Limitations of "ease of hiring-firing" labour reforms

Ease of hiring and firing is popularly talked about as the much-required reform. However, it's debatable. It might not be the true binding constraint.

The survey of industries doesn't list ease of hiring and firing as one of the constraints that they face. In fact, they list corruption, electricity as major concerns. 

Gulzar Natarajan in his book "Can India Grow?" also argues that hiring policies may not be the constraint. Companies have found a way around it by recruiting contract workers. The downside of contract workers is that firms don't invest in building their skills.

Shamika Ravi of Brookings rightly points out the limitations of easing hiring and firing policies.
Lack of labour reforms has generally meant multiple labour legislation that deter hiring of labour. Over the last several years, some states have been proactive and have lowered the stringency of labour regulations and simplified compliance and procedural requirements. But the empirical evidence on this leads us to a fundamental puzzle: Even in those states of India that achieved a high labour reform index, like Gujarat and Andhra Pradesh, the jobs that were created were overwhelmingly informal in nature.
Shamika argues that demonetisation has the potential to bring informal firms into formal sectors. She further says that it may increase firms' costs but it's okay because it's a necessary labour market correction. She quotes an increase in wages due to NREGA without hurting employment or growth, as an example. I disagree with her argument for demonetisation as a means to make informal firms and its potential to bring that change.

Firstly, the shift from informal to formal might not happen in first place. Due to the protracted cash crisis, the informal units may die before turning formal.

Secondly, as Manish Sabharwal, Gulzar Natarajan and others argue, mandatory EPFO savings is one of the true binding constraints. For those below the salary of 15k, 24% of the salary is cut for savings purpose (EPFO). Workers at levels of such salary aren't ready to forego the money. Firms hence stay informal.

So, even if forced through demonetisation, firms may not turn formal due to these constraints.

Easing these rules can help. The government has been taking steps to ease it. For instance, in the last budget, it was announced that a part of EPFO for such workers would be paid by the government. There was a recent announcement that the mandatory savings clause of employees (employers still have to pay 125%) for those below 15k is removed in the textile sector. 

The debate on demonetisation's potential to expand formal sector can only be settled with data. One might have to wait for that but there's a more fundamental objection.

If other constraints like EPFO are the true bottle necks, easing such constraints is a much more clean way of doing reform. One doesn't need demonetisation, which results in collateral damage to innocents, to achieve this. As Kaushik Basu says, a cancer treating drug might increase hair on your bald head. But, that won't be the reason for you to wish for cancer. There are other ways to do it.

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