Asian Journal of Law and Economics 2015; 6(1): 6584

Irfan Ahmad Sofi* and Pritee Sharma

Labour Laws and Informalisation of

Employment: Panel Evidences from Indian
Formal Manufacturing Sector
Abstract: Labour law is widely being cited as one of the principal factors creating
rigidities in industrial business and, thereby, holding back productivity growth
and employment generation. However, a substantial chunk of literature disputes
the rigidity argument on the ground that there has been a sharp growth in
informal employment, which is often considered as flexible labor input as it does
not fall under the purview of what is believed to be directly related with rigidity employment protection legislation (EPL). However, given empirical evidence
showing that informal worker is less productive as compared to its formal (regular)
counterpart, the question arises: what motivates the employer to employ less
productive worker? Using three-dimensional panel data on 28 industrial sectors
between 19992000 and 20072008 across 13 states of India, our results show that
the incidence of informal employment is directly linked with EPL, volatility, and
labor bargaining power. We utilize instrumental variable two stage least square (IV
2SLS) to overcome the endogeneity issues. The results are robust.
Keywords: bargaining power; employment protection legislation; informal
employment; rigidity; volatility.
JEL codes: J21; K31.
DOI 10.1515/ajle-2014-0007

1 Introduction
The abysmal performance of Indian manufacturing sector for the last couple of
decades has dismayed the economists and policy makers who expected that it
(manufacturing sector) would serve as an engine for economic growth, and would
*Corresponding author: Irfan Ahmad Sofi, School of Humanities and Social Science, Indian
Institute of Technology Indore, M-Block, IET DAVV Campus Khandwa Road Indore, Madhya
Pradesh, Pin Code: 452017, India, Cell no: +918370038163, e-mail: sofiirfan.irfan@gmail.com
Pritee Sharma: School of Humanities and Social Science, Indian Institute of Technology Indore,
M-Block, IET DAVV Campus Khandwa Road Indore, Madhya Pradesh, Pin Code: 452017, India

66Irfan Ahmad Sofi and Pritee Sharma

generate thumping employment opportunities, so as to ensure that the country
reaps the benefit of demographic dividend. For the last three decades, not only
is the share of manufacturing employment and output suspended at a meager
level, but also the emerging issue alarming the policy-makers most, is the upward
trajectory of informalisation of employment and that too in the formal manufacturing sector. In the last 10 years, the manufacturing sector may have witnessed
a considerable growth in output; however, the growth of employment has been
stuck around 23%, causing the share of employment to be rather low at around
12%. And what captivates the attention of the economists and policy makers
is the fact that the share of contract workers, which fall outside the purview of
employment protection legislation (EPL), has gone up to 35% in 20102011 from
13% in 19931994, as per Annual survey of Industries (ASI) data.
In India, pioneered by Fallon and Lucas (1991), the discourse on labour law
and its impact in industrial sector has reached to the extent that even the government has taken on board the potential effects of pro-worker laws such as EPL
(Sunder 2012). A substantial body of literature exists showing a negative impact
of EPL on growth in output, employment and productivity (see, e.g., Besley and
Burgess 2004; Mitra and Ural 2008; Ahsan and Pags 2009; Gupta, Hassan,
and Kumar 2009; and Dougherty, Roubles, and Krishna 2013). However, given
the fact that informal employment such as contractual employment in Indian
manufacturing, and elsewhere also, does not fall within the purview of EPL,
many researchers have claimed that by substituting contractual employment for
regular employment, employers have managed to evade the labour laws. Besides,
researchers also claim that there may exist a plethora of labour laws, but due to
weak enforcement machinery, their effectiveness has been awful.
The upward trend in informal employment does not prevail only in developing countries, like India, it is also increasingly emerging in developed
countries as well (see, e.g., ILO 2012; OECD 2013). Besides India and OECD
countries, the sharp growth in informal employment has been registered also
in Scandinavian countries, where it has increased four times in the last two
decades, and also in some of the European countries, where it has nearly
doubled (CIETT 2007).
Although contractual employment offer flexibility to employers in employment adjustment, economists believe that informal labour in general is an inferior labour input as compared to regular worker (Sen, Saha, and Maiti 2013).
Literature shows that informal employment does not augur well for productivity and efficiency, which is a key to competitiveness (Kleinknecht etal., 2006).
Likewise, given the fact that informal workers are offered lesser wages as compared to regular workers, Maiti (2013) has shown that contractual employment
may help employers in saving on wage bills, but it does help them in boosting the

Labour Laws and Informalisation of Employment67

productivity. Therefore, the question arises: why then employers prefer to choose
contractual labour rather than the regular labour?
Under this backdrop, this study mainly focuses on investigating whether
there is a link between employment protection legislation (EPL) and informalisation. Besides, we link contractual employment with labour bargaining power and
volatility as well.
The study is based on 3-digit level data on 28 industrial sectors across 13
major states of India for time period 19992000 to 20072008 t hree-dimensional
panel data. We exploit the state level variation in EPL and quantify it, using leximetrics approach, to capture its impact. Given a dearth of literature on the issue,
this study significantly adds to the existing body of empirical literature. Unlike
most of the existing studies in India and/or internationally, which could not
exploit the fixed effect strategy owing to the time-invariant nature of EPL indexes
available, we are able to provide the evidences, in fixed effect framework. The
results show that informal employment is positively linked with EPL. Further,
our results show that with the increase in workers bargaining power, employers
tend to substitute informal-employment for the formal. Finally, we also provide
the evidence showing a positive association between volatility of demand and
informal-employment. Our results are robust to endogeneity that we remove by
following the instrumental variable two stage least square (IV 2SLS) estimation.

2 Labour Laws in India

Article 246 of the Indian constitution offers the legislative authority to central as
well as state governments. Consequent to this, there exists a considerable variation in pro-worker labour laws across states. There are as much as 100 labour laws
at central level and 50 at state level, governing the employer-employee relations
(SNLC 2002). The most debatable are those that are provided under Industrial
Disputes Act (IDA), 1947 and Contract Labour Act (CLA), 1970. The chapter V-B
of the IDA 1947 provides for the job-security to workers working in firms with at
least 100 hundred workers. It requires the employers to have government permission for retrenchment and layoffs. Section 25-B provides that a worker can claim
regularization of his/her service after working continuously for 240 days. Section
25-f provides that employer ought to pay monetary compensation or severance
payment towards worker on layoff or retrenchment following a formal issuance
of notice to the worker. Workers covered by these laws are generally considered
as regular formal workers as their jobs are protected to a large extent by the very
laws. On the other hand, contract workers, which are generally hired through

68Irfan Ahmad Sofi and Pritee Sharma

contractors, are not covered by these laws and hence they are considered as
informal workers whose jobs happen to rather precarious in nature. Employers
are in a position to fire out the contractual worker without any barrier and cost.
Therefore, in literature, contractual labour is considered as flexible labour input.
Besides, the contractual employers are not represented by labour unions either,
hence they are left with lesser bargaining power as compared to regular workers.
Nevertheless, the contractual employment system is covered under Contract
Labor Act (1970) it covers firms and contractors employing 20 or more contract
workers. The act exempts establishments performing intermittent work, work
performed for <120 days and seasonal work, which is performed for <60 days
(Sunder 2012). Section 10 (1) of the Act provides for the prohibition and abolition of contract employment, authorising the government to abolish or prohibit
the contract employment if and when required. The act lays down the provisions
under section 119 in chapter V for improvement of health and welfare of contractual workers. Besides, under rule 2 (V) (a), the act makes incumbent upon
the principle employer to pay the same wages to contractual worker as paid to
permanent worker, if they perform the same work. However, bypassing the provisions of the Act, employers have resorted to enormous use of contractual labor
force, claiming that the need of contractual employment arises mainly due to
rigidities created by the employment protection under IDA. The share of the contract worker has increased sharply from 13% in 19931994 to 35% in 20102011,
as per ASI data (see also Bhandari and Heshmati 2006; Maiti 2013). As per ASI
data, the incidence of contract employment henceforth, contractualisation
during 20042005 is higher in states like Andhra Pradesh (55.23%), Haryana
(44%), Gujarat (34.28%), Rajasthan (35.51%), and Uttar Pradesh (31.41%). On
the other hand, it is lower in states like Kerala, Tamil Nadu, and West Bengal
(Sunder 2004). There is considerable variation in state-wise incidence of contractual employment over time during our sample period. It also varies substantially
across industries also. The industry-wise average incidence of contractualisation
is shown in Chart 1. It covers the period 19992000 to 20072008 for the selected
28 industries constituting the sample for this study.

3 Literature Review
The impact of Employment Protection Legislation (EPL) on industrial performance is documented well in the theoretical literature (see, e.g., Nickell 1986;
Bertola 1990; Hamermesh 1993; Hopenhayn and Rogerson 1993). Bertola (1990)
developed a dynamic partial-equilibrium model in which he shows how the firing

Labour Laws and Informalisation of Employment69

publishing

Printing and

spining, weaving

Other food

Special purpose

other textiles

General purpose

Plastic products

Electric

Rubber products

other fabric

Insulated wire

other chemical

Furniture

paper and paper

Basic precious

Basic Iron and

Casting of metals

basic chemicals

Refined

Electricity dist

Grain mill

Dairy products

Structural metal

ppp of

Beverages

Non metalic

Intensity of worker contractualisation

0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0

Chart 1:Intensity of Worker Contractualisation.

costs imposed by EPL can distort the optimal employment policy of a firm. the
model shows that at times when market demand is subdued and the labour force
available with employers become unprofitable, the firing costs associated with
EPL has the potential to hinder the layoffs, resulting into redundancy in firms and
thus lead to inefficiencies. The model also shows that these firing costs also serve
as prospective costs, which are taken into consideration by employer while hiring
fresh workers. Therefore, during favorable economic conditions, the actual hiring
of worker may be lesser than the desired. In this way, the EPL is shown to have
the potential of creating inefficiencies and stifling employment generation. Likewise, Hopenhayn and Rogerson (1993) developed a general equilibrium model
based on US economy that accounts for entry and exit of firms. They presuppose
a context, wherein job creation and destruction of firms take place every period in
response to firm-specific shocks; and then explain that the average employment
in US would be positively linked with firing costs as the latter will result in lesser
firing. However, this model also shows that the firing costs would impinge upon
firm entry and job creation in newly created or existing firms. In their empirical analysis, they find that higher firing costs in US negatively affected average
employment. In his model, Kugler (2000) shows that job security regulations
would induce the firms with higher labour-turnover to operate in informal sector.
Also, the effect of EPL is also drawn from the insider/outsider literature (see, e.g.,
Lindbeck and Snower 1987).
The increasing trend in informal employment across the world predominantly
in developing countries like India drew attention from researchers into studying
the various aspects of the informal employment system [see, e.g., Autor (2003)
for America; Pierre and Scarpetta (2013) for cross-country level; Almeida and
Almeida and Carneiro (2009) for Brazil, Gimpelson, Kapelyushnikov, and Lukyanova (2010) for Russia; and Ronconi (2010) for Russia]. However, the literature

70Irfan Ahmad Sofi and Pritee Sharma

on causes of informal employment is scarce especially from Asian region. Specifically, in India, despite the alarming trajectory of informalisation breaching
even core activities of business in manufacturing sector, the literature on informalisation did not cast light on the causes of sharp growth in informal employment and the impact of labour laws on regular employment. Goldar (2009) only,
attempts to link informalisation with labour laws using 3-digit level cross-section.
The study draws on state-level variation in labour laws to capture the impact.
He concludes that EPL significantly contributes to informalisation. The finding
of the study may, however, be questionable on several grounds. One, that it is
based on too small number of observations. Second, it does not account for the
fixed effects in the model, which are crucial for studies involving various states
that significantly differ from each other on economic policy front, political ideological front, and natural characteristics. Besides, it also omits several important
control variables. Kapoor (2014) recently brought up the issue of dualism in workforce, i.e., co-existence of regular and contractual worker, in the context of labour
laws. In her non-econometric article, she concludes that reforming labour laws
in employer direction may not help create job, adding that there is a need to curb
the dualism in labour market. However, she too fails to explain the basic causes
of the dualism.
However, there is a substantial body of literature in Indian context using
econometrics techniques which examines the economic effects of EPL on employment, output and productivity in Indian manufacturing sector. The literature has
followed two distinctive mythological approaches. One type of aproach is what
economists call as before and after which is pioneered by Fallon and Lucas
(1993). Under this approach, researchers exploited upon the fact that the EPL was
made further stringent with the amendments in IDA in 1976 and 1982. Using time
series econometrics techniques, the impact of EPL is captured by using before
and after. And, the second approach, pioneered by Besley and Burgess (2004),
is exploiting upon the fact that state governments in India are competent to legislature over labor and/or to amend the central laws and hence there exists a
considerable variation in the stringency of labour laws across various states. In
this approach, researchers capture the impact of EPL by using the state-level variation in labour laws, using panel data econometric model estimation techniques.
In their study for the period 19591982, Fallon and Lucas (1993) exploited
the fact that the EPL was made further stringent with the amendments in IDA in
1976 and 1982. They created the dummy variable, taking the value zero up to
19751976 and one thereafter. The findings of their study show that the sluggishness in employment adjustment was not significantly higher after 19751976
than before. However, they find that the amendments had a significant impact on
employment, especially in large business establishments covered by EPL under

Labour Laws and Informalisation of Employment71

IDA. Along the similar methodological line, Roy (2004) finds in his analysis that
there were significant rigidities in employment adjustment. However, he notes
that the rigidities existed even before 19751976.
Besley and Burgess (2004) constructed an index, henceforth BB index, using
the amendments undertaken by state governments to Industrial Disputes Act
(IDA). The study classifies the amendments into three categories pro-worker,
pro-employer, and neutral and assigns the scores 1, 1, and 0, respectively.
The scoring/coding is based on reading all the state level amendments to the
Industrial Disputes Act of 1947 from Malik (1997). By cumulating the scores over
time, they construct a stringency measure of EPL. Using the index along with
control variables, they investigate the impact of EPL on industrial performance.
The study concludes that EPL has a negative impact on output, employment,
and investment. However, the study drew many criticisms from researchers on
grounds such as false interpretation of certain amendments, and faulty coding
and cumulation procedure (Bhattacharjea 2006). However, after making the
changes in the BB index as per Bhattacharjea (2006), many studies find the
results are still in line with Besley and Burgess (2004) see, e.g., Ahsan (2009);
Adhvaryu, Chari, and Sharma (2014) etc. Using OECD index, Dougherty, Roubles,
and Krishna (2013) carried out a firm-level analysis and find higher productivity in firms that are operating in flexible states. Similarly, Mitra and Ural (2008),
using BB index, finds a positive effect of industrial-de-licensing in flexible states
on labor productivity.
Our study is important because it contributes in the existing literature by overcoming the above-mentioned research gaps in the literate. Besides, we also study
the link between informalisation, and labour bargaining power and volatility.

4 M
 easuring Employment Protection
Legislation(EPL)
To capture the impact of employment protection legislations on the incidence of
informal employment, we exploit the state-level variation in these legislations to
categorize the states into rigid, flexible, and neutral. Using Besley and Burgess
(2004) database on labour laws, OECD index (2007), and Bhattacharjea (2006)
we derive the quantitative index capturing the state-wise stringency of EPL, using
majority principle. We designate a state as rigid and assign it score 1 if majority of the three sources (or measures) treat the given state as rigid. For example,
under BB index and OECD index (2007), West Bengal is picked up as a state with
flexible labour market. Therefore, we assign score 1 to it. Likewise, under BB and

72Irfan Ahmad Sofi and Pritee Sharma

OECD index, Andhra Pradesh is picked up as a state with flexible labor market
so we assign score 1. And, if the state is picked as having neither too rigid nor
too flexible labor market, we pick it as neutral and assign score 0. In this way,
we calculate what we call as EPL index (EPLI) varying from 1 to 1 (see column
5, Table 1). The main limitation of this index is that it is time-invariant and, therefore, is not compatible with fixed effect model specification unless interacted
with relevant time-variant variable.
The use of majority principle, in this context, has manifold merits. It overcomes the potential measurement errors subject to single source, unless the error
lies systematically in all the three sources. And, the OECD index (2007), which is
a latest one taking into account also the enforcement of the pro-labour legislations, ensures that under majority rule, any reforms undertaken by central or
state government between 1999 and 2008 are taken care of while reaching at the
quantitative regulatory index.
We make two changes in the BB index. First, as noted by Bhattacharjea
(2006), Gujarat is designated as rigid by BB index on account of a single inconsequential amendment. Therefore, we pick Gujarat as neutral state and assign
score 0 to it. Likewise, the average value of cumulative scores under BB method
for Madhya Pradesh is very close to zero. We effectively assign it 0 and treat the
state as neutral.
Table 1:Employment Protection Legislation Index (EPLI) Based on Majority Rule on BB
Index, OECD Index, and Bhattacharjea (2006).
State

BB Index

Battacharjea

OECD Index

Andhra Pradesh
Gujarat
Haryana
Karnataka
Kerala
Madhya Pradesh
Maharashtra
Orissa
Punjab
Rajasthan
Tamil Nadu
Utter Pradesh
West Bengal

Flexible
0*
0
Flexible
Flexible
0*
Rigid
Rigid
0
Flexible
Flexible
0
Rigid

0
0
0
Flexible
0
0
Rigid
Rigid
0
0
Flexible
Flexible
0

Flexible
Flexible
Flexible
0
Rigid
0
Rigid
0
0
Flexible
0
Flexible
Rigid

*Original coding was changed based on narrative/evidence from other studies.

State gets code 1 if majority of studies (i.e., at least two out of three BB index,
Battacharjea, and OECD index) designate it as a flexible state. Likewise, it gets 1 or 0 if
majority designates it as a rigid or neutral, respectively.

EPLI
1
0
0
1
0
0
1
1
0
1
1
1
1

Labour Laws and Informalisation of Employment73

5 Empirical Strategy
5.1 Econometric Model: Three-Dimensional Panel Regression
To investigate under fixed effect model1 whether employment protection legislation (EPL) and bargaining power constitute disincentives to employment of formal
workers, we first identify a relevant time-variant variable with which the EPL
index (EPLI) can be interacted to make it compatible with the fixed effect model.2
The time variant variable must, in this context, be strategically related with the
share of contractual worker, preferably negatively. For this purpose, we draw on
the empirical evidence in Sapkal (2014) which shows a decreasing impact of fixed
capital a proxy for technology on the share of contract workers, suggesting
that the industries using more technology prefer less contractual workers and
more regular worker. To confirm this, we run a regression of the following form:

( CW / TW )ist = o + 1 K / List + Xk k + i + s + t + ist(1)

Where, (CW/TW)ist is the log ratio of contractual worker to total number of workers
in industry i, state s and year t the total number of workers is equal to the
sum of contractual and regular workers. K/List is the log ratio of total fixed capital
to total labour force proxy for technology. The coefficient of our interest (1)
captures the impact of technology on the relative share of contract workers. Xkk
is a vector of state-specific and industry-specific control variables. i, i and t are
the industry, state and year fixed-effects, respectively. The results in column 1,
Table 3, show that the coefficient on K/L is negative and highly significant, implying that the higher use of technology discourage the employment of contractual
workers and encourage that of regular workers.
Now, in order to estimate with fixed effect model the impact of EPL on relative
share of contract workers, we interact the EPLI with K/L, as follows:
( CW / TW )ist = o + 1 K / List + 2 K / List EPLI s + 3 S / Lst + Xk k + i + s + t + ist(2)

1The importance of using fixed effect model arises from the fact that under the Hausman test,
the null hypothesis of zero correlation between error term and explanatory variables is rejected.
In other words, the hypothesis of coefficient estimates of random of random effect model and
fixed effect model are equal to one another is rejected, which suggests that random effect estimator is inconsistent. Besides, as our data is three-dimensional panel involving cross-industry
as well as cross-state variation, therefore it is important to include fixed effects in the model.
2Since the EPLI is a time-invariant variable, it cannot be included separately in the fixed effect
model. We must interact it with a relevant time-variant variable, so as to include it in the model.

74Irfan Ahmad Sofi and Pritee Sharma

Given the negative sign on 1 in equation (1), if EPL is there as a disincentive to
employment of regular workers, then the coefficient on the interaction between
EPLI a proxy for rigidity and K/L (i.e., 2) is likely to be positive. The positive
significant coefficient on the interaction would suggest that the more use of technology in states with rigid labour markets encourages the employment of contractual workers.
To measure the impact of labour bargaining power, we use ratio of number
of strikes to number of lockouts (S/Lst) as a proxy for bargaining power.3 Number
of strikes per lockout is an appropriate measure of worker bargaining power,
with higher value of it indicating higher bargaining power for regular workers
(Sen, Saha, and Maiti 2013).

5.2 Autocorrelation and Endogeneity Issues

To deal with the problem of auto-correlation in the model, we estimate robust
standard errors clustered at the industry-by-state level (Bertrand, Dufflo, and Mullainathan 2004). One of the major concerns in our model is the reverse causality
between S/L and CW/TW. Increasing usage of contractual worker may provoke the
regular (or permanent) workers into resorting to strikes, causing a bi-directional
relation between the share of contractual worker and ratio of strikes to lockouts.
The bi-directional relation or reverse causality may in turn lead to the problem of
endogeneity, which in turn may detract from the credibility of the estimates. To
overcome such problem, we follow instrumental variable two stage least square
(IV 2SLS) estimation. We run a first stage least square (FSLS) whereby we estimate, using some valid instruments, the endogenous ratio of strikes to lockouts
(S/L). Then, we store the predicted values of it, which are free from endogeneity.
In other words, the predicted value (s
/ l) also called as instrumented is an
exogenous variable. Then, this predicted variable is included back in equation
(2) to measure the impact of labour bargaining power on contractualisation. This
approach is formally discussed as follows:
First stage least square:

( S / L ) FSLS st = 0 + Zn n + st n 1, 2, , n(3)

3Strike is a refusal to work, organized by a body of employees as a form of protest, typically

in an attempt to gain a concession or concessions from their employer. On the other hand, lockout is the exclusion of employees by their employer from their place of work until certain terms
are agreed upon.

Labour Laws and Informalisation of Employment75

Where, Zn is a vector of instruments fulfilling the following conditions:

Cov( Zi , ist ) = 0 and Cov( Zi , S / Lst ) 0
Two stage least square:
( CW / TW )ist 2 SLS = o + 1C / List + 2C / List EPLI s + 3 s
/ l st + Xk k + i + s + t + ist(4)

Where, ( s / l ) is instrumented strike to lockout ratio or estimated values of the
ratio.
Thus, for policy implications, we are finally interested in equation (4).

5.3 Test of Over-Identifying Restrictions

The instruments we employ in equation (3) must be valid in that they have to
satisfy the condition, Cov(znist, ist)=0. We check the validity of the instruments
using Sargans test, whereby we calculate the residuals from 2SLS and then
regress them on the instruments and the remaining other exogenous variables
included in our original equation. This is as follows:

2 SLS
ist
= o + n Znist + kk Xkist + vist (5)

Under the Null hypothesis, H0 : Cov(znist, ist)=0, N*R2X2 with L-K degrees of
freedom. Where, L is the number of instruments and K is the number of endogenous right hand side variables in the original equation. If the null-hypothesis (H0)
is not rejected based on the Sargan statistics, then we may consider the instruments as valid.
To identify the relevant instruments for endogenous ratio of strikes to
lockouts, we draw on the information in Botero et al. (2004), which shows
that the left of the centre political parties across the world lead more stringent
pro-worker regulations and happen to be more inclined towards labour unions.
Likewise, in India too, the left of the centre political parties are claimed to be
pandering to labour unions, and are biased more in favour of workers than
employers (Aghion etal. 2008; Cali and Sen 2011). Therefore, we exploit the relative share of electoral seats occupied by various groups of political parties in
state legislature, between 19992000 and 20072008. Between this time-period,
there had been at least two rounds of state elections, causing a pronounced variation in the electoral seat share. For classifying the political parties according
to their fundamental ideologies left or right, we follow Aghion etal. (2008).
The political parties are classified into three categories soft left, hard Left,

76Irfan Ahmad Sofi and Pritee Sharma

and right of the centre party.4 We expect a positive effect of electoral seat share
of soft-left and hard-left party on the ratio of strikes to lockouts; and a negative
effect of left of the centre partys share of electoral seats, in the state legislature,
on the strike to lockout ratio.

5.4 Data Source

We use ASI (Annual Survey of Industries) 3-digit level data on 28 industrial
sectors, across 13 states, between 19992000 and 20072008. The data on fixed
capital stock, total number of workers, number of workers employed through
contractors (contract workers),5 Consumer price index number for industrial
workers (CPI-IW) is collected from Central Statistical Organisation (CSO). The
data on control variables such as development expenditure, road length density,
per-capita power consumption are collected from Indian Labour Bureau government of India and CMIE states of India. Data on number of strikes and lockouts
is taken from Labour Bureau government of India. Data on per capita net state
domestic product (PCNSDP) is taken from CSO. We convert the data on daily earnings of contractual and regular workers, using CPI-IW. The summary statistics of
the key variables is presented in Table 2. The average value of regulatory stringency (or rigidity) is 0.153 with standard deviation of 0.769. The average share of
contractual workers for the selected sample, between 19992000 and 20072008,
is 0.491 with standard deviation of 0.997.

6 Empirical Results
6.1 I mpact of EPL and Labour Bargaining Power
onInformalisation
The policy implications of our study are based on the 2SLS equation equation
4. But before estimating it, we first estimate OLS equation equation 2 to see
how the results turn up when the endogeneity concerns are not taken care off.
As discussed in Section 5.1, the existing literature finds that in capital-intensive

4Soft Left includes the Indian National Congress and the National Congress Party. Hard Left
includes the CPI and the CPI-M and other socialist parties. And, Right of the centre party includes the Bharatiya Janata Party.
5The data on contract workers is available at state-wise only since 1998.

Labour Laws and Informalisation of Employment77

Table 2:Summary Statistics: 19992000 to 20072008.
Variables
Output (real terms)
Contractual workers
Permanent workers
Fixed capital
Total workers
Share of permanent worker
EPLI
Man days lost to STLO
Per capita NSDP
Dev. Exp pm

Mean

Standard
Deviation

267,878
2675.85
8538.07
103,749
11,213.93
0.4917997
0.1538462
1,966,562
20,212.21
3.104701

641,706.2
5098.25
19,010.79
262,460.3
21,544.55
0.9979931
0.7693482
4,344,532
6843.574
0.1948673

Variation
By Industry, year and state
By Industry, year and state
By Industry, year and state
By Industry, year and state
By Industry, year and state
By Industry, year and state
By state and year
By state and year
By state and year
By state and year

industries using more technology, the employer tends to usher in regular workers.
Therefore, to use the EPLI in the fixed effect model, we interact it with K/L ratio,
which is a proxy for technology. As shown in column I, Table 3 the coefficient
on K/L ratio is negative and highly significant, confirming the evidence in the
existing literature mentioned in the Section 5.1. In column II, Table 3 we include
the interaction of EPLI and K/L ratio, and number of strike per lockouts. The
coefficient on the interaction is positive but not significant. We control for state
development expenditure per capita per million on economic services as it has a
bearing with state infrastructural facilities. Besides, we control for per capita net
state domestic product and real output, which determine external and internal
economies of scale, respectively (Mitra and Ural 2006).
Before coming to the 2SLS equation, we first discuss the FSLS estimates. The estimates are presented in Table 4. With highly significant coefficients, well in line with
our expectations drawn from the literature as stated in Section 5.3, the instruments
seem to be strong enough. As expected, the number of strikes per lockouts increases
with the increase in the share of electoral seats of Congress and the Hard left political parties, while Bharatiya Janata Partys seat share being negatively affecting the
number of strikes per lockouts. All these findings are well in line with the implications of the literature mentioned in the Section 5.3. Moreover, the instruments are
valid as suggested by the higher p-value against Sargan test shown in Table 5.
Now we come to the equation of our interest, i.e., equation 4, from which we
derive the policy implications. The estimates are presented in Table 5. In column
I, we are interested in examining the impact of instrumented ratio of strikes to
lockouts, and that of K/L ratio. The coefficient on strikes per lockouts is positive
and highly significant, suggesting that the informalisation is positively linked
with labour bargaining power. This finding is in line with the implications of

78Irfan Ahmad Sofi and Pritee Sharma

Table 3:Impact of EPL and Labour Bargaining Power on Informalisation (OLS results).

Constant
Ratio of strikes to lockouts (log)
Capital-labor ratio (log)
K-L ratio*EPLI
Control variables
Development exp. per capita pm
Per capita NSDP (log)
Real output (log)
Year effects
Industry effects
State effects
R2
No. of observations

(I)
OLS Results

(II)
OLS Result

5.075***
(1.743)

0.155***
(0.045)

5.123***
(1.744)
0.008
(0.025)
0.141***
(0.046)
0.055
(0.051)

0.021
(0.092)
1.041***
(0.393)
0.065*
(0.044)
Yes
Yes
Yes
0.697
2772

0.038
(0.093)
1.048***
(0.393)
0.065*
(0.044)
Yes
Yes
Yes
0.697
2772

Dependent variable: Ratio of number of contractual workers to total number of workers.

(a) Figures in parenthesis represents robust standard errors clustered at industry-by-state level.
(b) *=p<0.10, **=p<0.05, ***=p<0.01. (c) Under the Hausman test the null hypothesis of zero
correlation between error term and explanatory variables is rejected. In other worlds, the hypothesis that the coefficient estimates are equal to one another is rejected, which suggests that
random effects estimator is inconsistent. Therefore, in this study we use fixed effect model.

theoretical model propounded by Sen (2013). The finding implies that employers
use informal employment to debilitate the labour bargaining power and to curb
the consequences of labour union movement, given that the informal workers are
incapable of forming or joining the union. The coefficient on K/L ratio, as shown
in column I, Table 5 is quite in line with that in OLS regression negative and significant. Now, in column II Table 5 we introduce the interaction between K/L ratio
and EPLI, so as to capture the impact of rigidity on informalisation. As shown,
the coefficient on the interaction is positive and significant suggesting that in
the rigid states, if technology increases, the substitution takes place in favour of
contractual employment. That is, the additional perspective costs, in the form
of firing costs associated with EPL, serves as a disincentive to employment of
regular workers. This finding supports the main proposition of the theoretical

Labour Laws and Informalisation of Employment79

Table 4:First Stage Least Square Results.

Standard Errors
are Not Clustered

Standard Errors
are Clustered

Hard Left Parties: share of seats

Congress: Share of seats

Bharatiya Janata Party: Share of seats

R2
No. of observations

Year dummies

Industry-by-state dummies

State dummies

0.038
(0.043)
0.415***
(0.116)
0.471***
(0.056)
0.033
(0.100)
0.755
2772
Yes
Yes
Yes

0.038
(0.046)
0.415***
(0.213)
0.471***
(0.083)
0.033
(0.145)
0.755
2772
Yes
Yes
Yes

Constant

Dependent variable: Ratio of number of strikes to number of lockouts proxy for labour
bargaining power.
Figures in parenthesis represents robust standard errors, and (c) *=p<0.10, **=p<0.05,
***=p<0.01.

literature (mentioned in literature review section) that the EPL, for it imposes cost
on employers to employer regular workers, would give rise to informalisation. The
increase in the share of contractual worker when the employer uses more technology in rigid states as suggested by the positive and significant coefficient on
the interaction indicates that the employer, perhaps, hires skilled contractual
worker which may not necessarily be at par with the regular worker, just as to
evade the brunt of labour laws. The coefficients on the strikes per lockouts and on
the interaction term in 2SLS vary significantly from those in the OLS regression,
reason being the presence of endogeneity in the latter model.

6.2 Impact of Market Volatility on Informalisation

The existing literature shows that the laxer EPL does benefit the volatile industries relatively higher (Poschke 2009), implying that the volatile industries are
the ones worst hit by labour laws. Therefore, it can be argued that the volatile
industries for they require frequent employment adjustments are more likely
to use contractual employment to circumvent the cost of rigidities associated with
EPL. To analyze the impact of volatility on informalisation, we follow Krishna and
Levchenko (2009) by creating a dummy based on coefficient of variation of the

80Irfan Ahmad Sofi and Pritee Sharma

Table 5:Impact of EPL and Labour Bargaining Power on Informalisation (2SLS Results).

Constant
Ratio of strikes to lockouts (log)
Capital-labor ratio (log)
K-L ratio*EPLI
Control variables
Development exp. per capita pm (log)
Per capita NSDP (log)
Real output (log)
Year effects
Industry effects
State effects
R2
No. of observations
Sagan test (p-value)

(I)
2SLS Resutls

(II)
2SLS Results

7.907***
(1.896)
0.283***
(0.092)
0.137***
(0.043)

7.921***
(1.895)
0.280***
(0.091)
0.113**
(0.045)
0.105**
(0.051)

0.018
(0.088)
1.682***
(0.428)
0.079**
(0.042)
Yes
Yes
Yes
0.681
2772
0.242

0.049
(0.089)
1.677***
(0.427)
0.078**
(0.042)
Yes
Yes
Yes
0.682
2772
0.230

Dependent variable: Ratio of number of contractual workers to total number of workers.

(a) Figures in parenthesis represents robust standard errors.
(b) *=p<0.10, **=p<0.05, ***=p<0.01.

annual growth of industry output in a given state. Using Median, we construct

a dummy variable for high volatile industries and include it in the model along
with control variables to capture its impact on informalisation. The results are
shown in Table 6. We first run a regression without controls. In column I, Table6
the coefficient on volatility is positive and highly significant. In columnII, Table6
apart from the controls used in previous regressions, we also control for labour
bargaining power and technology. As shown, the coefficient is still positive and
highly significant. This finding offers support to Poschke (2009).

7 Discussion and Conclusion

As the industrial business struggles to maintain its growth at higher trajectory,
the researchers and policy-makers are raising questions regarding the relevance

Labour Laws and Informalisation of Employment81

Table 6:Impact of Market Volatility on Informalisation.

Constant
High volatility
Ratio of strikes to lockouts (log)
Capital-labor ratio (log)
Development exp. per capita pm
Per capita NSDP (log)
Real output (log)
Year dummies
Industry dummies
State dummies
R2
No. of observations

(I)
Without Controls

(II)
With Controls

0.747***
(0.125)
0.419***
(0.174)

Yes
Yes
Yes
0.662
3276

8.683***
(1.983)
0.775***
(0.214)
0.283***
(0.092)
0.137***
(0.043)
0.018
(0.088)
1.682***
(0.428)
0.079*
(0.042)
Yes
Yes
Yes
0.681
2772

Dependent variable: Ratio of contractual worker to total number of workers.

(a) Figures in parenthesis represents robust standard errors clustered at industry-by-statelevel,
(b) *=p<0.10, **=p<0.05, ***=p<0.01.

of EPL, which, analysts claim, does neither ameliorate the plight of the workers
nor let the business grow. Despite the substantial body of contract labor laws
strictly prohibiting contractual employment in core activities, the incidence of
contractual employment has registered an unprecedented growth over the last
two decades, cutting across non-core as well as core activities. Provoked by the
unfair exploitation against contract workers, the labour unions in India have been
strongly resisting the contractualisation, demanding job security for the workers.
Though alarming, the uncontrolled rise in informalisation has not received adequate attention of policy makers. What is more worrying is the fact that there
are evidences suggesting that the overdependence of informal employment may
impinge on efficiency and productivity growth of industries, and thus drive them
out of the competitive markets, in the long run.
In this study, we investigate the factors driving the use of contractual workers
in Indian manufacturing sector. Using three-dimensional panel data on 28 industrial sectors, between 19992000 and 20072008, across 13 major states of India,

82Irfan Ahmad Sofi and Pritee Sharma

we find that the incidence of informalisation is directly linked with EPL, volatility, and labour bargaining power.
The results suggest that, by creating rigidities and raising the firing cost,
employment protection legislations discourage the employment of formal
workers and induce informalisation. Moreover, that the rising tide of globalization render the markets more volatile is indisputable, the employers, therefore,
require employment adjustments frequently, so as to maintain the optimality in
the production. Contractualisation may offer numerical flexibility to employer;
however, there is a notable trade-off between flexibility and inefficiency
associated with contractualisation which calls for earnest attention of employers as well as government policy makers. The whole gamut of labour laws,
particularly employment protection legislations, must be rationalized to ensure
that the employers are provided with adequate flexibility and the workers rights
are saved from being infringed upon.
Acknowledgments: We are thankful to Prof. Aditya Bhattacharjea (Head: Delhi
School of Economics), Prof. Kunal Sen (University of Manchester) and Dr.Rana
Hassan (Principal Economist: Asian Development Bank) for their v
aluable suggestions. The errors remaining in this paper are the authors own.

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