Demand shocks and employment adjustments: Does employment protection legislation create rigidity?

• Author: Mohd Hussain KUNROO,Irfan Ahmad SOFI
• Date: 01 September 2018
• Published date: 01 September 2018
• DOI: http://doi.org/10.1111/ilr.12116

International Labour Review, Vol. 157 (2018), No. 3

Copyright © The authors 2018

Journal compilation © International Labour Organization 2018

Demand shocks and employment

adjustments: Does employment

protection legislation create rigidity?

Irfan Ahmad SOFI* and Mohd Hussain KUNROO**

Abstract. With state-level panel data from the Indian manufacturing sector for 2000–12,

and labour turnover as a proxy for employment adjustments, the authors estimate dif-

ferential effects of demand shocks on employment adjustment across states with high

and low levels of EPL. They find that EPL does not hinder employment adjustment;

the response of labour separation rates to negative demand shocks is relatively higher

in states with high levels of EPL, and labour turnover is inversely associated with EPL,

which may be viewed as indicative of the beneficial effects of EPL for both enterprises

and workers.

Economists have shown profound interest in identifying the effect of

employment protection legislation (EPL) on industrial performance over

the past couple of decades. There is a perception among a section of econo-

mists that EPL discourages industrial expansion by creating significant rigidity

for businesses. However, the theoretical implications of the models introduc-

ing the effect of EPL are, at best, ambiguous (Nickell, 1986; Hopenhayan and

Rogerson, 1993).

The empirical literature examines the effects of EPL on productivity and

employment based on the a priori belief that pro-worker labour laws restrict

the ability of employers to respond to demand shock by carrying out employ-

ment adjustments (Besley and Burgess, 2004; Mitra and Ural, 2008; Gupta,

Hasan and Kumar, 2008; Ahsan and Pagés, 2009; Dougherty, Frisancho and

Krishna, 2013; Deakin and Sarkar, 2011). However, the fundamental question

*Assistant Professor, Department of Economics, Baba Ghulam Shah Badshah University,

Rajouri, Jammu and Kashmir, India, email: irfan.sofi@bgsbu.ac.in. **Sir Ratan Tata Trust

Fellowship, Institute of Economic Growth, New Delhi, email: mhkunroo@gmail.com.

Responsibility for opinions expressed in signed articles rests solely with their authors, and

publication does not constitute an endorsement by the ILO.

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462 International Labour Review

of whether EPL actually creates considerable rigidity in contemporary dualis-

tic labour markets where the share of permanent workers is shrinking day by

day has so far been neglected. The evidence in the empirical literature does

not show a conclusive picture (Betcherman, 2014). A significant number of

studies show either a positive effect of EPL or no effect on industrial perfor-

mance (Belot, Boone and Ours, 2007; Nickell and Layard, 1999; Koeniger,

2005; Autor, Kerr and Kugler, 2007, who found a positive effect, or Bertola,

1990; Dutta Roy, 2004; Fagernäs, 2010; Deakin and Sarkar, 2011, who found

either an insignificant effect or none at all).

Against this backdrop, we investigate whether EPL is indeed a sig nificant

obstacle to employment adjustments undertaken in response to demand shocks

in the economy. We use a time-variant dummy variable for demand shocks,

which allows us to study the behaviour of producers in the context of EPL.

Additionally, we demonstrate that the econometric models used in the empiri-

cal research to capture the effects of EPL on productivity in dualistic labour

markets tend to exaggerate the estimates due to an unmanageable endogeneity

problem.

The study is based on the Indian manufacturing sector. The fact that EPL

varies significantly between the states of India enables us to carry out a panel

data analysis. As the subject of labour is included in the Concurrent List of

the Indian Constitution, both the central authorities and state governments

have the authority to regulate and address labour issues through the enact-

ment and amendment of labour laws. The country is known for having a pleth-

ora of labour laws on paper (OECD, 2007). On the basis of a classification of

the Indian states into groups having rigid, flexible and neutral EPL borrowed

from Gupta, Hasan and Kumar (2008), we create a quantitative EPL indicator

reflecting the level of employment protection at the state level. The indicator

is then used as an independent variable (EPLI) to capture the effect of EPL.

For our research, we select 15 major states of India, taking into consideration

the availability of an EPL indicator.

The remainder of the article is organized as follows: the first section

describes Indian legislation on employment protection. Section two provides

a brief review of previous empirical literature on the subject. Section three

introduces the methodology and section four discusses our results. Finally, the

conclusions are presented in section five.

Employment protection legislation in India

The Indian state introduced EPL over time to provide a certain degree of

job security to workers. The legislation is contained in Chapter VB of the

Industrial Disputes Act, 1947, which applies to firms in the formal manufac-

turing sector employing 100 workers or more. Chapter VB makes it man-

datory for employers to obtain prior government permission in order to

proceed with lay-offs, retrenchment or shutdown and to issue prior notice

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