India's labour laws: Protecting to hurt

The state government of Rajasthan has begun making amendments to various labour laws in order to make labour markets more flexible. Summarising research on the impact of rigid labour laws on the growth of firms, Devashish Mitra argues that these steps are in the right direction. In his view, all outdated labour laws constraining India’s manufacturing need to be reformed.

Recently, Prime Minister Modi announced a few labour reforms. Rajasthan has also started making some bold amendments to the various central labour acts, with a few other states indicating similar intentions. Unlike attempts by other states to amend labour laws in the past¹, the recent changes are taking place in the context of efforts to attract Foreign Direct Investment (FDI), improve infrastructure and promote a more liberalised trade regime.

Labour law reforms: Recent initiatives

There are currently approximately 200 labour laws in India, of which 52 are central acts. The key, but not the only constraining regulation, is the Industrial Disputes Act (IDA) that requires a firm employing more than 100 workers to seek permission from its state government for retrenching or laying off workers. Rajasthan’s recent amendment raises this threshold to 300 workers. It also increases the threshold employment for registration of a firm under the Factories Act, a regulation that puts a number of stipulations on work hours and work days in addition to the minimum age requirement. Rajasthan is also raising the minimum membership for the registration of a representative union from 15% of the firm’s employment to 30%, thereby attempting to reduce managerial and labour time lost in building consensus among multiple unions. In addition, the state government’s amendment to the Apprenticeship Act will encourage the employment of apprentices, a source of human capital formation.

Narendra Modi’s announcement of labour reforms at the national level includes the setting up of a unified web portal where firms can themselves file their compliance reports pertaining to 16 central labour acts, with a built-in algorithm that will determine which firms need to be visited by inspectors, thus taking away their discretion in this regard. This is expected to drastically reduce harassment and rent seeking. Moreover, the reforms aim to increase the portability of provident funds²; this, along with modifications to the Apprenticeship Act, will encourage labour mobility and skill formation.

Is India’s manufacturing sector losing out?

India’s restrictive labour regulations have made it difficult for firms to adjust their employment in response to changes in demand, thereby introducing labour market rigidities. These laws also severely limit the flexibility of firms in moving workers across tasks as such reshuffling currently often requires government approval. Since these laws apply above a certain employment threshold they encourage firms to remain small and informal. Contrary to the inferences recently made by some commentators³, the absence of bunching of firms at the employment thresholds associated with these laws does not mean the regulations are not binding constraints. The selection of technology or product type requiring large-scale production might be discouraged by such regulations. In turn, firms might be pushed to select smaller-scale production techniques or product types whose optimal employment size might be much smaller than, for instance, even the IDA threshold. Additionally, the imperfect enforcement of regulations can further contribute to the absence of bunching⁴.

Recent research exploits the variation across states in the effective rigidity of their labour regulations, driven by the concurrent roles of the centre and the states in labour policy and its enforcement⁵. This research has shown that restrictive labour laws have slowed down the growth of labour-intensive industries, restricted their average firm size, and the proportion of large and medium-size firms relative to small ones. It is, therefore, not surprising that while employment in the apparel industry in India is concentrated in firms employing less than nine workers each, China’s apparel production is concentrated in firms employing more than 2,000 workers. India’s labour productivity in apparel is among the lowest. Bangladesh (with a much lower per capita income, a higher poverty rate, worse infrastructure and higher corruption levels) has been performing far better than India in this sector. This suggests that the constraints imposed on labour adjustments and firm size, are indeed binding.

Other recent research, using cross-national data, shows that restrictive labour regulations are associated with an increase in capital intensity, especially in labour-intensive industries and those facing frequent demand fluctuations (and hence, requiring frequent labour adjustments). Since India’s labour regulations are highly restrictive, its techniques of production turn out to be much more capital intensive than expected based on its level of development and labour abundance. Interestingly, in a large majority of manufacturing industries, such as paper and printing, leather and plastics, minerals, metal products etc., India uses more capital-intensive production techniques (or specialises in more capital-intensive product types) than does China (Hasan, Mitra and Sundaram 2013a,b). Adoption of highly capital-intensive technologies, along with the small size of labour-intensive firms coming in the way of reaping economies of scale, lowers India’s comparative advantage in labour-intensive manufacturing. Thus, its gains from international trade get severely constrained. Recent empirical investigations have shown that exposure to trade has increased industry-level productivity and employment but less so in the restrictive labour law states (Mitra and Ural 2008).

All outdated labour laws need to be reformed

Thus, the recent steps by the centre and the Rajasthan government are in the right direction and a good beginning in trying to make labour markets more flexible. However, this is just a tiny fraction of what needs to be done. For example, while raising the IDA threshold employment from 100 to 300 might be useful, it should be further raised in steps to much higher levels. And reforms need to go beyond this Chapter of the IDA, which some commentators often focus on. All outdated labour laws constraining India’s manufacturing need to be reformed. While firms in India have been able to get around, such getting around is costly. Contract workers hired in this process have limited incentive to acquire firm-specific skills and have no loyalty to the employer. Firms will also not invest much in transient workers.

No doubt providing more flexibility in the hiring and firing of workers will have to be accompanied by new and more creative forms of social protection, especially the provision of unemployment benefits whose costs the government and employers will have to share. But the current laws are a barrier to entry into the elite class of permanent workers in the formal sector. Instead of protecting, they end up hurting the vast majority of India’s workers.

Notes:

Those amendments were made to make the laws applicable within states that were either pro-employer or pro-employee relative to the central regulations, depending on the ideological inclinations of those respective state governments.
Provident fund portability enables employees to transfer funds in their provident fund accounts when they change jobs.
See for instance, Bardhan (2014) and Amirapu and Gechter (2014). See also Bhagwati and Panagariya (2013) for a counterargument to these inferences; the counterargument I provide in this article is effectively the same (only explained slightly differently).
This means that small violations of the legal thresholds might either go unnoticed or disregarded by the inspectors.
See, for instance, Hasan and Jandoc (2013), Gupta, Hasan and Kumar (2008), Mitra and Ural (2008) and Dougherty, Frisancho Robles and Krishna (2011). See also the pioneering work by Besley and Burgess (2004) and its critique by Bhatttacharjea (2006).