IN PART I of this article published on June 13, we showed that India’s genuine middle class is much smaller than is commonly presumed. To realise the country’s economic ambition, a large, expanding, and increasingly prosperous genuine middle class is needed — one that has income stability, resilience, and the ability to grow its income steadily through value-added work. Why is the middle class stunted?

We believe that it is both the cause and consequence of the widespread informal sector that is commonly estimated to account for 90% of employment, but generating only a third of the value added in the economy. It is huge with limited efficiency because of its many constraints, and is a low-productivity trap that chokes off the formation ofa genuine middle class in India.

Typically, informal workers either work as individual casual labour or in micro enterprises with very small operations, having fewer than 10 employees under conditions ofinstability in both employment and income. Conditions in the informal sector vitiate workers’ effort to get ahead and become middle class regardless of the legendary Indian capability for hard work and a highly entrepreneurial spirit, trapping them in situations where they are unable to increase productivity and income by working with better tools, easy learning of new skills, getting the effort-multiplier benefit of team work, and accessing the full suite of reasonably priced and regulated financial services.

The nature of temporary or contract workers in the informal economy disincentivises the employer from investing in productivity-enhancing tools and training workers to use them, since the payofftime horizon is longer term than the workers’ tenure; besides, informal employers themselves do not have the wherewithal to invest in worker productivity.

The informal sector also denies workers the opportunity of benefiting from team work. A key feature ofthe new world, as we know, is the need for workers to collaborate with others with complementary skills so that they can collectively perform and benefit from complex and high value-added tasks that none ofthem could do on their own.

hat none ofthem could do on their own. However, in the informal sector, because of the transient nature of the workforce, even if a person is part of a work crew of thousands (for example in delivery services or large construction projects), working with others as a stable team does not happen.

There is a large contingent of what we call solo service providers even among higher-skilled occupations like carpenters, tailors, auto mechanics — and even when they are a part of digital aggregator platforms, are still largely on their own. The International Labour Organization (ILO) has estimated that in 2017, a full one-third of Indian workers in the informal sector were the so-called “own account workers”. The result is persistently low productivity.

The problems of access to financing for informal workers and micro enterprises which are not a part of any formal supply chain is well known, and we will not reiterate it. The ratio of domestic credit to GDP, which measures how much credit has been extended to people and businesses benchmarked against the size of the economy, is far lower in India than in, say, China or the United States, and has also been stagnant for the entire decade ending in 2022, while it expanded in all the key economies in the world.

For all these reasons, the informal sector in India undermines the economy’s ability to create a large genuine middle class. India’s stunted middle class is also the flip side ofits stunted manufacturing sector, a significant proportion of which is fragmented and carried out mostly by small and micro enterprises, which do not possess the competitive efficiency to grow and create formal jobs. Large competitive manufacturing exists mostly in the small formal sector accounting for a minor fraction ofthe labour force.

Historically, manufacturing is the welltrodden path to economic development. The Harvard economist Dani Rodrik has characterised manufacturing as the elevator that lifts a country’s productivity rapidly from the basement to the penthouse. ‘Make in India’ is the crucial conduit through which formal jobs and a genuine middle class could rapidly expand despite a modestly educated workforce, which is India’s other reality. The post World War II manufacturing sector in the US enabled someone with a high school education or less to earn a middle-class income. Manufacturing in India so far has not been able to do this.

Given the success of India’s IT sector, could India leapfrog to IT services to fuel the expansion of the middle class, bypassing manufacturing?

NASSCOM data show that even using the broader definition ofthe sector, which includes low-end functions such as call centres, the total employment is 4.5 million, a drop in the ocean of India’s large labour force. Can the rest ofthe services sector create jobs that have all the ingredients we discussed so far to qualify as being truly formal and hence deliver productivity-driven income boosts and fuel high quality-entrepreneurship?

So far, we have not seen it happen on a large scale. Even platform aggregators are unlikely to deliver it, by the very nature of their business model, though they do address some of the limitations of “own account workers” like market access, improved pricing power, and better buyer power ofingredients needed for businesses like finance or consumables supplies.

The Indian economy is at a fork in the road: a policy push that delivers a large and prosperous middle class, or a business-asusual growth story with a massive informal sector that increases consumption but not ofthe calibre of a genuine middle class.

fthe calibre of a genuine middle class. In order to rapidly expand India’s genuine middle class with all its manifold benefits, there appears to be no shortcut to creating a large-scale manufacturing sector that can drive formal employment. This, coming on top ofthe modern welfare state that has been built in the past decade, will truly transform India’s trajectory on many fronts.