change how informal businesses obtain loans in South Asia is also worth examining. Such platforms use automated processes to screen loan applicants and match them with lenders. This potentially enables the lenders to lend more quickly and more optimally than traditional banks; the fact that they do not take deposits reduces their regulatory requirements and allows them to lend without collateral (Beaumont, Tang, and Vansteenberghe 2021). These attributes make the platforms particularly well suited for extending credit to small and young firms, which often lack collateral and credit history with traditional banks.32 Some evidence on South Asia suggests that small firms that already use digital payments are more likely to benefit from online lending platforms.33

Not all the findings in chapter 5 are good news for the informal sector. Two observations suggest that many informal firms are currently not in a position to benefit from selling on e-commerce platforms. First, there is significant attrition among both formal and informal firms; 8.6 percent of firms exited the platform within one month of registering. Only about 50 percent of firms remained active on the platform for more than two years.

Second, firms that sell on the platform are also notably different from the average firm. They are, for instance, disproportionately located in two major metropolitan areas, Delhi and Mumbai. Some other key differences with typical firms become apparent if they are compared with the sample of entrepreneurs in a large survey that is representative of the population of family business owners in age, sex, and educational attainment.34 Entrepreneurs selling on the e-commerce platform are substantially younger, better educated, and more likely to be women than the general population of family business owners. While the average age of sellers in the sample is about 32, it is around 44 in the general population. The majority of entrepreneurs on the platform has a university degree, while the range is 15 percent to 40 percent in the general population depending on the size of the firm. The share of women entrepreneurs in the sample—only 20 percent—is much higher than the 2 percent to 4 percent share in the general population of entrepreneurs. This degree of self-selection into the use of online sales channels suggests that the observed