The commanding presence of the heavy hand of government regulation has been the major institutional cause for the emergence of the massive informal sector. Deregulation and better regulatory frameworks will help partially address this challenge. The more immediate cause for the stunted growth of the formal sector and outsized proliferation of the informal sector has been the lack of adequate flexibility in labor hiring and firing policies. This has had the effect of distorting incentives by discouraging firms from hiring employees and growing their businesses, while "crowding-in" employment into the informal economy.
An OECD Economic Survey of India 2007 found that
"Although regular employment has risen, it still represents only 15% of total employment and its growth has been almost exclusively in the smaller, least productive enterprises. Employment in firms with more than ten employees accounts for only around 3.75% of total employment (one quarter of regular employment) and has been falling... India has a much smaller proportion of employment in enterprises with ten or more employees than any OECD country. The number of workers has also fallen in the manufacturing sector where the share of labour income in value-added is low compared to other countries and capital-intensity is relatively high. Such developments indicate that India is not fully exploiting its comparative advantage as a labour-abundant economy."
It also finds that laws governing regular employment contracts in India are stricter than those in Brazil, Chile, China and all but two OECD countries.
Measure of restrictions on indefinite contracts in the formal sector (Regular employment)
Its conclusion about India's labor market is instructive,
"In labour markets, employment growth has been concentrated in firms that operate in sectors not covered by India’s highly restrictive labour laws. In the formal sector, where these labour laws apply, employment has been falling and firms are becoming more capital intensive despite abundant lowcost labour. Labour market reform is essential to achieve a broader-based development and provide sufficient and higher productivity jobs for the growing labour force."