National Council of Applied Economic Research
Opinion: Manish Sabharwal and Kartik Narayan.
A five-point agenda to fix the country’s PF scheme could shift 50 million people from informal to formal work. Let’s blend idealism with pragmatism.
The excellent book Making Social Spending Work by Peter Lindert suggests societies need safety nets to catch those in need because of unlucky opening balances, past mistakes or hard times. A policy success of the last decade has been re-imagining India’s subsidy spend for 100 million citizens via direct benefit transfers for better social security. However, India’s unimaginative trade union movement—it believes job preservation is a form of job creation and chooses the old over the young—has hamstrung work-linked social security programmes with high costs, low competition and excessive deductions. Consequently, only 1 million of our 63 million enterprises and about 7.5% of our 550 million labour force make monthly social security contributions.
We propose five design reforms for the Employee Provident Fund Organization (EPFO) around efficiency, choice, competition, effectiveness and sustainability that would shift an estimated 50 million people from informal to formal work. These reforms matter because India’s big labour-market problem is not jobs, but wages. Lindert’s research suggests that countries walk different paths in public education, healthcare and pensions and welfare based on their philosophy about inter-generational inequality, fiscal redistribution and returns to human capital. He suggests social security takes off only with fiscal capacity; universal education is often under-resourced, spending is hijacked by the powerful and elderly at the expense of the young and poor, and ageing is the biggest threat to safety nets, employer-based provisions are flawed, and universal provisions provide more equity. India doesn’t have the ageing challenge; ours is regulatory cholesterol encouraging informality (a sense of humour about the rule of law). Let’s examine five flick-of-the-pen reforms that could accelerate formalization:
Efficiency: The EPFO is the world’s costliest government securities mutual fund; it charges employers ten times what an equivalent fund from State Bank of India does, with employers paying total expenses of almost 4% of contributions. Collecting these costs from employers amounts to taxation; globally, pension funds pay these costs. The EPFO should be a non-profit, flow-through entity with benchmarked costs, but it suffers the cost disease identified by Nobel Laureate Bill Baumol on account of a monopoly that holds employers hostage, not clients.
Competition: The EPFO and Employees’ State Insurance (ESI) monopoly on work linked social-security payments has toxic consequences for employees (disrespect and poor service), employers (high costs and corruption demands) and society (making informality more lucrative than formality). A budget speech by former finance minister Arun Jaitley had announced a push for competition. But the proposal was sabotaged by false arguments of private sector exploitation of employees, costs coming down with scale, and the effectiveness of enforcement, administration and fund management housed in the same organization. All three arguments have been disproved by our price and service revolution since 1991 in the sectors of petroleum, telecom, digital payments, airlines and steel. We can think about private sector provisions later, but should immediately allow employee choice (not employer choice) on paying their contributions to either the EPFO or public-sector National Pension Scheme (NPS). This election at the time of joining could be kept open to being changed annually, with easy interoperability between the two, replicating the relationship of our two equity depositories.
Choice: Salaries belongs to employees who should choose what to do with the money. Our prescribed gap between haath waali (net) salary and chitthi waali (gross) salary in a cost-to-company world is unfair; mandatory deductions that are sometimes higher as a proportion of salary for those earning less (possibly to ensure greater savings) are weird. Especially since research suggests the savings rate for individuals with incomes of ₹25,000 per month (or less) is close to zero, implying they barely get past essential spending. Employees should get two choices: Whether to make any employee contribution at all (set at 12% right now), and if so, whether to opt out of the portion that goes to the defined-benefit Employee Pension Scheme (EPS) and contribute the sum fully to the core Employee Provident Fund (EFP) account.
Effectiveness: Employment has shifted from being a lifetime contract to a taxicab relationship; most employees of this generation will have multiple employers, including themselves. The EPFO has a design birth defect that links records to employers rather than employees and their hundreds and thousands of orphaned accounts, with the last estimate putting unclaimed balances at over ₹25,000 crore. Making EPFO contributions to an Aadhaar number will create traceability, portability and access. This change will also enable EPFO products to be offered to self-employed and gig workers.
Sustainability: The EPS diverts 8.33% of a subscriber’s salary to a defined-benefit plan. But the EPS has a birth defect; pension contributions or pension benefits can be fixed, but the EPS fixes both. This scheme has become even more unviable with the November 2022 court judgement that bankrupts the scheme, with the court upholding the entitlement of opting for a higher pension by contributing to the EPS on an uncapped salary. The EPS must be removed from the EPFO and merged with some universal and fiscally funded old-age security pension scheme like the Atal Pension Yojana. The EPFO, as a work-linked programme, must remain a defined-contribution plan to avoid the risks of ageing, inadequate investment income and cross-subsidization that it can’t handle.
Idealism and pragmatism: In 1947, Constituent Assembly member K.T. Shah wrote a letter to Rajendra Prasad suggesting that “We need a time limit for Directive Principles to be justiciable, lest they become mere pious wishes.” However, our distinction between fundamental rights enforceable in court and social objectives embedded in the Directive Principles was not a lack of ambition, but a matter of policy pragmatism.
India’s first Prime Minister Jawaharlal Nehru had said, “We cannot have a welfare state unless our national income goes up. India has no existing wealth for you to divide; there is only poverty to divide. Our economic policy must, therefore, aim at plenty.”
We must continue our pursuit of the plenty that will pay for fiscally financed safety nets. But let’s also undertake five flick-of-the-pen reforms of employer social security programmes that would lead an estimated 50 million existing workers to make their transition from informality to formality.