India’s well-known demographic dividend is yet to be reaped. Employment growth has stagnated in recent years, with the economy adding only 2m jobs a year, Goldman Sachs Global Macro Research said in a report today.
Manufacturing employment is weak, the scale of production is small, and 93% of the workforce is in the informal sector. Further, migration from rural agriculture to urban manufacturing is slow, thus reducing productivity gains.
India’s stringent labor laws are a key factor constraining employment growth, it added.
If labor share in manufacturing were to increase from the most stringent labor law states to more flexible ones like Gujarat, we estimate that 40 million jobs could be added in manufacturing, Goldman Sachs said.
Below are the excerpts of Goldman Sachs report:
We show that government policies on rural employment guarantees and rural subsidies are reducing the incentives for surplus labor to migrate from agriculture to manufacturing and services. Reforms to encourage urbanization, such as reducing the scope of NREGA and subsidies, can help in our view.
The gains from reforms can be very large. In our bull case, some 110 million jobs can be added over the next 10 years, the largest for any major economy. Demographics could contribute 3 percentage points to GDP growth, from 1.7 ppt currently.
As a new government takes charge from mid-2014, we see labor market reforms as a critical ingredient to accelerate India’s growth rate.
India’s employment growth in recent years has been anemic. The economy added only about 2 million jobs each year between FY05 to FY12, compared to 12 million a year in the 5 years before this. Moreover, increasing numbers of workers are leaving the workforce – the labor force participation rate has fallen by 3 percentage points over the same period. As a labor abundant country, India should be generating jobs in labor-intensive manufacturing. However, the manufacturing sector saw a net decline of 5 million jobs between FY05 and FY10, at a time when industrial growth was very strong at over 9% during this period. The industries which are losing jobs are the most labor intensive ones – textiles, electronics, and apparel.
In theory, India can get significant labor market gains from its favorable demographics due to – i) increases in labor input from the young; ii) urbanization - moving labor from low productivity agriculture to high productivity industry and services; and iii) economies of scale in operation – as a firm grows, it can initially have increasing returns to scale – whereby adding more labor and other inputs leads to a more than proportional increase in output.
Both supply and demand factors are at work. Stringent labor laws are affecting the demand for labor, while generous rural programs may be reducing the supply. We argue that labor laws are leading to a smaller scale of operation as well as taking recourse to informality in employment. We discuss issues arising from these in Section II. The supply of labor from agriculture to other sectors is being affected by programs such as NREGA (the National Rural Employment Guarantee Act), which are reducing the ‘push’ factor. We discuss this in Section III. In section IV, we discuss the benefit of demographics.
Labor Demand – small scale, mostly informal
India’s employment is remarkable for its small scale and informality. To escape stringent laws, entrepreneurs keep the scale of their operations small. Most workers are in small enterprises, with the share of workers in enterprises of less than 6 people 65.6%. Self-employed are half the workforce. Even in the formal sector, India’s average factory employs only 75 people, compared to 191 in China. They employ largely contractual workers – the labor force in the formal sector is heavily unionized and protected, consisting of 7% of workers, while 93% of workers are informal. This informality level is the highest in the emerging world.
According to research by the World Bank, the value added per worker in the informal sector is less than half of the value added per worker in the formal sector. Further, employers have no incentive to invest in skills of contractual workers or in providing insurance. Moving workers from the informal to the formal sector can unleash productivity growth. In addition, formal workers in the formal sector pay taxes, so revenue collections can rise.
Complex labor laws incentivize firms to remain small and in the informal sector. This allows them to remain under the radar of labor officials and escape stringent provisions. The large number of laws leads to inspection visits by different officials under different laws, which increases transaction costs and opens up opportunities for rent seeking. There is also no standardization of documentation required or time periods for which records have to be kept. The inflexibility of labor laws has prevented large scale employment growth in manufacturing, in our view.
Pro-Worker versus Pro-Employer
There is a lot of evidence suggesting that states which implemented pro-worker amendments to the Industrial Disputes Act faced a decline in output, employment, and productivity, while those which introduced pro-employer amendments saw an increase in employment and output. Estimates using plant-level data suggest that firms in labor intensive industries with flexible labor laws have 14% higher TFP than in states with more stringent labor laws.
States which are classified as having more liberal labor laws have generated more manufacturing sector employment. We estimate that if states were to increase their share of labor in manufacturing to the level of Gujarat currently, some 40 million jobs could be added in manufacturing over the next decade.
There is a trade-off between employment protection and unemployment benefits. Employment protection helps those who already have a job, creating a labor aristocracy. To reduce employment protection, generous severance payments and notice periods can be chosen. To develop a constituency for reform, we believe it is better to provide for increased severance payments and notice periods as employment protection is reduced. The Voluntary Retirement Schemes (VRS) which allow for such payments have worked well in India. A younger population tends to prefer a more flexible labor market regime where it is relatively easier to find a job, but likewise easier to lose a job.
Labor Supply – not increasing
The movement of excess workers from low productivity agriculture to higher productivity sectors is critical to increase the supply of labor and for economic growth. In India, the shift from rural agriculture to urban manufacturing and services is taking place at a slow pace. The urbanization rate in India was higher than that of China in 1980 at about 20%. Since then, China’s urbanization rate has accelerated to over 50%, while India has only moved to just above 30%. The pace of movement from rural to urban usually accelerates with economic growth as opportunities increase in other sectors. Therefore, agricultural employment typically falls quite rapidly during this process.
Low Labor Productivity
India’s labor productivity is one of the lowest in Asia. A key reason is that a large number of workers are still in low productivity agriculture. We find that labor is 4 times more productive in industry and 6 times more productive in services compared to agriculture. We measured the impact on GDP of ‘urbanization’ by looking at productivity differences between agriculture and the manufacturing and services sector. We find that in recent years the increase in GDP due to the shift from rural to urban areas has not increased significantly. The increase in GDP from migration of workers from agriculture to other sectors was 0.87 ppt of GDP, according to our estimates, between FY05 and FY12. This was not significantly higher than the contribution of migration between FY00 and FY05 of 0.73 ppt of GDP. Moreover, the contribution of moving from agriculture to industry has actually fallen over this period. Compare this with China, where we estimate urbanization is contributing 2-3 percentage points to GDP growth.
The Impact of NREGA – Tight Labor Markets, Higher Inflation
In our view, government policies to boost rural incomes may have contributed to limiting urbanization. Rural wages have been growing by 17% on average since FY07 and have outstripped urban wages. A number of government programs have supported this, including the NREGA which provides 100 days of employment to a member of each rural family.
We found evidence to suggest that NREGA has contributed to rural wage growth. To investigate this, we looked at states which have had the largest share of households enrolled under NREGA, and compared them to states which have the least. We also looked at the same state before and after the program. The share of households enrolled in NREGA was a significant explanatory factor for wage growth. We did the same exercise for CPI inflation in the states. We found evidence to support the hypothesis that inflation has been higher in states where NREGA has been implemented to a greater degree.
Not only are agricultural workers not moving to urban areas, the increase in wages, without an increase in productivity, is fueling inflation. Earlier we showed that rural wages have been driving CPI inflation rather than the other way around, a finding which has also been corroborated by the RBI4. NREGA has led to workers moving from agriculture to rural construction. The number of workers in rural construction has jumped from 17 million to 37 million between FY05 and FY12. This suggests that there is little surplus labor coming out of agriculture which could drive down wages and inflation. Therefore, there may not be as much slack in the labor market as output gap measures would suggest.
Policies to encourage Urbanization
We think that government policies should incentivize urbanization. To do this would require a reduction in rural subsidies, which are fueling inflation without increasing labor productivity. We think that the scope of NREGA could be reduced to make it applicable only to women. A possible reform to NREGA could be to have the program focus on women, and their skill development. This would increase female labor force participation, reduce the scope for wage inflation, and would not hinder the movement of labor from agriculture to manufacturing. Further, policies to increase efficiency of land markets, by improving land records, easier conversion of land use, and land acquisition for industry, could help incentivize urbanization.
The Benefits of Demographics
India’s demographics remain extremely favorable. The UN estimates that over the next decade, another 117 million people will enter working age (15-64). Given current trends in work force participation rates, the economy will add only 73 million workers, which could contribute 0.8 percentage points annually to GDP growth. In addition, if current trends in urbanization continue, it could add another 0.9 percentage points to GDP growth annually.
However, if India were to undertake significant reforms in the labor market, the benefits could be quite large. In a bull scenario, we project that India could add some 110 million workers over the next decade. At this level, the number of jobs that India could create would be larger than that of the US, China, Russia, and Brazil combined. This can add 1.2 percentage points annually to GDP growth. The gains from more accelerated urbanization could be even greater, adding some 1.8 percentage points to GDP growth. Therefore, labor supply and demand reforms could increase the annual contribution of demographics to GDP to 3 percentage points from 1.7 percentage points currently.