India has some of the more restrictive labour laws in the world, but a large informal sector to which these do not apply. Therefore, firms thinking of growing in size and becoming formal must trade off the advantages of size with the disadvantages of facing regulations. This dilemma keeps Indian firms small and informal unless they have a lot to gain by growing, i.e. when they are very good indeed. The result, it is argued, is a skewed firm size distribution with a very long tail of smaller, less productive firms – many of which operate in the informal sector – which employ nearly 90% of the Indian workforce. Such a skewed outcome makes sense given the uneven protection of employment across the formal and informal sectors, with the latter being virtually unregulated. Strict labour laws may also result in market concentration, as these regulations act as a barrier to becoming large.
A number of studies have argued that strict (and obsolete) labour laws explain India’s manufacturing problem (Panagariya 2008, Dougherty et al. 2009, Hasan and Jandoc 2012). Although the country has recorded impressive output growth rates since the 1970s, the share of manufactures in total output has remained stagnant at around 15%. Moreover, the top seven goods exported during 2012-13 represented over 50% of the country's total exports and these were all relatively capital-intensive goods: petroleum products, gems and jewelry, transport equipment, nuclear and mechanical machinery, electrical machinery, organic chemicals, and pharmaceutical products. In contrast, ready-made garments, traditionally an unskilled-labour-intensive export, saw its share in total Indian exports decline from 12.5% to less than 6% between 2000 and 2013.
There has been a recent renewal of interest in pursuing labour market reforms in India, and it has been an issue in the run-up to the current elections. Last year the Ministry of Finance argued in its Economic Survey that labour regulations appeared to be an impediment to the growth of jobs in manufacturing, a message emphasised in last month’s IMF Article IV review  and earlier OECD Surveys (2007, 2011). Articles in the The Economist  and the New York Times  give colour to the scarcity of quality jobs in the country, and highlight how stringent labour laws appear to have played a key role. The latest in-depth official figures on employment from the 2011 12 Employment and Unemployment Survey (NSSO) suggest that only 20% of those employed in India are on a regular wage or salary with a contract (Shaw 2013). Clearly, such a system does not provide a stable work environment and may be costly for firms.
How large are the effects of such laws? In our recent paper we provide some idea of these costs in terms of their impact on productivity (Dougherty et al. 2013). We use state-level variation in labour market reform and firm-level data on the performance of industrial establishments in recent years to tease out the effects of such reforms. Using plant-level data between the late 1990s and the late 2000s, we find evidence of the impact of reforms of employment protection legislation (EPL) and related labour market policies on plant-level productivity in India. Identification of the effect of EPL reforms follows from a ‘difference-in-differences’ estimator that takes advantage of the state-level variation in labour regulation reform and heterogeneous industry characteristics. The fundamental identification assumption is that EPL is more likely to restrict firms operating in industries with higher labour intensity. The results show that labour market reform mattered, and more so in labour-intensive industries.
A strength of our work is that the labour reform measure (OECD 2007) used is much more comprehensive and appropriate for the post-1991 period analysed than the Besley-Burgess (2004) index, popular in the EPL literature in India. The labour reform index we use covers 50 specific subjects of possible reform in seven major areas of labour regulation in addition to the IDA, taking into account both formal and informal amendments at the state level. An additional strength is the use of plant-level information from the Annual Survey of Industries (ASI) to evaluate the direct effect of EPL in India. We take advantage of the ASI panel data to obtain plant-level total factor productivity (TFP) measures that control for simultaneity and selection bias (using the Olley-Pakes approach), in contrast to previous work on the topic that has, due to the lack of a panel, mostly measured the effects of EPL on labour productivity at the industry level.
Figure 1 Number of labour reforms carried out in India by 2007
Source: OECD (2007), Dougherty (2009).
We find that the modest easing of regulations in Indian states that has taken place in recent years was enough for firms in states with higher levels of pro-employer reform to benefit substantially through gains in TFP. Our point estimates indicate that, on average, plants in labour-intensive industries and in states that have transitioned towards more flexible labour markets have TFP residuals 25.4% higher than those registered for their counterparts in states with less EPL reform. However, no important differences are identified among plants in industries with low labour intensity when comparing states with high and low levels of EPL reform.
We also verify that the different strategies used by plants to partially overcome the constraints imposed by labour regulations generate heterogeneous effects of state-level labour reform, both by plant size and type of ownership. Given the extensive use of contract labour among large plants and voluntary retirement schemes among public plants, smaller plants and private plants could accrue the largest productivity gains from state-level labour reforms. Of course, these additional TFP gains are relative and do not imply that large plants and public plants are not held back by the current regulations.
Although our EPL reform indicator shows that state-level actions, both de facto and de jure, have already led the way in labour reform, these reforms could be taken much further. Out of the 20 states surveyed, only three had conducted more than half of the potential procedural or administrative changes they were surveyed about, suggesting that there is still much room to ease the burden of labour regulations at the state level. Given the difficulty in carrying out reforms at the central level, states may be in a better position to accelerate their own labour reform processes while prioritising reforms according to the characteristics of their home industries. However, the central government urgently needs to resolve ambiguities in the Supreme Court’s ruling and provide clear general guidelines, particularly in areas such as contract labour and fixed-term contracts.
Until recently, labour reform had taken a backseat in discussions of structural reforms in India. However, recent contract labour cases have split the Supreme Court’s bench and have forced the issue of labour market deregulation back into the public debate. In addition, the government has expressed a newfound desire to ‘seiz[e] the demographic dividend’, increasing chances that labour law reform will be back on the reform agenda. However, there is still little clarity on the type of reform we should expect; many worry that the government may just impose stringent regulation for contract labour instead of implementing a deep liberalising labour reform that can put India back in the manufacturing business.
Authors’ note: The views expressed in this article are solely those of the authors and do not reflect those of the OECD, the IDB, or their member countries or partners.
Besley, T and R Burgess (2004), "Can labour regulation hinder economic performance? Evidence from India ", The Quarterly Journal of Economics 119(1), 91-134.
Dougherty, S (2009), "Labour regulation and employment dynamics at the state level in India ", Review of Market Integration 1(3), 295-337.
Dougherty, S, R Herd and T Chalaux (2009), "What is Holding Back Productivity Growth in India? Recent Microevidence ", OECD Economic Studies 45(1), 59-80.
Dougherty, S, V Frisancho Robles and K Krishna (2013), "State-Level Labour Reform and Firm-level Productivity in India ", India Policy Forum 2013.
Hasan, R and K R L Jandoc (2012), "Labour regulations and the firm size distribution in Indian manufacturing ", in J. Bhagwati and A. Panagariya (eds.), Reforms and Economic Transformation in India, Oxford University Press, New York.
OECD (2007, 2011), OECD Economic Surveys of India , OECD Publishing, Paris.
Panagariya, A (2008), India: The Emerging Giant , Oxford University Press, New York.
Shaw, A (2013) "Employment Trends in India: An Overview of NSSO’s 68th Round ," Economic and Political Weekly 48(42), 23-25.