The effect of easing labour restrictions: Evidence on employment in Rajasthan

Stringent labour laws in India can hinder firms’ growth and increase the incidence of informal and contract employment. Looking at evidence from firms in Rajasthan after the amendment of the Industrial Disputes Act, this article finds that relaxing labour laws did not significantly affect total employment and output. Counterintuitively, it increased employment of contract workers and reduced the permanent workforce. The study however estimates that the implicit labour cost fell for firms impacted by the amendment.

The economic effects of India’s industrial labour laws are much debated. At the centre of this debate is the Industrial Disputes Act (IDA), a law that governs the procedures for hiring and firing regular workers and the closure of factories. It contains some extreme employment protection provisions: Chapter V-B, for example, requires official permission for any retrenchment, and a 90-day advance notice for closure, in any factory above a specified size threshold. As in several other countries, it has been argued in India that such laws retard growth by making it difficult for firms to adjust labour optimally. For example, Besley and Burgess (2004) suggest that Indian labour laws led to slower growth in India’s formal manufacturing sector and an increase in informality during 1958-1992. There is also evidence that firms have attempted to compensate for the IDA through the use of more flexible ‘contract’ labour (Chaurey 2015).

State-level labour law amendments

Most prior studies of Indian labour laws have exploited variations in the ‘pro-worker’ or ‘pro-employer’ tilt of the IDA that has arisen because of state-level amendments to this act. Because the last major state-level amendment to the IDA was enacted in 1989, many of these studies have had to rely on cross-sectional or state-level variation for identification. This changed in 2014, when the state of Rajasthan amended the IDA and other labour laws in a pro-employer direction by raising the employment size threshold at which Chapter V-B of the IDA starts to apply to a factory from 100 to 300 workers. It also imposed more stringent minimum membership size requirements on unions, and exempted factories with fewer than 50 contract workers from the Contract Labour Act (CLA), the law which regulates the hiring of contract workers. These amendments were noted by the business press as a major reform.

Exploiting the natural experiment generated by this policy change in Rajasthan, our study provides new evidence on long debated questions about the impact of employment protection laws (Chaudhary and Sharma 2022). Our results suggest that reforming extreme employment protection provisions can reduce the implicit regulatory tax on labour in firms, but may not necessarily lead to sizable aggregate impacts.

Study and findings

We conducted a comparative case study of the amendments using the synthetic control method. This involves using a weighted combination of potential comparison units – in our case, Indian states other than Rajasthan – as the control group, with the choice of weights being data-driven¹ (Abadie and Gardeazabal 2003). For this exercise, we used official state-level estimates of the formal manufacturing sector for the period between 1980 and 2018.

The results suggest that, contrary to expectations, the amendments did not have a sizable aggregate impact on employment and output in Rajasthan’s formal manufacturing sector. There is some indication of a positive impact on output, but it is not robust to standard checks.

We then used factory level panel data from 2010 to 2018 to conduct a difference-in-differences² analysis of the main policy change: the repeal of Chapter V-B. We compare outcomes before and after the amendment across factories with 100-300 workers and those with more than 300 workers, across Rajasthan and other states.

The results indicate that the amendment had no sizable impact on total employment but increased contract worker employment by about 124%. In contrast, there was a 19% reduction in the permanent workforce. Part of the increase in contract employment was on the extensive margin, with the share of firms using any contract workers at all estimated to have increased by 14 percentage points (from a baseline rate of 49%).

Conceptualising the regulatory burden associated with permanent employees as an implicit variable labour cost, we estimated it using a method based on the firm’s optimal cost-minimisation conditions. We find that among treated firms (that is, those firms that saw the repeal of Chapter V-B) the implicit labour cost fell by approximately 14%. This may have been driven by the switch to more lightly-regulated contract labour. Moreover, the repeal of Chapter V-B did not have any detectable effect on the output, investment and labour productivity in treated firms. Counter-intuitively, there was a significant increase in their employment of contract workers and reduction in employment of formal, regular workers. We confirm that these difference-in-differences results are not driven by differential trends in the pre-treatment period.

To examine the puzzling increase in the number of firms increasing the employment of contract workers, we consider that our results could be picking up the effect of a different but concurrently implemented amendment, in which Rajasthan eased the contract labour regulations applying to firms with 20-50 contract workers by exempting them from the CLA. Testing for differential impacts between firms that would be impacted by this amendment (that is, firms with less than 50 contract workers) and those who would not (firms with more than 50 contract workers), we observe that the proportional increase in contract employment in treatment firms with more than 50 contract employees at baseline is more than twice that in treatment firms with fewer than 50 workers. This dissuades us from this possible explanation.

Critically, we find that the strength of the impact of the IDA amendment is linked to the inherent technological viability of contract labour in firms – the switch towards contract labour, which is felt more strongly in industries with inherently higher dependence on such labour, suggests that the amendment may have eased binding regulatory constraints on contract labour hiring in firms with the potential to replace permanent workers with contract workers in core tasks.

Conclusion

Our results suggest that amending the most extreme employment protection provisions of the IDA could ease regulatory costs on firms, but with limited aggregate effects. The unexpected hiring-mix response of firms calls for more research on the broader regulatory and institutional framework under which Indian manufacturing firms make their employment decisions. There is evidence that by the time Rajasthan enacted its amendment, the nation-wide acceleration in the use of contract labour (which began after 2000) had already eased labour adjustment costs on firms significantly in practice, without any major change in the legally sanctioned protection of regular workers (Bertrand et al. 2021). This emerging dualism in the labour market may be of particular relevance when explaining the compositional shifts observed by us, and may have implications for how to design labour market reforms.

It is worth emphasising that our findings speak to a selective amendment of the IDA. Employment in formal Indian firms is regulated by several other provisions of the IDA and several other labour laws; thus, more evidence on the effects of a more holistic change to the Indian labour code may be particularly important to the policy discussion. It is possible that in time, Rajasthan’s labour law amendments will have significant impacts on firms’ investments in technology and innovation. Revisiting this amendment to examine such long-term effects would also be interesting.

Notes:

The choice of weights is made by an algorithm in such a way that key attributes of the comparison unit resemble those of Rajasthan in the period before the policy reform.
Difference-in-differences is a technique to compare the evolution of outcomes over time in similar groups that gained access to an ‘intervention’ with other groups that did not