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India: Selected Issues

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
February 2017
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Optimal Reform Strategy in Labor and Product Markets: Isolated, Sequential or Simultaneous?1

India’s tightly-regulated labor and product markets have constrained the expansion of the formal sector of the economy, and have resulted in a sub-optimal level of employment and low productivity. Building on recent progress with product market deregulation, further labor market reforms are urgently needed to enhance the impact of product market reforms and facilitate greater and better-quality job creation.

Rigidities in Indian Labor and Product Markets

1. Tightly regulated product and labor markets in India undermine business competition, constrain the expansion of the manufacturing sector, and result in a large informal sector. The vast majority of workers in India—more than 90 percent—are employed in informal sector (unorganized) jobs. Rigidities in labor and product markets due to strict regulations have been identified as the main drivers of this large informality, which discourage firms from hiring full-time employees on full benefits.2 India ranks high on the OECD’s employment protection legislation (EPL) index, indicating a lack of flexibility in the labor market due to a multiplicity of labor laws (numbering around 250 at central and state level) and high costs of meeting legal requirements.3 The challenges of burdensome product market regulation are captured in the World Bank’s 2016 Ease of Doing Business Indicators, which ranked India 130th amongst 189 countries.1 Product and labor market rigidities have also constrained the expansion of the manufacturing sector, whose GDP share remains low (17 percent of GDP in 2014/15) and has not grown in recent decades despite many policy initiatives.

Product and Labor Market Regulations

Source: OECD.

Note: The scale of the PMR and EPL indicators run from 0 to 6, representing the least to the most restrictive regulatory regime.

2. Although significant progress has been made in enhancing the business climate and easing the burden of product market regulation, larger challenges persist in the labor market. As the Economic Survey 2015–162 pointed out, informal sector jobs were inferior to those in the formal sector—for instance, average wages in the formal sector were 20 times higher than those in informal sector. The key priority is thus enabling a labor market environment that facilitates the transition from informality and leads to higher employment and better quality jobs. Many of the recent reforms, such as easing of FDI norms, “Make in India”, as well as introduction of the pan-India GST, will ease product market rigidities and create better business opportunities. However, with limited progress on reforming labor laws, job creation and productivity gains from these reforms are likely to be small.

Short-Run and Long-Run Effects of Deregulation Reforms

3. Staff analysis indicates that lowering rigidities in Indian labor and product markets leads to an increase in GDP, employment, greater product market competition, and lowers informality. The impact of deregulation reforms is examined in this chapter using a small open-economy dynamic stochastic general equilibrium model tailored to India, featuring formal and informal sectors, endogenous firm entry, monopolistic competition and price and wage stickiness in the formal sector. Product market regulation affects firm entry costs and the degree of competition, and labor market regulation affects hiring costs and the bargaining power of workers. An easing of labor market regulations in the formal sector (reduced hiring/firing costs and bargaining power) leads to an increase in hiring of formal sector labor, higher overall employment, and greater output and exports. On the other hand, a relaxation in product market regulations, by reducing formal sector firms’ entry costs, leads to more firms setting up in the formal sector, increases competition, investment, exports and output. Entry of new firms also boosts hiring, leading to an increase in formal sector employment in the long run.3

4. Despite generating ample benefits over the long-run, deregulation entails short-term costs, posing challenges to reform4. As reallocation of resources between the formal and informal sectors following deregulation reforms takes time, economic adjustment entails a temporary fall in output, an increase in unemployment, a decline in formal sector wages, and a rise in informality, which may last up to 4-6 quarters. These short-term costs may reduce incentives for reform, which may be exacerbated by political cycles and the presence of various vested economic and political interests. Moreover, labor market reform can face challenges in gaining nation-wide momentum given that labor market regulation falls largely under the purview of the Indian states.

Interplay Between Macroeconomic Policies and Structural Reforms

5. Supportive macroeconomic policies help mitigate short-term costs. Moreover, deregulation improves the transmission and makes demand policies more effective. With a more flexible economy, the trade-off between prices and economic activity improves—a lower decline in output for the same fall in inflation following a monetary policy tightening (Figure 1)—making monetary policy more effective (Anand et al., 2016). In addition, accompanying macroeconomic policy stimulus helps bring forward long-run gains and eases political impediments to such reforms mainly through two channels: a) a direct impact through an increase in aggregate demand, and b) an indirect impact as higher aggregate demand leads to more hiring by firms in the aftermath of the reforms. However, at the current juncture, any monetary policy support should be calibrated carefully given the Reserve Bank of India’s need to bring inflation down towards the medium-term inflation target of 4 percent. On the other hand, given India’s limited fiscal space, demand-inducing deficit-neutral fiscal packages could be considered, while continued fiscal consolidation and improvements in tax collection, including as a result of GST implementation, will free up resources which can help towards providing fiscal support for deregulation reforms.

Figure 1.Monetary Policy is Less Effective Under Tight Regulations

Source: IMF staff calculations.

Note: The impulse response functions shown above are responses to a 50 basis point positive one-period shock to the interest rate. Each variable’s response is expressed as the percentage deviation from its original steady-state value.

6. Structural reforms can help boost India’s ongoing economic recovery. We consider the following policy experiment: the impact of a negative productivity shock in the formal sector at quarter 0 (lasting about 5-6 years for the economy to return to initial steady state) under two scenarios: a) followed by a permanent change in labor market regulation in quarter 1 (black dashed line in Figure 2); and b) no deregulation reform at all (black solid line in Figure 2). Lower aggregate productivity reduces the present discounted value of product and job creation in the formal sector, leading to a fall in the number of producers and hiring in the formal sector, thus leading to lower investment, formality and a fall in GDP below its potential. However, when followed by lowering rigidities in the labor market it induces workers and firms to shift from the informal to the formal sector, which helps mitigate the contractionary impact of a negative productivity shock, resulting in a faster recovery.

Optimal Reform Strategy—Isolated, Sequential or Simultaneous?

7. Which is better—isolated, sequential or simultaneous reforms? Analysis of the optimal strategy for implementing deregulation policies entails comparison of the macroeconomic outcomes across five reform scenarios: two scenarios with either labor or product market reform implemented individually; two scenarios that entail different sequencing of the two reforms; and a scenario with a simultaneous package of reforms. In the case of a sequential approach, the time lag between the reforms is assumed to correspond to India’s five-year-long electoral cycle (Table 1).

Table 1.Macroeconomic Impact of Various Reform Strategies
Policy SequencingVariables (% change)
PolicyYearGDPCons.ExportsInv.UnempFormality
Labor market reforms (LMR) firstLMR only1 year1.13.4−4.82.1−6.51.2
5 years4.25.11.65.9−12.54.0
PMR & LMR6 years5.85.63.79.8−13.34.3
(% change from previous period)1.50.52.03.6−0.90.3
Product market reforms (PMR) firstPMR only1 year1.73.9−4.11.8−9.6−2.8
5 years3.05.1−11.17.8−17.1−7.0
LMR & PMR6 years2.45.0−2.42.2−8.9−0.1
(% change from previous period)−0.6−0.19.7−5.29.97.4
Simultaneous implementation1 year2.84.4−2.75.3−8.81.4
5 years6.36.04.310.2−14.24.2
Long run impact20 years9.18.610.711.0−19.44.6
Source: IMF staff estimates.Note: Cons. is real consumption, Inv. is real investment, Unemp. is unemployment, and formality is relative share of formal labor
Source: IMF staff estimates.Note: Cons. is real consumption, Inv. is real investment, Unemp. is unemployment, and formality is relative share of formal labor

8. Simultaneous reform packages and sequential deregulation strategies have lower economic costs compared to a single reform outcome. Implementing a complete reform package reinforces the gains when compared to the individual reform scenarios, leading to larger overall macroeconomic gains. While both of the sequential scenarios and the simultaneous reform scenario have the same impact over the long-term, the simultaneous reform scenario results in the lowest costs of transition and also leads to a steady and faster increase in output, investment, exports and formality (Figure 3). These results suggest that prioritizing and sequencing such reforms can be particularly important for optimizing their impact in the current environment of limited policy space in India.

Figure 2.Structural Reforms Help Boost Recovery from a Recession

Source: IMF staff calculations.

Note: The impulse response functions shown above are responses to a 10 percent negative productivity shock in the formal sector: a) with no deregulation reform (black solid line); and b) followed by a deregulation reform in the labor market (dashed line). Each variable’s response is expressed as the percentage deviation from its original steady-state value.

Figure 3.Sequential versus Simultaneous Reform Scenario

Source: IMF staff calculations.

Note: The impact is the percentage change in each variable over time where the black dashed line shows the impact of a simultaneous package of reforms; blue solid line shows the impact of implementing labor market reforms first followed by product market reforms; and red solid line shows the impact of implementing product market reforms first followed by labor market reforms.

Policy Recommendations

9. Labor market reforms are a top priority. In the context of India’s large informal sector, staff analysis suggests that in terms of maximizing macroeconomic gains and minimizing short-run economic costs, beginning with labor market reform is preferred to other policy scenarios. There are three key factors driving these results:

  • Even though product market reform leads to an increase in the share of formal sector output, it does not necessarily generate greater formal sector employment, as unchanged regulations and high costs of hiring labor in the formal market encourage firms to increase their capital intensity and hire labor on an informal basis. On the other hand, when labor market reforms are implemented first, formal sector employment increases even in the short-run and stays at higher levels throughout. This in turn leads to higher profits and investment in the formal sector, and faster and greater gains in unemployment, consumption and GDP.
  • While a fall in net exports in the short-run is present in all policy scenarios—arising from a moderate real appreciation—a recovery is quicker when labor market reform is implemented first, as lower labor costs gradually increase export competitiveness. This result is consistent with Raissi and Tulin (2015) who find: (i) a positive link between Indian exports and their price competitiveness that is being dampened by labor market rigidities; and (ii) a positive long-run relationship between labor market flexibility and exports.
  • The short run costs of product market reforms are alleviated when implemented in a more flexible labor market environment, thus leading to a steady and smooth transition towards the new steady state. However, implementing labor market reforms well after goods market reforms carries with it some undesirable adjustment costs. Reforming product markets first increases formal sector wages, which may result in greater opposition to any subsequent labor market reforms.

Therefore, the policy agenda should be geared toward enabling greater labor market flexibility. This will help India achieve its manufacturing potential, and meet its demographic transition and income-raising challenges.

References

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1

Prepared by Purva Khera and Volodymyr Tulin.

3

Although the Industrial Disputes Act (IDA) of 1947 is the basis for industrial labor regulations in India (requiring firms employing 100 workers or more to seek government permission to dismiss a worker or close a plant), 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).

1

This is a slight improvement on the 2015 ranking, where India placed 134th, with the increase in the ranking being due to an increase in the ease and speed of acquiring an electricity connection, and a decrease in redundant inspections.

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