---
type: faq
question: >-
  The GST is levied on the formal economy. How does informality influence GST’s
  actual impact on society?
topic: gst
topic_title: Goods and Services Tax
topic_url: 'https://liberty-lighthouse.vercel.app/topics/gst/'
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---
# The GST is levied on the formal economy. How does informality influence GST’s actual impact on society?

One of the most important nuances when analysing the effects of the GST is recognising how India's vast informal economy mediates the GST's impact on society. One of the main reasons why essential items, like food and footwear, are taxed at reduced rates under the GST is concern for poor households. The assumption is that poor households pay the GST on their daily purchases, so a tax relief directly benefits them.
 
But across low- and middle-income countries, a large share of everyday shopping happens outside the formal economy. Using expenditure surveys from 31 countries, researchers [Pierre Bachas, Lucie Gadenne and Anders Jensen](https://academic.oup.com/restud/article/91/5/2604/7280167?__cf_chl_f_tk=M_cLsXza4zUDt3GT8sRWW09NExfHR2Bm4jQL2WOnWY8-1783413713-1.0.1.1-.Wh5K__jmm5vuTTG9lE5diFumUXUFDWuSww9Ao6Nbhs) document a steep "informality Engel curve": as households get richer, the informal share of their budget falls: in Rwanda, the share of budget spent on informal sellers falls from about 90% for the poorest decile to 70% for the richest decile; in Mexico, it falls from about 55% to 25%.
 
The same gradient runs through India. The poorest tend to buy loose rice or atta from a handcart or a tiny unregistered kirana, where no GST is charged; better-off households buy the branded, packaged version off a supermarket shelf or a quick-commerce app, tax included. So a cut in the GST on "food" often reduces a tax the poorest were never paying in the first place—while handing the saving to those who already shop in the formal sector.
 
Bachas et al. show that in poorer countries, helping the poor by cutting GST on "necessities" (like food) is often weakly targeted because much of poor households' food consumption already happens in informal outlets—so lowering the tax rate on formal food purchases can miss the poorest households.
 
This leads to a sharper way of thinking about "targeting" in low-income settings where informality is widespread:
 
- "What people buy" can be a noisy proxy for poverty, because rich households also buy "essentials" in large rupee amounts.
- "Where people buy" (formal vs informal channels) can segment households more sharply, because richer households shift faster into modern/formal retail.
In India, this channel-vs-product point matters because the system deliberately keeps many very small sellers out of the full invoice-and-credit regime through registration thresholds. (See "Does GST help small businesses, or crush them with compliance?"). That means "the GST rate is X%" can be a misleading shortcut for what different households actually face, depending on where they shop.
 
So informality changes who really pays GST because poorer households often consume through channels where GST is less likely to be collected—so a policy that cuts GST on "essential goods" sold in the formal sector may not help the poor as much as it seems.