November 1, 2013

Labour market reforms in India

Among India’s still-born second generation reforms, labour market reforms is one of the most important and politically difficult.

A labyrinth of state and central labour market regulations, nearly 250 in number, has created an excessively regulated labour market with large compliance costs. The Industrial Disputes Act (IDA) 1947, which applies to all formal sector firms employing more than 50 people, is the most important. An amendment to IDA in mid-eighties made mandatory for firms with more than 100 employees to seek government permission before firing workers. The permission is rarely given, and the process can be tortuous and lengthy. The IDA also requires that employees be given a 21-day notice before modification of work content, wages and allowances, and other work conditions. Others like the Industrial Employment (Standing Orders) Act regulate work conditions in great detail, leaving employers with limited flexibility in redeploying their work force. Cross-country comparisons of labor market indicators, including by the World Bank, reveal that India has among the most rigid labor markets.

labour reforms

These regulations add layers of direct and indirect costs, some of them being large enough to seriously erode competitiveness. Further, ensuring compliance with these regulations is fraught with litigation troubles and rampant corruption.

It has also contributed to several structural distortions. The larger firms have no choice but to either endure the harassment or bribe their way out. But it has adversely affected the growth of Small and Medium Enterprises, who have sought to limit their formal employment below 100, preferring to either hire labour informally or not to hire at all. This has serious economy-wide implications. Global experience shows that, contrary to conventional wisdom that big firms create jobs, the largest share of job creation happens when smaller firms expand and transition into medium and large-sized ones.

While it is difficult to draw direct causal relationships, there is strong evidence to believe that rigid labour market regulations are responsible for Indian manufacturing’s “missing middle” – disproportionately low number of intermediate-sized firms. A recent study by International Finance Corporation compared the sizes of the typical Indian, Mexican, and US firms at start-up and at the end of 35 years and found that their size declined by a fourth in India whereas it doubled in Mexico and rose 10 times in the US.

Firms have also sought to circumvent these restrictions by hiring part-time or using contract labour – either directly or through manpower contractors like Teamlease – for long periods and even for core activities. The share of contract labour in the industrial workforce rose from 16 percent to 25 percent in the high-growth 2000-07 period to touch 150 million.

This growth has been despite the uncertainty surrounding interpretation of the Contract Labor Act 1970, which has been amplified by contradictory court judgments. Labour representatives claim that contract labour cannot be deployed on core activities, should be compensated at the same rate as regular employees, and should be regularised if they are working continuously in the firm’s premises.

Nowhere is contracting more pervasive than in construction sector, which has also been India’s dominant job creator. A recent Planning Commission report reveals that half of the 48 million net non-agriculture jobs generated in 2004-05 to 2011-12 was in construction sector, whereas manufacturing contributed just 5 million. It should come as no surprise that more than 90 percent of jobs in the construction sector, where employment is project-wise and generally cyclical, are in the informal sector. Construction contractors prefer to outsource their work through large numbers of labour contracts, which offer minimal or no protection to labourers.

Contracting and part-time work lower business operating cost by avoiding the payment of gratuity, provident fund, medical insurance, and other benefits. But as this trend consolidates, and given the fundamental underlying tensions, it is certain to generate industrial disputes, as evidenced by the lockout at Maruti’s Manesar plant in late 2011.

Collectively, these dynamics contribute to deepening our informal economy. More than 90 percent of India’s labor force is in the unorganised sector, the highest in the world, far higher than the average of 40 percent for developing countries. Though the informal sector employs nearly 94 percent of India’s labour force, it produces just 57 percent of the GDP, leaving the formal 6 percent to generate 43 percent of GDP.

Informal labour distorts the incentives of both employee and employer. It is less productive, low paid, leaves workers vulnerable, and discourages business investment. Further, informal jobs are the equivalent of a government subsidy to such employers, in so far as it allows them to pass on the social protection externalities to the government.

Supporters of labour market reforms, especially those advocating big-bang liberalisation, underestimate its complexity. A political and social consensus about protecting the interests of workers underpinned these regulations. In this India was no different from any developed country in their similar phase of development. This consensus remains strong even today. However, the emergence of a global supply chain, a massive global outsourcing market, and closer integration of India with the world economy pose an important set of challenges to this labor market. Firms need to be flexible with their production processes to adapt to the dynamics of this environment to succeed.

We need a careful balancing of both these apparently conflicting objectives. Labour regulations should be fair to both employers and employees, allowing firms sufficient flexibility with their production decisions without compromising on basic protections of workers. This requires a political consensus among atleast all the major parties.

Such reforms are always likely to face strong opposition in democracies. An unemployment insurance program, predominantly government funded, can mitigate some resistance to such reforms. It is also true that such labour market reforms have succeeded only in countries with such unemployment cushions. In any case, a robust social safety net may be an essential pre-requisite for pushing through many other second generation reforms. The challenge would be to get their design right so that it does not end up as another incentive distorting entitlement program.

Photo: Rajesh_India

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