Friday, December 12, 2014

Labor market reforms - deregulation or lower taxation?

I have briefly observed that instead of wading into the controversial hire-and-fire reforms, the next round of labor market reforms should involve addressing the dual price market in labor wages.

The fundamental problem is that Indian manufacturing firms start and remain small and informal. This engenders an inefficient equilibrium of low productivity, low wages, deficient social protections, limited investments, and stunted growth. What is required to break out of this equilibrium?

The likes of Arvind Panagariya argue that the restrictive hire and fire policies encourage firms to start small and informal and remain so. There is another possibility, as highlighted by Manish Sabharwal, that the high rate of labor taxation, payable by both employers and employees (upto 45% of wages are deducted for pensions and insurance for those with smaller incomes, whereas just over 5% of wages are deducted from those with higher wages), encourages much the same as above. It is certain that both - restrictive labor regulations and high rate of labor taxation - contribute to keeping firms small and informal. What is not certain is which is a greater constraint facing firms.

In this context, I have argued in detail that restrictive regulations may not be as binding a constraint as prohibitive taxation rates are. Consider this story. If you are the typical entrepreneur starting a textile unit, you are more likely  to start small and not be able to afford higher salaries. However, at such salaries, you are also unlikely to be able to attract workers, especially given the prohibitively high payroll deductions. So the firm prefers to either start informal or contract labor. Once it starts informal, it gets entrapped in a low-level equilibrium, exiting from which is constrained by several factors, including informality itself as well as restrictive labor regulations.

A more prudent strategy involving labor market reforms would revolve around lowering mandatory payroll deductions and replacing it with publicly funded social protection that is programmed for a gradual phase out. 

No comments: