Resource Misallocation in India: The Role of Cross-State Labor Market Reform

IMF Working Papers, February 26, 2021

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At the macro level, productivity is driven by technology and the efficiency of resource allocation, as outcomes of firms’ decision making.
The relatively high level of resource misallocation in India’s formal manufacturing sector is well documented.
This paper builds on existing research to further investigate the drivers of misallocation by exploiting micro-level variation across Indian states.
The analysis examines the interaction of labor market rigidities with informality, a key feature of India’s labor markets.
The results suggest that reducing labor market rigidities in states with high informality has a net positive effect on aggregate productivity.

States with less rigid labor markets have lesser misallocation.
Reducing labor market rigidities in states with high informality yields a net positive effect on aggregate productivity.
The paper focuses on firm-level measures related to misallocation such as firm TFPR and revenue TFP, and considers factors like exit from informality and product market regulation.

Labor market reform that reduces rigidity can lower resource misallocation at the state level.
Targeting reforms in states with high informality can generate positive aggregate productivity gains.
Policy design should account for the interaction between labor market rigidities and informality to maximize productivity benefits.