Impact of labour regulations on Indian manufacturing sector

  • Blog Post Date13 March, 2018
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In this article, Devashish Mitra discusses structural bottlenecks in the Indian manufacturing sector such as labour market regulations and recent policy changes that incentivise capital-intensive production technologies, potentially restricting employment opportunities.

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With a 17% share in world population and only 3% of world GDP (gross domestic product), India, with its low average education levels, can be labeled a low-skilled labour abundant country. However, the Modi government’s recent doubling of import duties on beauty aids, watches, toys, furniture, footwear, kites, and candles shows India’s lack of competitiveness in these entry-level labour-intensive industries. Also experiencing a doubling of duties are electronics and communications devices such as mobile phones, and TVs, and related inputs and parts. Any highly labour-abundant country should normally be able to process or assemble imported inputs and parts (exempt from duties) to export finished mobile phones and TVs. Input processing or assembly consists of highly labour-intensive, repetitive tasks, not requiring any formal education or technical skills. Processing inputs on a large scale, using vast supplies of cheap labour, is how China has rapidly industrialised. But it is clear from the recent tariff increases that India is not able to grasp its natural comparative advantage. India is being outperformed not just by China but also by Bangladesh and Vietnam in labour-intensive textiles and apparel exports.

Not only is India’s performance in labour-intensive manufacturing unsatisfactory, there is evidence that in many industries India uses techniques of production that are significantly more capital-intensive than other countries at comparable stages of development (Hasan, Mitra and Sundaram 2013). Even compared to China, which has a much higher per capita income, India’s production techniques are considerably more capital-intensive in many industries such as paper and printing, leather, rubber and plastics, chemicals, non-metallic minerals, etc. Moreover, within industries, India specialises in products that are relatively more capital-intensive than what is predicted by its per capita income.

India’s labour regulations

Clearly, Indian firms find it cost-effective to engage in capital-intensive production despite the country’s labour abundance. To anyone who is aware of the panoply of restrictive labour regulations firms in India face (that makes labour effectively quite expensive) this does not come as a surprise. According to Bhagwati and Panagariya (2013), India has about 200 labour laws, 52 of which are Central Acts. Of these, probably the three most restrictive ones are the Industrial Disputes Act (IDA), the Industrial Employment (Standing Orders) Act, and the Trade Union Act. The IDA requires firms with 100 or more workers to seek government permission to retrench or lay-off any worker. This permission is rarely granted. As a result, firms are probably hesitant to hire too many workers as they can be stuck with each of them in the event of a negative shock or incompetence. The Standing Orders Act requires employers in firms with 100 or more workers (50 or more in some states) to seek permission for changing the job description of any employee, that is, reassigning her to a different task. The Trade Union Act allows any seven employees to form a union, leading to several unions within a firm, thereby using up a large proportion of the firm’s managerial resources. Through this regulation, unions have the right to strike and represent workers in legal disputes with employers. There are several other laws, mainly specifying work conditions and benefits, that become applicable at different employment thresholds. Last but not the least, there is the Contract Labor Act, that restricts, and even prohibits, the use of contract workers for certain tasks. Thus, it is not always that easy to circumvent labour laws to keep production techniques labour-intensive. Also, since these laws have a threshold employment level above which they become applicable, firms often have an incentive to remain small and “informal”.

Impact of labour regulations on industry and firm performance: The evidence

By now, there is a large literature on the impact of India’s labour regulations on economic outcomes. Since labour issues are in the “concurrent list” of the Indian Constitution, both the central (federal) and state governments can pass and amend labour laws, with their implementation being exclusively in the hands of state governments and varying across states. This feature of Indian labour regulations provides researchers with considerable variation to study the economic impact of these laws.

The pioneering work in this area was done by Besley and Burgess (2004), who were the first to quantify state-level labour regulations, based on amendments to the IDA. They found that state-level manufacturing output, investment, and productivity in the formal sector went down, while these same aggregates went up in the informal sector, as labour regulations became more pro-employee (labour markets became more rigid). Thus, when labour laws squeeze the formal sector, there is a spillover into the informal sector.

Subsequently, there have been micro-level studies that have also made improvements to the labour regulation measure to include amendments to other labour laws as well as enforcement of regulations. An important industry-by-state study is by Hasan, Gupta and Kumar (2009), who find output and employment growth in labour-intensive industries to be slower in states with relatively restrictive labour regulations as compared to other states. Going more micro and pooling formal- and informal-sector manufacturing firms, Hasan and Jandoc (2013) find that while in rigid labour-regulation states 60% of labour-intensive manufacturing employment is concentrated in small firms employing 0-9 workers, this proportion is 40% for the remaining states. These proportions for large firms employing over 200 workers are 10% and 25%, respectively, for the rigid states and others. Clearly, this suggests that static and dynamic economies of scale are better exploited in states where labour regulations make for relatively flexible labour markets, thereby resulting in faster employment growth in such states. In fact, plant-level productivity in labour-intensive industries and in those facing volatile demand (requiring constant input adjustment) is about 11-14% higher in the flexible labour market states than in others (Dougherty, Frisancho-Robles and Krishna 2014).

Impact of international trade on industry and firm performance: Do labour laws matter?

There is also evidence that restrictive labour regulations have prevented India from reaping the full potential benefits from opening the economy. Mitra and Ural (2008) find that industry performance, measured by productivity, output, value added, employment, capital stock and investment, improves with tariff reductions, with the impact on productivity being 33% greater in states with relatively flexible labour markets than in others. Interestingly, a recent study by Ahluwalia, Hasan, Kapur and Panagariya (2018) finds strong evidence for wage and employment gains, after the lifting of import quotas in developed countries through the expiration of the Multifibre Arrangement in 2005, in India’s textiles and apparel firms in states with flexible labor regulations relative to those with restrictive regulations.

The constraints imposed by labour regulations are further evidenced by the opposite effect of trade openness on informal sector firms with five or fewer workers. These firms experience a greater increase in output, value added, and employment due to tariff reductions in the relatively rigid labour regulation states as compared to other states (Sundaram, Ahsan and Mitra 2013). This might be driven by the need for formal sector firms, due to restrictive labour regulations, to outsource some of their work to informal sector firms.

The constraints imposed by labour regulations are further evidenced by the opposite effect of trade openness on informal sector firms with five or fewer workers. These firms experience a greater increase in output, value added, and employment due to tariff reductions in the relatively rigid labour regulation states as compared to other states (Sundaram, Ahsan and Mitra 2013). This might be driven by the need for formal sector firms, due to restrictive labour regulations, to outsource some of their work to informal sector firms.

The benefits from trade are generated through inter- and intra-industry reallocation of resources, which labour regulations can distort. Greater trade openness is expected to move resources into comparative-advantage sectors. However, despite unilateral trade liberalisation by India and the Uruguay Round’s multilateral trade liberalisation, the share of labour-intensive products (in which India is expected to have a natural comparative advantage), such as food and beverages, apparel, textiles and furniture, in India’s exports has fallen slightly, while the share of skill- and capital-intensive goods, such as automobiles, petroleum refining, engineering goods, finance, software etc., has risen considerably from 41% to 65% during 1990-2008.

Conclusions and policy recommendations

Often analysts infer that labour regulations do not have any bite just from the absence of bunching of firms at any of the threshold employment levels for the various labuor regulations. There are two factors that might prevent this bunching. Firstly, let’s suppose firms choose between a small-scale and a large-scale technology. For firms below a threshold intrinsic productivity level, the small-scale technology will be more profitable, that is, it might not pay for them to incur the additional fixed costs of the more efficient large-scale technology. Restrictive labour laws might throw more firms into that category. However, the optimal employment size for such firms might be lower than the threshold employment at which a labour regulation like the IDA becomes applicable (Bhagwati and Panagariya 2013). Secondly, there is imperfect enforcement of labour regulations. Firms may then cross labour law thresholds but not follow applicable laws. In any event, the lack of bunching does not mean one can disregard all the robust statistical relationships mentioned above.

Clearly, the main policy implication of the discussion above is the urgency of labour reforms. Small steps, especially at the state level, have been taken recently. The IDA threshold has been raised from 100 to 300 workers in Andhra Pradesh, Haryana, Madhya Pradesh, Maharashtra, Rajasthan, and Uttarakhand. Rajasthan has also raised the membership threshold of a union to 30% of a firm’s employment. At the central level, a unified web portal for the self-reporting of compliance with 16 central acts has been set up. Inspections take place only when triggered by a built-in algorithm within the portal, reducing possible harassment by inspectors.

Further reforms should include, as suggested by Bhagwati and Panagariya (2013), the exclusion of non-confirmation of a worker on probation and downsizing in response to demand and technology shocks from IDA’s definition of retrenchment. Also, more flexibility in task reassignment should be allowed within the Standing Orders Act. Both these changes will provide Indian producers more flexibility in response to shocks. Also, no more than a single union should be allowed within any firm. And, finally, more labour laws should be covered within the newly installed self-reporting web portal.

Further Reading

  • Ahluwalia, R, R Hasan, M Kapoor and A Panagariya (2018), ‘The Impact of Labor Regulations on Jobs and Wages in India: Evidence from a Natural Experiment’, Deepak and Neera Raj Center Working Paper 2018-02, Columbia University.
  • Besley, Timothy and Robin Burgess (2004), “Can Labor Regulation Hinder Economic Performance? Evidence from India”, Quarterly Journal of Economics, 119(1):91-134.
  • Bhagwati, J and A Panagariya (2013), Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries, Public Affairs, New York.
  • Das, DK, D Wadhwa and G Kalita (2009), ‘The Employment Potential of Labor Intensive Industries in India’s Organized Manufacturing’, Indian Council for Research on International Economic Relations (ICRIER) Working Paper 236, June.
  • Dougherty, S, VC Frisancho-Robles and K Krishna (2011), ‘Employment Protection Legislation and Plant-Level Productivity in India’, NBER Working Paper 17693.
  • Dougherty, S, V Frisancho and K Krishna (2014), ‘The costs of employment protection’, Ideas for India, 30 April 2014.
  • Gupta, Poonam, Rana Hasan and Utsav Kumar (2008), “Big Reforms but Small Payoffs: Explaining the Weak Record of Growth in Indian Manufacturing”, India Policy Forum, 5(1):59-123.
  • Hasan, R and K Jandoc (2013), ‘Labor Regulations and Firm-Size Distribution in Indian Manufacturing’, in J Bhagwati and A Panagariya (eds.), Reforms and Economic Transformation in India, Oxford University Press, New York, 15-48.
  • Hasan, Rana, Devashish Mitra and Asha Sundaram (2013), “What Explains the High Capital Intensity of Indian Manufacturing?”, Indian Growth and Development Review, 6(2):212-241.
  • Mitra, Devashish and Beyza Ural (2008), “Indian Manufacturing: A Slow Sector In A Rapidly Growing Economy”, Journal of International Trade and Economic Development, 17(4):525-560.
  • Sundaram, A, R Ahsan and D Mitra (2013), ‘Complementarity Between Formal and Informal Manufacturing in India’, in Jagdish Bhagwati and Arvind Panagariya (eds.), Reforms and Economic Transformation in India, Oxford University Press, New York, 49-85.
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