4.5 Correlation between Informality and Elasticities, by Sector

range from around −1 in some sectors (for example, beverages and tobacco or plastics) to −8 in other sectors (such as metal products, machinery, and vehicles).

The analysis then tests the correlation between sector elasticities and the informal market share of a sector. One hypothesis is that formal firms operating in industries with substantial competition from informal firms might be more reactive to changes in tax rates, compared with firms operating in a sector in which firms are mostly registered. One might then expect a positive correlation between estimated elasticities that are negative and the formal market share at the sector level.

To test this hypothesis, the analysis correlated the sector-specific elasticities to the formality shares in each sector (figure 4.5). The exercise reveals a negative relationship. For example, the leather and wood sector, which is highly informal, exhibits moderate elasticity, comparable with the elasticity of the drugs and pharmaceutical product sector, which is much more formal. At the other end of the spectrum, metal products and vehicles, the two most formal sectors, have some of the largest elasticities.

This result invalidates the hypothesis that the sales of formal firms are more elastic in sectors with more competition from the informal sector. This may be because informal and formal firms operate in segmented markets and are not in direct competition. What might then explain the negative correlation between formal market shares and the ETI? A possibility is that the formal firms in the highly informal sectors are largely selected. Thus, these are precisely the firms in which the directors have decided to register and which are more compliant at baseline or more differentiated in terms of product quality.

FIGURE 4.5 Correlation between Informality and Elasticities, by Sector

Source: based on gST data provided by development data lab and statutory tax rates based on the gST council minutes. Note: The x-axis represents the formal market share in a sector based on the definition of formality used in the analysis. Of the 15 sectors, only 11 are ranked. For the other 4, either variation in tax reform is lacking at the sector level, or the current first stage is too noisy to be informative (F-statistic less than 10). These sectors are not currently included. gST = goods and services tax.