Economic Reforms, Labour Markets and Formal Sector Employment: Evidence from India

Development economists generally concur that the implications of economic reform for employment are influenced by an economy’s institutional framework. This paper examines the extent to which differences in regional labour market flexibility shaped the impact of unanticipated economic reforms on employment in formal manufacturing firms in India in the 1990s, using pooled cross-sectional firm survey data. It employs a difference-in-differences strategy for this analysis and finds that, on average and ceteris paribus in the 1990–1997 period, declines in input tariffs were associated with increased employment in formal firms across all Indian states, while FDI reform was associated with increased (reduced) formal firm employment in states with flexible (inflexible) labour markets. Supporting analysis indicates that these results were underpinned, at least in part, by product market competition within the formal sector. As policy makers in developing economies increasingly emphasise increases in formal employment as a key policy objective, these findings are of general interest. They underline the relevance of market structure and geographical variation in institutional characteristics to a study of the effects of economic reform. Furthermore, this paper highlights the continuing relevance of formal sector analysis, notwithstanding the persistent primacy of informal enterprises in developing economies.