Information about Asia and the Pacific Asia y el Pacífico
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India: Selected Issues

International Monetary Fund. Asia and Pacific Dept
Published Date:
February 2014
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Information about Asia and the Pacific Asia y el Pacífico
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Macroeconomic Effects of Labor and Product Market Deregulation in India1

Tightly-regulated labor and product markets in India have given rise to a large informal sector, sub-optimal level of employment, and low productivity. Our analysis suggests that reforms can increase employment, improve competitiveness, and boost potential growth. A package of reforms reinforces the gains, minimizes short-term costs, and increases the acceptability of these politically-difficult reforms. These reforms will help harness demographic dividend by absorbing India’s rapidly-growing labor force.

1. Despite some progress, product and labor markets remain tightly regulated in India. Although significant progress has been made in liberalizing product markets in India, product market competition remains low. The OECD’s product market regulation index (2008) suggests that product markets in India are less competitive compared to other OECD countries (including the emerging market economies within the OECD area, Table 1). Labor market rigidities remain high because of multiplicity of labor laws and high costs of meeting legal requirements. Although the Industrial Disputes Act (IDA) of 1947 is the basis for industrial labor regulations in India (it requires firms employing 100 workers or more to seek government’s permission to dismiss a worker or to close a plant),2,3 firms are required to comply with numerous laws governing different aspects of the labor market (such as laws governing minimum wages, resolution of industrial disputes, conditions for hiring and firing workers, and conditions for the closure of establishments). In addition to being time-consuming, this implies much higher costs for the firms, which to a large extent determines their size and operations of these firms.

Table 1.Product Market Regulation in India: An International Comparison






United States
Overall Indicator2.851.491.981.491.822.081.03
State Control3.472.122.462.402.742.161.19
Barriers to Entrepreneurship2.571.461.891.431.441.941.20
Barriers to Trade

and Foreign

Source: OECD’s product market regulation (PMR) index, 2008.Notes: The scale of the PMR indicators runs from 0 to 6, representing the least to the most restrictive regulatory regime.
Source: OECD’s product market regulation (PMR) index, 2008.Notes: The scale of the PMR indicators runs from 0 to 6, representing the least to the most restrictive regulatory regime.

2. High labor and product market rigidities have resulted in a large informal sector in India and sub-optimal employment. The unorganized sector employs nearly 90 percent of the Indian workforce, and contributes almost half of India’s GDP (Figure 1). The large size of the informal market has been attributed to tightly regulated formal (organized) sector, which forces firms to remain small and informal to avoid regulations (Ulyssea, 2010 and WTO, 2009). In addition, regulations have encouraged capital-intensive modes of production, resulting in sub-optimal employment, as high costs associated with firing workers have forced firms to hire sub-optimally despite a liberal hiring policy (Kathuria, 2013). Product and labor market rigidities have also constrained the expansion of manufacturing sector, whose share remains low (15 percent of GDP) and has not grown despite many policy incentives (World Bank, 2004).

Figure 1.Informality in India

Sources: Report on the Conditions of Work and Promotion of Livelihoods in the Informal Sector, National Commission for Enterprises in the Unorganized Sector (based on National Sample Survey Organization (NSSO) data) Note: The informal (or unorganized) sector, by definition, consists of self-employed, and those working in establishments with less than 10 workers.

3. In addition, tight regulations have hurt productivity and labor welfare. On average, value added per worker in India’s informal manufacturing sector is about one tenth that of the formal sector.4 With an incentive to remain in the informal sector (to avoid regulations), firms fail to benefit from economies of scale, and are generally much less productive than formal sector enterprises. Although the informal sector provides employment opportunities, the high level of informality has failed to improve labor welfare (as workers operate in an unregulated environment), negating the very motive of these pro-worker regulations.

4. A dynamic stochastic general equilibrium (DSGE) model with informality and product and labor market rigidities for India is used to study the impact of deregulation. The model—estimated on ten key macroeconomic variables from 1996 to 2008 using Bayesian estimation techniques—adds the informal sector and unemployment in a standard small open economy DSGE model. To capture rigidities in formal product markets, firms in the formal sector face higher entry costs (to set up a new business) and have higher market power (relative to the informal sector firms)5. Labor market rigidities are modeled by a higher cost of hiring and firing workers in the formal sector. Also, workers employed in the formal sector have higher bargaining power in the wage determination process (i.e. unionized labor).6 Only goods produced in the formal sector are exported and only formal sector workers pay taxes.7

5. Results suggest that labor market and product market reforms can increase output, exports, employment and formality in the long run. A relaxation of labor market regulations in the formal sector (reduced hiring/firing costs and bargaining power) increases labor hiring by the formal sector firms, higher employment and size of the formal sector (Figure 2). More firms enter the formal sector due to increased output and profitability, increasing competition and lowering the prices of formal goods. This improves the competitiveness of the economy leading to an increase in exports. A relaxation in product market regulations (reduced entry cost and increased competition) stimulates investment and increases output (Figure 3). Increased competition improves the economy’s competitiveness and exports. New firm entry also boosts job hiring, leading to an increase in formal sector employment.

Figure 2.Long-Run Effects of Labor Market Deregulation

Source: IMF staff estimates.

Figure 3.Long-Run Effects of Product Market Reforms

Source: IMF staff estimates.

6. A package of reforms could minimize the short-term transitional costs associated with individual reforms. While all reforms are found to stimulate GDP and formality in the short run, some of them may temporarily—typically for one to two years—increase economy-wide unemployment (due to frictional unemployment), if implemented in isolation. In particular, the reform leading to a fall in the bargaining power of workers in the formal sector without lowering hiring/firing costs, results in higher unemployment. Increased competition in the product market without reducing entry barriers has similar short-run costs. If policies to lower the bargaining power of workers are implemented simultaneously with policies to reduce hiring and firing costs (which immediately results in increased hiring and reduced unemployment), transitional costs are minimal (and may even be reversed). Similarly, reducing entry costs along with increasing competition minimizes the transitional costs, as reduced entry barriers encourages new firms to enter the formal sector, boosting formal sector employment, leading to a decline in unemployment. In addition, simultaneous reforms to product and labor markets also reduce transitional costs and maximize long-run gains. Compared with individual reforms, a broad package yields a larger income gain, the expectation of which immediately boosts aggregate demand and job hiring.


    KathuriaV.2013Efficiency Comparison between Formal and Informal Firms—Evidence from Indian ManufacturingThe Journal of Industrial Statistics.

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    UlysseaG.2010Regulation of Entry, Labor Market Information and the Informal SectorJournal of Development Economics Vol. 91 pp. 8799.

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    World Bank2004India Investment Climate Assessment 2004: Improving Manufacturing Competitiveness” (Washington: The World Bank).

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    World Trade Organization2009Globalization and Informal Jobs in Developing Countries” (Geneva: World Trade Organization and International Labor Office).

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Prepared by Rahul Anand and Purva Khera. Based on R. Anand, P. Khera, Z. Munkacsi, and M. Saxegaard, 2014, “Macroeconomic Effects of Labor and Product Market Deregulation in an Environment of Labor Market Informality: An Application to India and South Africa,” IMF Working Paper (forthcoming).


Data from the Ministry of Labor shows that in 2000 there were 533,038 pending cases of labor disputes in India’s labor courts, most of which dealt with retrenchment; and of these 28,864 cases have been pending over ten years.


The Act was passed by the central government, and applied equally to all states. This Act has been amended by state governments, which has caused the states to differ markedly in their labor regulation.


Estimates based on National Sample Survey Office (NSSO, 2001) and Central Statistical Organization (CSO, 2001).


Higher market power implies less competitive formal goods market.


Households (assumed to be identical) are either employed in the formal sector, employed in the informal sector or unemployed.


Both capital goods and government services are provided solely from the formal sector and the latter are financed by an employment tax.

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