India’s Productivity Problem Is Not Agriculture, It’s Informality

For years, public debate has blamed India’s large agricultural workforce for low productivity and sluggish wage growth. Yet a closer look suggests that the real constraint lies elsewhere: in the vast informal economy that spans farms, factories and services. Understanding why informality persists, how it suppresses productivity, and what can be done about it is essential if India is to sustain rapid, inclusive growth in the coming decades.

Rethinking India’s Productivity Problem

When India’s growth puzzle is discussed, agriculture is often cast as the main culprit: too many workers on the farm, too little output to show for it. The story sounds plausible, but it is only half true. Agricultural productivity is indeed lower than productivity in modern services or advanced manufacturing. Yet the deeper challenge is that a huge share of India’s workforce—both rural and urban—remains locked in informal, low-productivity activities with weak links to capital, technology and markets.

In other words, India’s productivity problem is less about where people work (agriculture versus non-agriculture) and more about how they work (formal versus informal). An informal worker in a city slum or a tiny, unregistered workshop may not be much more productive than a smallholder farmer. Until policy focuses squarely on reducing informality, merely moving people off the farm will not deliver the productivity surge India needs.

What Do We Mean by Informality?

"Informal" is a broad term that can easily become fuzzy. In economic debates about India, it typically refers to activities that operate outside the reach of most labour laws, tax rules, and formal contracts. But informality is not a single category; it spans a wide spectrum.

Informal Firms

Informal firms are businesses that are not fully registered with tax and regulatory authorities, keep limited or no formal accounts, and usually employ only a handful of workers. They include:

• Family-run shops and roadside vendors
• Small workshops in garments, metalwork, food processing or repairs
• Home-based enterprises such as tailoring or packaging
• Micro service providers—salons, small eateries, local transport operators

Most of these firms are tiny by design. They rarely grow beyond a few workers, often because regulatory thresholds, credit constraints and market conditions penalise scaling up.

Informal Workers

Informal workers may be employed by informal firms or by formal firms under informal arrangements. They typically lack:

• Written contracts and clear job descriptions
• Social security coverage (pensions, provident fund, health insurance)
• Protection against arbitrary dismissal or non-payment of wages
• Access to formal skill upgrading or career trajectories

Even in sectors labelled "modern"—construction, logistics, retail chains, or export-oriented manufacturing—many workers are hired through contractors or on casual terms that keep them outside the formal social protection net.

Informality in Agriculture and Beyond

Agriculture is almost entirely informal: landholdings are fragmented, farm work is family-based, and formal contracts are rare. But informality permeates non-farm activities too—especially in micro, small and medium-sized enterprises (MSMEs) and in urban self-employment. The key insight is that the productivity gap often runs between formal and informal activities across all sectors, not simply between agriculture and everything else.

Agriculture vs Informality: Untangling the Real Constraint

It is tempting to argue that India’s productivity will automatically rise if workers exit agriculture for non-farm jobs. The structural transformation story—people moving from low-productivity agriculture to higher-productivity manufacturing and services—has held in many countries. Yet in India, the shift has been only partial and often disappointing in its effects on wages and living standards.

Why "Move Out of Agriculture" Is an Incomplete Strategy

Several dynamics blunt the productivity gains from leaving the farm:

• Urban informal absorption: Many rural migrants find work not in dynamic factories but in informal construction crews, street vending, or low-end services.
• Underemployment, not full employment: A worker may leave the field but end up with irregular hours and highly volatile earnings in the city.
• Skill mismatch: Skills learned in agriculture often do not match the requirements of modern industry or services, limiting the productivity jump.
• Lack of capital deepening: Informal urban jobs often involve very little capital per worker—similar to subsistence agriculture.

The result is that measured labour productivity may rise only modestly when a worker moves from a small farm to an informal urban job. The transformative gain comes when workers move into formal, capital- and technology-using firms that can scale.

The Productivity Stack: From Farm to Formal Firm

To understand the hierarchy, it helps to think of a rough productivity ladder:

1. Subsistence farming and casual rural labour
2. Urban informal self-employment and micro-enterprises
3. Small formal firms with basic compliance and record-keeping
4. Medium and large formal firms integrated into national and global value chains

India has made progress moving people from the first rung to the second. The challenge is enabling large-scale movement to the third and especially the fourth rung. Focusing policy only on reducing agricultural employment risks missing this bigger productivity transition.

How Informality Depresses Productivity

Informality can be a safety valve—it allows people to earn something when formal opportunities are scarce. But as a dominant mode of production, it traps the economy at a low productivity equilibrium. Several mechanisms are at work.

Limited Access to Finance and Technology

Informal firms struggle to access bank credit because they lack formal accounts, collateral and documented tax histories. Without reliable finance, they cannot:

• Invest in better tools and machinery
• Adopt productivity-enhancing technologies
• Smooth cash flow shocks that might otherwise shut operations

This keeps capital per worker low and prevents learning-by-doing on modern equipment, both crucial for productivity growth.

Weak Incentives to Invest and Scale

Operating in the shadows may reduce tax and compliance costs in the short run, but it also blunts incentives to build reputation, brand value and durable customer relationships. Informal entrepreneurs face:

• Uncertainty about enforcement of contracts and payments
• Difficulty attracting talent who seek formal benefits
• Higher vulnerability to harassment, rent-seeking or eviction

Under these conditions, it is rational for many firms to remain small, opportunistic and informal rather than make long-term investments that could raise productivity.

Low Human Capital Investment

Informal employment relationships are inherently fragile. Employers may hesitate to spend on training, and workers may not have clear career ladders. This leads to:

• Minimal firm-level training or upskilling
• High turnover that disrupts learning on the job
• Limited diffusion of best practices and modern work processes

In contrast, formal firms with longer horizons are more likely to invest in worker skills, which in turn raises output per worker.

Under-Reporting and Misallocation

Informality also undermines the state’s ability to allocate resources efficiently. When large chunks of economic activity are unrecorded or under-recorded:

• Tax bases shrink, reducing the fiscal space for infrastructure and public goods
• Policymakers lack accurate data on where bottlenecks lie
• Credit allocation is distorted because banks cannot see true firm performance

This misallocation reinforces a low productivity trap across the economy, even if some individual informal units can be relatively efficient.

Why Informality Persists in India

If informality is so costly for productivity, why is it so widespread? The answer lies in a combination of historical legacies, institutional design and policy choices. Several factors keep India’s informal sector large and persistent.

Regulatory Thresholds and Compliance Burdens

India’s regulatory system often changes requirements sharply once a firm crosses certain size or turnover thresholds. These include obligations related to labour laws, environmental rules, and multiple layers of licensing or inspections. Even with recent reforms, many entrepreneurs still perceive formalisation as:

• Complex and time-consuming, involving many agencies
• Costly, through fees, compliance staff and unexpected “informal payments”
• Risky, because it exposes them to future tax and regulatory claims

For a small enterprise, it can feel safer to split operations across several tiny units or under-report scale rather than trigger these thresholds.

Labour Market Institutions and Dualism

Labour regulations in India have historically been stricter for large, formal enterprises than for small or informal ones. While protections for workers are important, the way rules are structured can create a dual market:

• Formal jobs with strong protections but limited in number
• Informal jobs with few protections but easier to create and destroy

Employers may use contract labour or outsourcing to avoid crossing thresholds where more stringent rules kick in. The outcome is a segmented labour market that pushes many workers into informality even in otherwise advanced sectors.

Urbanisation Without Planning

India’s urbanisation has often been driven by informal settlements and ad hoc expansion rather than proactive planning. Migrants arriving in cities frequently end up in:

• Unplanned slums without secure property rights
• Areas with weak access to formal utilities and public transport
• Neighbourhoods where formal businesses are reluctant to operate

This spatial informality feeds economic informality: when land and housing are insecure, businesses operating there tend to stay underground as well, constraining both productivity and investment.

Social Safety Nets and Risk

In a context of limited social protection, people cling to informal arrangements that offer some security, even if low productivity. For instance, family farms or family-owned shops may provide:

• Implicit insurance against unemployment or illness
• A place to return to when urban jobs dry up
• Flexible hours that accommodate care responsibilities

Without portable social protection and reliable urban public services, the leap into fully formal employment or entrepreneurship can feel too risky for many households.

The Hidden Cost: Wages, Inequality and Growth

The dominance of informality has profound implications not just for abstract productivity measures, but for everyday livelihoods and long-run growth.

Stagnant or Volatile Earnings

Informal workers often face:

• Lower average wages than comparable formal workers
• Greater volatility in earnings due to seasonal or project-based work
• Limited recourse when wages are delayed or underpaid

This makes it difficult for households to plan, invest in education or health, or build assets. It also dampens aggregate demand, as households remain cautious in their spending.

Entrenched Inequality

Formal jobs bring not just higher current income but pathways to advancement, credit, housing and better schooling. When large groups are stuck in informality, inequality hardens along class, regional, caste or gender lines. Women, for instance, are disproportionately represented in home-based or casual informal activities with very low pay and visibility.

Slower Aggregate Growth

Economies grow faster when resources—capital, labour, ideas—flow naturally to their most productive uses. Informality obstructs this process through:

• Misallocation of credit and investment
• Reduced innovation and technology diffusion
• Weaker tax revenues and public investment

Over time, these frictions can shave significant points off potential GDP growth compared with a more formalised, efficient economy.

Formalisation Is Not Just Registration

Government programmes in India have increasingly promoted formalisation through initiatives like easier business registration, simplified tax regimes, and digital identification. These steps matter, but formalisation is not simply a matter of registering a firm or assigning a number.

Dimensions of True Formalisation

Genuine formalisation involves progress along several dimensions:

• Legal: Registration with relevant authorities and compliance with core laws
• Fiscal: Regular tax filing and inclusion in the tax base
• Labour: Use of written contracts, social security and standardised wage payments
• Financial: Access to formal bank accounts, credit and digital payments
• Operational: Book-keeping, quality standards and participation in formal supply chains

Policies that focus narrowly on pushing firms to register, without easing compliance or improving their access to markets and finance, risk creating "paper formalisation" with limited productivity gains.

Policy Priorities: Tackling Informality Head-On

If informality, not agriculture per se, is the binding constraint on productivity, what should policy prioritise? The agenda is broad, but some pillars stand out.

1. Make It Easy—and Worthwhile—to Be Formal

Governments can reduce the perceived and actual costs of formalisation by:

• Simplifying registration and licensing into unified, online processes
• Streamlining inspections with risk-based, transparent protocols
• Designing tax regimes that are simple, predictable and progressive
• Offering time-bound incentives for small firms that formalise, such as access to subsidised credit or government procurement

The goal is not to coerce firms into formality but to create a clear business case: being formal should open doors that remain closed to informal operators.

2. Reform Labour Regulations for Flexibility with Security

Labour laws can be modernised to reduce rigidities that discourage formal hiring while strengthening core protections. A balanced approach might include:

• Consolidating fragmented laws into clear labour codes (as India has begun to do)
• Linking social security to workers rather than specific employers, making benefits portable
• Allowing greater flexibility in contracts and work arrangements, while enforcing minimum wages, safety and non-discrimination
• Expanding coverage of social protection to gig and platform workers

Such reforms can narrow the gap between formal and informal employment arrangements, reducing employers’ incentives to remain in the shadows.

3. Invest in Human Capital for Non-Farm, Formal Work

Moving workers from agriculture into formal sectors requires more than relocation; it demands the right skills. Key steps include:

• Aligning vocational training with local industry demand, not generic courses
• Strengthening apprenticeship programmes that connect youth to formal firms
• Supporting continuous skill upgrading, especially in digital and technical fields
• Facilitating recognition of prior learning so that experience gained informally can be validated

These investments increase the productivity of workers and make it more attractive for firms to hire them formally.

4. Enable Productive Urbanisation

Urban policy is central to the fight against informality. Priorities include:

• Upgrading informal settlements with secure tenure, basic services and connectivity
• Designing industrial and commercial zones that welcome small as well as large firms
• Improving public transport to connect workers with formal job clusters
• Digitising and simplifying local permits and approvals

Urban spaces that are planned for productivity and inclusion make it easier for firms and workers to transition out of informality.

A Step-by-Step Lens: Shifting Workers into Productive Formal Jobs

For policymakers and practitioners, it can help to think in terms of concrete steps that move a typical worker from low-productivity informality to higher-productivity formal employment.

1. Identify the Worker Segment: Map where large clusters of informal workers are—e.g., construction helpers, home-based garment workers, street vendors.
2. Diagnose Skill and Constraint Gaps: Assess which skills are missing, what barriers exist (such as lack of documentation, childcare, transport), and which sectors nearby generate formal jobs.
3. Design Transition Pathways: Develop sector-specific pathways—for instance, from informal construction labour into certified masonry roles in formal firms.
4. Bundle Support: Combine recognition of prior learning, short targeted training, and job-matching support with basic services like ID and bank account opening.
5. Create Employer Incentives: Offer time-bound incentives for formal firms that hire and retain workers from informal pools, while monitoring compliance on wages and benefits.
6. Ensure Portability: Anchor social protection and skill certificates in digital, portable systems so workers can move jobs without losing benefits.
7. Measure and Iterate: Track outcomes—job stability, earnings, productivity—and adapt programmes based on what works.

This stepwise approach emphasises that formalisation is a process, not a one-time event, and that productivity gains hinge on careful design along the entire path.

Looking Beyond Agriculture-Centric Narratives

Reframing India’s productivity challenge around informality rather than agriculture alone has important implications for public debate and policy focus.

Why the Narrative Matters

Blaming agriculture can inadvertently cast farmers as the problem and encourage simplistic solutions like forced urbanisation or mechanisation without safety nets. A focus on informality, by contrast, highlights systemic features that cut across sectors:

• Institutional design of regulation and taxation
• Quality of urban governance and infrastructure
• Structure of labour markets and social protection
• Access to finance, technology and skills

It also recognises that raising productivity on farms—through better irrigation, inputs, aggregation and market access—is compatible with, and complementary to, efforts to formalise non-farm work.

Final Thoughts

India’s development story is often told through the lens of shifting labour out of agriculture. That transition does matter, but it is not enough. The more fundamental divide is between informal and formal modes of production across the entire economy. As long as the majority of workers and firms remain trapped in low-productivity, informal arrangements, the country’s vast demographic potential will be underused.

Policies that make formality attractive, feasible and rewarding—backed by investments in human capital and better-functioning cities—can gradually shift the balance. The prize is not merely higher GDP numbers, but more stable, higher-quality jobs and a fairer distribution of opportunity. Recognising that India’s productivity problem is, at its core, a problem of informality is the first step toward designing reforms that match the scale and texture of the challenge.

Editorial note: This article is an independent analysis inspired by themes in policy discussions on India’s growth and labour markets. For related perspectives, see the original reference at Policy Edge.