When the Goods and Services Tax (GST) was introduced in India on July 1, 2017, it was heralded as the most significant tax reform since independence. While much of the public debate focused on tax rates and administrative challenges, a quieter revolution was taking place beneath the surface: a massive formalisation of India's traditionally informal economy.
Understanding the Formalisation Cascade
The term "formalisation cascade" refers to the domino effect triggered by GST that compelled businesses across supply chains to register, maintain proper accounts, and operate within the formal regulatory framework. Unlike previous tax regimes where businesses could selectively participate in the formal economy, GST's design made informality increasingly costly and difficult to sustain.
This cascade worked through a simple yet powerful mechanism: the input tax credit (ITC) system. Under GST, businesses can claim credit for taxes paid on their purchases only if their suppliers are registered and issue proper tax invoices. This created a strong incentive for buyers to demand that their suppliers join the formal system, which in turn pressured those suppliers' vendors to formalise, and so on up the supply chain.
The Mechanics Behind the Shift
Several features of GST contributed to this formalisation wave. The requirement for digital invoicing and the GST Network (GSTN) portal meant that every registered transaction left a digital footprint. Unlike the previous regime where sales tax and excise were separate and often easier to evade, GST created a comprehensive, technology-enabled monitoring system.
The threshold limits also played a role. While GST exempted businesses with turnover below Rs 40 lakh (Rs 20 lakh for special category states initially, now Rs 40 lakh for goods and Rs 20 lakh for services), many smaller businesses voluntarily registered to become part of formal supply chains. Large organized buyers increasingly refused to deal with unregistered suppliers, knowing they would lose valuable input tax credits.
Measuring the Impact
The numbers tell a compelling story. Before GST, India had approximately 65 lakh indirect taxpayers registered under the previous regime. By 2024, GST registrations crossed 1.4 crore, more than doubling the formal taxpayer base. This expansion happened despite the availability of composition schemes designed to ease compliance for smaller businesses.
The formalisation cascade also had spillover effects on direct taxation. Many businesses that registered for GST subsequently came under the income tax net. The integration of GST and income tax databases enabled better cross-verification, making it harder for businesses to under-report income. Tax authorities could now match GST returns with income tax filings, identifying discrepancies that were previously hidden.
Winners and Challenges
Large organized businesses benefited significantly from this shift. They gained access to input tax credits throughout their supply chains and faced less competition from informal players who could previously undercut prices by evading taxes. Consumers, in theory, benefited from a more transparent pricing system, though implementation challenges often obscured these gains.
However, the formalisation cascade also created hardships. Small businesses faced increased compliance costs, both in terms of money spent on accountants and software, and time spent understanding complex regulations. Many micro-enterprises struggled with technology adoption, particularly in tier-2 and tier-3 cities where digital literacy remained limited.
Unintended Consequences
The formalisation drive also revealed structural issues in India's economy. Some sectors saw consolidation as smaller players unable to bear compliance costs exited the market or were absorbed by larger firms. In certain industries, this reduced competition and entrepreneurial dynamism.
Additionally, the cascade did not reach uniformly across all sectors. Industries with shorter supply chains or those selling predominantly to unregistered end-consumers remained partially informal. Street vendors, local service providers, and certain agricultural market intermediaries continued operating largely outside the formal system.
The Road Ahead
The formalisation cascade initiated by GST represents a structural transformation of India's economy. As digital payment systems expand and the government pushes initiatives like e-invoicing and e-way bills, the pressure for formalisation will likely intensify. The challenge for policymakers is to balance the benefits of a formal economy with the need to keep compliance manageable for smaller businesses.
This transformation is far from complete. The coming years will determine whether India can build on this momentum to create a truly comprehensive formal economy, or whether informal practices will find new ways to persist in the gaps that remain.
This article is for general informational purposes only and does not constitute professional tax or legal advice. Readers should consult qualified professionals for guidance on their specific business circumstances and tax obligations.
