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Indian manufacturing: A slow

sector in a rapidly growing
economy
a b
Devashish Mitra & Beyza P. Ural
a
Department of Economics , Syracuse University , NY,
USA & IZA
b
Department of Economics , University of Alberta ,
Canada
Published online: 11 Nov 2008.

To cite this article: Devashish Mitra & Beyza P. Ural (2008) Indian manufacturing:
A slow sector in a rapidly growing economy, The Journal of International Trade &
Economic Development: An International and Comparative Review, 17:4, 525-559, DOI:
10.1080/09638190802250282

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 The Journal of International Trade & Economic Development
Vol. 17, No. 4, December 2008, 525–559

Indian manufacturing: A slow sector in a rapidly growing

economy
Devashish Mitraa* and Beyza P. Uralb
a
Department of Economics, Syracuse University, NY, USA & IZA; bDepartment of
Economics, University of Alberta, Canada
(Received December 2006; final version received December 2007)
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In this paper, we investigate the determinants of productivity in Indian

manufacturing industries during the period 1988–2000. Using two-digit
industry level data for the Indian states, we find evidence of imperfect
interindustry and interstate labor mobility as well as misallocation of
resources across industries and states. We find that trade liberalization
increases productivity in all industries across all states. Productivity is
also found to be higher in the less protected industries. These effects of
protection and trade liberalization are more pronounced in states that
have relatively more flexible labor markets. Similar effects are also found
in the case of employment, capital stock and investment. Furthermore,
we find that labor market flexibility, independent of other policies, has a
positive effect on productivity. Importantly, per capita state develop-
ment expenditure seems to be the strongest and the most robust
predictor of productivity, employment, capital stock and investment.
Industrial delicensing increases both labor productivity and employment
but only in the states with flexible labor market institutions. Even after
controlling for delicensing, trade liberalization is shown to have a
productivity-enhancing effect. Finally, trade liberalization benefits most
the export-oriented industries located in states with flexible labor-
market institutions.
Keywords: productivity; India; trade liberalization; labor markets;
institutions
JEL Classification: F14, F16, L60, O10, O14, O24, O25, O53

Introduction
In recent years, economists have understood and have emphasized the role
of institutions in growth and development. The Nobel laureate Douglass
North (1981, 201–2) defines institutions as ‘a set of rules, compliance
procedures, and moral and ethical behavioral norms designed to constrain
the behavior of individuals in the interests of maximizing wealth or utility of

*Corresponding author. Email: [email protected]

ISSN 0963-8199 print/ISSN 1469-9559 online

Ó 2008 Taylor & Francis
DOI: 10.1080/09638190802250282
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 526 D. Mitra and B.P. Ural
principals.’ According to him, institutions affect the process of capital
accumulation as well as the process of converting this capital into output,
both of which are important for economic growth and poverty reduction.
Rodrik (2000, 2) has tried to dig deeper into the issue of which particular
institutions countries should try to acquire and under what circumstances.
He argues that

a clearly delineated system of property rights, a regulatory apparatus curbing

the worst forms of fraud, anti-competitive behavior, and moral hazard, a
moderately cohesive society exhibiting trust and social cooperation, social and
political institutions that mitigate risk and manage social conflicts, the rule of
law and clean government . . . are social arrangements that usually economists
take for granted, but which are conspicuous by their absence in poor countries.
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These non-market institutions need to exist to support the full and

proper functioning of the market mechanism, where private economic
agents face the right kind of incentives. The basic Arrow–Debreu model that
shows the optimality of the market mechanism assumes a well-defined set of
property rights, and the perfect enforceability of contracts, institutions that
are absolutely essential for the development of a strong and robust private
sector. On the whole, Rodrik argues that it is the ‘meta-institution’ of
democracy and participatory politics, which in most cases can bring success
in the search for specific economic institutions that are appropriate for local
conditions.
Rodrik’s ‘meta-institution’ of democracy and participatory politics exists
and has had a long tradition in India. Huang and Khanna (2003) have argued
that it is the presence of strong institutions in the form of India’s ‘rule of law,
its democratic processes and a relatively healthy financial system’ (summar-
ized by Huang 2006) that will provide India with the competitive edge over
China. Huang (2006), in a recent Financial Times article, has claimed
vindication of their predictions, since India’s last two years of 8% growth per
annum (compared with China’s 10%) have been achieved with just half of
China’s level of domestic investment in new factories and equipment and
only 10% of China’s foreign direct investment. He also writes, ‘While China’s
GDP growth in the last two years remained high in 2003 and 2004, it was
investing close to 50% of its GDP in domestic plant and equipment – roughly
equivalent to India’s entire GDP. That is higher than any country, exceeding
even China’s own exalted levels in the era of central planning.’ He goes on to
write further that while China’s growth is based on ‘massive accumulatio-
n’,India’s growth is driven by ‘increasing efficiency’. He defends his claim by
contrasting the recent, stellar performance of the Indian stock market to the
dismal performance of the Chinese stock market where half the wealth has
been wiped out in the last five years.
It is true that India’s overall economic performance in recent years has
been outstanding, with the economy growing at roughly 8% per annum in
 The Journal of International Trade & Economic Development 527
the last two years. One might argue, however, that the growth has been
service-led and that manufacturing, considered to be ordinarily the engine of
growth in a country at that stage of development, has not been so in India’s
case. Kochhar et al. (2005) point out that while India’s share of services in
overall GDP has increased from 37 to 49% in the last two decades, the share
of manufacturing has remained more or less constant at 16%. They also
show that the change in the share of manufacturing during this period in
India has been about 2.5 percentage points lower than the average country
at the same stage of development, while the change in the services share was
about 10 percentage points higher than average (even though its employ-
ment performance was below average). Kochhar et al. (2005, 22) write, ‘In
sum then, Indian manufacturing showed signs over the post-1980s period of
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not keeping up with the average performance in other, similar countries.’

Within India, even many of the fastest growing states have seen either no
change or a fall in the share of manufacturing. Thus, it is important to
understand why, in a rapidly growing Indian economy with the right ‘meta-
institution’ for growth, the manufacturing sector has been lagging. We
therefore investigate in this paper the determinants of productivity in the
Indian manufacturing sector using a three-dimensional panel of two-digit
industries across states and over time.
While institutions encompass the formal and informal rules and customs
within which individuals and firms operate, policies refer to various
strategies and measures a government adopts to achieve its goals and
objectives within the country’s institutional framework.1 One policy variable
that has received a lot of attention in the growth literature is the degree of
openness in trade. As a measure of this policy variable we use the nominal
rates of protection across various two-digit industries over the period 1988–
2000. Trade generates efficiency at the macro level through gains from
specialization and exchange. While the availability of a larger variety of final
goods represents gains for consumers and efficiency gains at the aggregate
level, the availability of larger varieties of intermediate inputs through trade
increases efficiency both at the aggregate as well as micro levels for
individual producers. A larger variety of inputs, as is well understood in the
trade literature, can increase productivity through greater division of labor
and/or through better matching between output and inputs.2
In addition, trade can affect research and development (R&D). These
effects can go in opposite directions, as argued by Rodrik (1992) and by
Devarajan and Rodrik (1991). While a tariff cut reduces the market size of a
domestic import-competing producer and therefore reduces the gain from a
cost-reducing innovation, it also increases competition from foreign
substitutes, thereby flattening the demand curve, reducing the mark up
(reducing monopoly power) and thereby increasing output. While the
former is the market size effect, the latter is called the pro-competitive effect
of trade liberalization. While the former represents a negative impact of
 528 D. Mitra and B.P. Ural
trade reforms on R&D and therefore on productivity, the latter represents a
positive effect. Which of the effects dominates is an empirical question.
However, the second channel, which basically focuses on the need to do
R&D to increase efficiency to fight the increase in competition arising from
international trade, is quite intuitive. In addition, recent work by Melitz
(2003) on firm heterogeneity and international trade clearly shows how trade
can get rid of the least productive firms and transfer labor from the less
productive to the more productive of the surviving firms to increase overall
productivity of the industry in question.
Another policy variable that is important for our analysis is the size of
government expenditure on infrastructure and social services, which we will
call development expenditure throughout the rest of the paper. While the
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productivity of the various inputs in production clearly depends on the

quality of public infrastructure, the quality of human capital (skilled
workers) clearly depends on the quality of education, health and social
services. This quality will not be captured in the simple head count of skilled
workers and will also show up in their productivity. We therefore study the
effects of the size of development expenditures per capita incurred by the
state government on productivity.
A somewhat neglected aspect in the literature on growth and
productivity is the effect of labor-market institutions.3 Rigid labor markets
constrain the ability of firms to hire and fire workers in response to shocks to
technology, relative prices of output and inputs, and the macroeconomic
environment. Thus, adjustment is restricted and that can have an adverse
impact on the functioning of private firms and therefore on efficiency at all
levels. Additionally, the realization of the beneficial effects of trade reforms
requires both substantial amounts of intersectoral labor reallocation as well
as intrasectoral labor reallocation across firms. Rigid labor laws can
constrain such reallocation. Panagariya (2001) has argued that rigid labor
laws raise the costs for employers and also constrain the size of firms by
discouraging them from employing more than a fairly small number of
permanent workers. He also argues that the costs of such rigid labor laws go
beyond those incurred by existing entrepreneurs as these laws discourage
entry. We explore the effect of labor-market restrictions on efficiency by
categorizing Indian states into pro-labor and pro-employer, which we will
call rigid and flexible labor institution states respectively. As explained in
our data section, the classification is from Hasan et al. (2007) and is based
on the earlier work of Besley and Burgess (2004) and of Dollar et al. (2002).
Another factor that has adversely affected the efficiency of the private
sector in India is the panoply of rules restricting entry and exit of firms. Such
restrictions limit competition faced by existing firms and thus lower firm
efficiency. They also prevent firms that are currently inefficient, from exiting
the market. Thus productivity of the industry as a whole gets adversely
affected. We capture the policy restrictions on entry and exit of firms using a
 The Journal of International Trade & Economic Development 529
variable, which we call ‘delicensed’. This variable measures the output share
of three-digit sectors, within any two-digit sector, that have been delicensed,
i.e. licensing restrictions on them have been lifted. It is expected that a
variable of this sort will interact with labor market institutions. For
example, removing entry and exit restrictions will not have an effect if labor
market restrictions on firing of workers are still in place, since effectively this
is an exit barrier. It is also an entry barrier since it discourages entry by
discouraging firms from hiring permanent workers who benefit from on-the-
job training.
Following the work of Hall and Jones (1999), we will focus on the
determinants of productivity levels rather than productivity growth rates.
Hall and Jones (1999, 85) have argued ‘levels capture the differences in
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long-run economic performance that are most directly relevant to welfare

as measured by the consumption of goods and services.’ In addition, in
this context they point to the recent evidence on the transitional nature of
growth rate differences across countries, the empirical questioning by
Jones (1995) of the relevance of endogenous growth models, and the
theoretical support from the recent models that show the effect of policies
on income levels and not on growth rates. They argue that countries in
the long run differ in their income levels and not growth rates. Other
important, recent papers that have focused on levels rather than growth
rates are Frankel and Romer (1999), Irwin and Tervio (2002) and Rodrik
et al. (2002).
Using two-digit industry level data for the India states for the period
1988–2000, we are able to obtain some results, that we think are
interesting and have important policy implications. We find certain
interesting trends in the inequality of per worker and aggregate output
and value added across industries and states that show imperfect
interindustry and interstate labor mobility as well as misallocation of
resources across industries and states. We find that trade liberalization
increases productivity in all industries across all states. Productivity is also
found to be higher in the less protected industries. The effects of protection
and trade liberalization are more pronounced in states that have relatively
more flexible labor markets. Similar effects are also found in the case of
employment, capital stock and investment. We also find that labor market
flexibility, independent of other policies, has a positive effect on
productivity. Importantly, per capita state development expenditure seems
to be the strongest and the most robust predictor of productivity,
employment, capital stock and investment. Furthermore, industrial
delicensing increases labor productivity but only in the states with flexible
labor market institutions. Even after controlling for delicensing, trade
liberalization is shown to have a productivity enhancing effect. Finally,
trade liberalization benefits most the export-oriented industries located in
states with flexible labor-market institutions.
 530 D. Mitra and B.P. Ural

Related literature
Hall and Jones (1999) look at how capital accumulation, productivity and
therefore output per worker are affected by social infrastructure. Social
infrastructure here refers to institutional and policy variables that determine
the economic environment determining capital accumulation, skill forma-
tion, invention, innovation and technology transfer. Their measure of social
infrastructure is based on measures of corruption, expropriation risk,
government repudiation of contracts, law and order, bureaucratic quality
and trade barriers. While output is made a function of social infrastructure
in their estimation framework, they correct for endogeneity of the latter
using instruments such as geographical variables, mainly distance from the
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equator and the extent to which modern European languages are spoken as
first languages today, which captures European influences on institutions.
Their study concludes that countries with better social infrastructure have
higher levels of output per worker in the long run, have higher investment
rates and are more efficient at converting inputs to output.
Recently, a major advance in this literature has been made by Acemoglu
et al. (2001) who have looked at former European colonies to study the
impact of institutions on per capita income levels. For these countries, they
are able to use European settler mortality rates as instruments for
institutions. In countries conquered by Europeans, whether they decided to
permanently settle or not was determined by their ability to survive there (by
their mortality rates). If they decided to settle in a country themselves, they
adopted good institutions, while if they decided to rule from their home
country, they put in place extractive institutions. Their decision to settle in a
region, therefore, was a function of their mortality there; on the other hand,
mortality rates of potential settlers, to begin with, can be viewed as a function
of geographical variables. While Acemoglu et al. find statistically significant
effects of institutional variables on per capita income in the expected
direction even after instrumenting institutions (with variables capturing
expropriation risk that current and potential investors face), this instrumen-
tation completely removes the effect of geographical variables on income.
From the literature on institutions, we move to trade policy. The effects
of trade barriers on growth and income have been studied since the early
1990s. While Dollar (1992), Sachs and Warner (1995) and Edwards (1998),
using different measures of openness, in many cases constructed from
standard policy measures, showed positive effects of trade on growth, these
papers have been strongly criticized by Rodriguez and Rodrik (2001) for the
problems with measures of trade openness and the econometric techniques
used, as well as for the difficulty in establishing the direction of causality.
While Rodriguez and Rodrik (2001) have criticized the measure of openness
used by Sachs and Warner (1995) as capturing many aspects of the
macroeconomic environment in addition to trade policy, Baldwin (2003) has
 The Journal of International Trade & Economic Development 531
recently defended that approach on the grounds that the other policy
reforms captured in the measure, although not trade reforms per se,
accompany most trade reforms sponsored by international institutions.
Therefore, using such a measure tells us the value of the entire package of
trade and accompanying reforms. Wacziarg and Welch (2003) have updated
the Sachs–Warner dataset and have again shown the benefit of such reforms
in driving growth.
Just as in the case of the literature on the effect of institutions as
explained above, the trade literature has also shifted focus to levels from
growth rates. Frankel and Romer (1999) look at the effect of trade share in
GDP on income levels across countries for the year 1985. They construct an
instrument for the trade share by summing up the gravity-model driven,
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geography-based predicted values of bilateral trade flows across all trading

partners. The variables used to predict bilateral trade flows include distance,
country size variables such as land area and population and dummies for
whether the countries are landlocked, have a common border, etc. They find
that their instrumental variables approach produces positive effects of trade
on income levels that are greater than the estimates produced by ordinary
least squares. Irwin and Tervio (2002) apply the Frankel–Romer approach
to cross-country data from various periods in the twentieth century to show
that this trade–income relationship is indeed highly robust.
Building on two literatures, namely the one on institutions and incomes
and the other on trade and incomes, Rodrik et al. (2002) have looked at the
simultaneous effects of institutions, geography and trade on per capita
income levels. Using a measure of property rights and the rule of law to
capture institutions and the trade–GDP ratio to capture openness in trade,
and treating them both as endogenous in their growth regressions, they use
the instruments that Acemoglu et al. (2001) and Frankel and Romer (1999)
use to instrument institutions and trade openness respectively (and
separately). Rodrik et al. (2002, 4) find that ‘the quality of institutions
trumps everything else’. However, trade and institutions have positive effects
on each other, so that the former affects incomes through the latter.
Similarly, geography also affects institutions.
The most closely related to what we are doing are a few papers on the
role of labor-market institutions, deregulation and trade reforms in Indian
manufacturing. Besley and Burgess (2004) look at the impact of state-level
amendments (made over the period 1958–1992) to the Industrial Disputes
Act of 1947. They find that states, with net pro-worker amendments, had a
relatively lower output, employment, investment and productivity in overall,
organized (formal) manufacturing than other states. The state-level data
they used were at the aggregate manufacturing level, and they did not look
at trade policy, the role of development spending or industrial deregulation.
Aghion et al. (2007) look at the effects of the dismantling of the system of
controls including entry deregulation and trade reforms on three-digit
 532 D. Mitra and B.P. Ural
industry level output, employment, the number of factories and total capital
stock across states. They find the positive effects of these reforms were more
pronounced in states with more pro-employer institutions. The difference
between the paper by Aghion et al. and our paper is that our focus is on
labor productivity and total factor productivity, while theirs is on overall
output and employment. We also separately look at employment and
capital, as do they. Our emphasis on productivity is important in the
context of the question we are trying to answer. We are looking at why
India’s exports in manufacturing are not taking off. Comparative
advantage depends on features of the aggregate economy such as
endowments, institutions and policies. These economy wide characteristics
affect production in different industries differently. Institutions and policies
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can affect productivity (efficiency) differently in different sectors. Produc-

tivity also depends on infrastructure and social services, the role of which
we also try to study in this paper, and which is completely missing in the
existing literature. It is the relative productivities of different sectors that
ultimately have a crucial role to play in the determination of comparative
advantage.
In Aghion et al. (2005), using the same industry-level, state-level data
from India they show that delicensing led to an increase in interstate
inequality in industrial output during the same period. This follows from
Aghion et al. (2007) where they showed that output and employment in each
industry increase relatively more in the pro-employer states than in other
states. Their focus here is only on delicensing.

Indian policy framework

The trade reforms in India
In the 1980s, India experienced moderate economic growth, but accom-
panied by large macroeconomic imbalances reflected in the rapid rise in the
fiscal deficit to GDP ratio, in foreign commercial debt and in the debt service
ratio. These problems were further accentuated by a drastic rise in the price
of oil as a consequence of the Gulf War. At this time, the general elections of
1991 brought to power a new government that inherited probably the
world’s most complex and restrictive trade regime. By the time the new
government assumed power, India’s external payments problem had
assumed crisis-like proportions. The government requested the IMF for
loans, which were granted but came attached with the strong conditionality
of major and deep economic reforms. The reforms were initiated almost
immediately. There were many members in the new cabinet who had been
cabinet members in past governments that had tried to avoid IMF loans
precisely because of these conditionalities. These governments were also
strong believers in inward-looking trade policies and the use of tariffs as a
primary source of revenues. Thus, the reforms came as a surprise.
 The Journal of International Trade & Economic Development 533
The major trade reform objectives announced by the Indian government
in July, 1991 included the removal of most licensing and other non-tariff
barriers on all imports of intermediate and capital goods, the broadening
and simplification of export incentives, the removal of export restrictions,
the elimination of the trade monopolies of the state trading agencies, the
simplification of the trade regime, the reduction of tariff levels and their
dispersion and the full convertibility of the domestic currency for foreign
exchange transactions. Subsequently, the maximum tariff was reduced from
400% to 150% in July 1991, to 110% in February 1992, to 85% in February
1993, 64% in February 1994 and to roughly 45% by 1997–1998. The mean
tariff went from 128% before July 1991 to 94% in February 1992, 71% by
February 1993, 55% in February 1994 and to roughly 35% by 1997–1998.
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The standard deviation of tariffs during this period went down from 41
percentage points to roughly 15.4 As far as the non-tariff barriers were
concerned, prior to 1991, there were quantitative restrictions on 90% of the
value added in the manufacturing sector. In April 1992, all 26 import-
licensing lists were eliminated. However, a ‘negative list’ (from which most
intermediate and capital goods were excluded) of items, whose imports were
prohibited, was introduced, thereby eliminating many of the licensing
procedures and discretionary decisions of the previous import regime.
As far as the exchange rate is concerned, the Indian Rupee was devalued
20% against the US dollar in July 1991 and further devalued in February
1992 when an explicit dual exchange market was introduced. The percentage
reduction in tariffs and non-tariff barriers were much greater than the
percentage devaluation (and even larger relative to the real exchange rate
devaluation on account of fairly high inflation, hitting roughly 14%, during
the initial years of the reforms).

Labor markets: regulations and rigidity

In this section, we describe some key, basic features of labor regulations in
India and their implications for labor-market rigidity.5 First, legislative
authority over labor issues lies with both the central (federal) government as
well as individual state governments. In other words, the state governments
have the authority to amend central legislations or to introduce subsidiary
legislations. In addition, the state governments are responsible for the
enforcement of most labor regulations, irrespective of who enacted them.
Thus, there may be considerable variation in labor regulations and/or their
enforcement across India’s states.
Second, it is widely believed that India’s labor laws have placed serious
impediments in the hiring and firing of workers. The Industrial Disputes Act
(IDA) requires firms employing more than 100 workers to obtain the
permission of state governments in order to retrench or layoff workers.6,7
While the IDA does not prohibit retrenchments, it is not easy to carry them
 534 D. Mitra and B.P. Ural
out. States have often been unwilling to grant permission to retrench,
perhaps for reasons of political expediency (see Datta-Chaudhuri 1996).
There are additional provisions for job security in the Industrial Employ-
ment (Standing Orders) Act. Under this act, all employers with 100 or more
workers (50 in certain states) are required to specify to workers the terms
and conditions of their employment. While the purpose of the Act is to make
labor contracts complete, fair, and legally binding, one can easily see how it
may interfere with quick adjustments to changing conditions. In particular,
modification of job descriptions or interplant transfers of workers, in
response to changing market conditions, cannot be done without worker
consent. The problems further accentuated by India’s Trade Union Act
(TUA), make it difficult to obtain worker consent. While the TUA allows
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any seven workers in an enterprise to form and register a trade union, it has
no provisions for union recognition (for example, via a secret ballot),
leading to multiple, rivalrous unions within the same firm, a consensus
among which becomes a virtual impossibility (see Anant 2000).
Panagariya (2001) argues very persuasively about the costs of these labor
laws. These laws restrict the size of firms below their minimum efficient scale,
hurting their competitiveness in export markets. Hiring workers under these
conditions, he argues, is a prohibitively costly activity when the number of
workers runs into thousands. Finally, these laws prevent entry and reduce
competition. This aspect of the cost of labor regulations goes beyond what
costs existing entrepreneurs incur.
It is important to note, however, that not all analysts agree that India’s
labor laws have made for a rigid labor market. In particular, a counter-
argument to the views discussed above is that India’s labor regulations
relating to job-security have been either ignored (see Nagaraj 2002) or
circumvented through the increased usage of temporary or contract labor
(see, in particular, Dutta 2003). Ultimately, whether India’s labor laws have
created significant rigidities in labor markets or not is an empirical issue. It is
hard to imagine that they have not created any rigidities or have not
constrained entrepreneurs at all in adjusting to shocks.

Measuring labor-market flexibility

We use the partitioning of states, in terms of whether they have flexible labor
markets or not, from Hasan et al. (2007). They start with Besley and
Burgess’ (2004) coding of amendments to the Industrial Disputes Act
between 1958 and 1992 as pro-employee, anti-employee or neutral. Hasan
et al. (2007) find the natural partition of states based on Besley and Burgess
(2004) (to treat states with anti-employee amendments, in net year terms, to
the IDA as those with flexible labor markets) somewhat problematic. They
make changes based on the recent survey work by Dollar et al. (2002) and
World Bank (2003) that strongly calls for some modifications. Maharashtra
 The Journal of International Trade & Economic Development 535
and Gujarat, two of India’s most industrialized states that have passed pro-
employee amendments to the IDA, are perceived by Indian businesses to be
good locations for setting up manufacturing plants, and are states where
overmanning of plants is not prevalent. Kerala is just the opposite case, with
net pro-employer amendments but with an overall perception of not being
very business friendly, and with substantial over-manning.

Empirical analysis
Data
The variables required are measures of employment, output and value
added, and indicators for protection, labor-market rigidity and industrial
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deregulation. Our source for production-related information is the Annual

Survey of Industries (ASI)8 from 1980 to 2000 which, among other things,
reports for each industry-state combination values of gross output
produced, intermediate inputs, wage bill, the book value of capital stocks
and the number of workers.9 Since the ASI reports monetary values in
current prices, appropriate price deflators are needed to convert the nominal
values into real ones. We use industry-specific wholesale price index (WPI)
series to deflate output to constant 1981 rupees. The WPI for machinery,
transport equipment and construction is used to deflate the book value of
capital stock. Dividing the total wage bill by the number of workers is used
to arrive at wages. Our materials price deflators are those constructed by
Trivedi et al. (2000).10
As regards our trade policy variable, we use industry-year specific tariff
rates, for the period 1988–2000 (summarized in Table 1). These variables are
based on the calculations for the 18 two-digit industries made by Hasan
et al. (2003, 2007).11
Table 2 provides a list of states as well as how they are classified.12 The
construction of this table is explained in the subsection on measuring labor
market flexibility. Based on this classification, we create a dummy variable
called ‘FLEX’ which takes a value of 1 for states with flexible labor market
institutions (and 0 otherwise).
Our variable on delicensing, which we call ‘delicensed’, is defined as the
share of manufacturing output accounted by delicensed industries. First,
we determined delicensed industries based on Aghion et al. (2005), who use
industrial policy statements, press notes, and notifications issued by the
central government to identify when various three-digit manufacturing
industries were delicensed.13 We then calculated the output share of these
industries within each two-digit industry for each state in each year.
Another policy variable we use is the real per capita development
expenditure. Development expenditure here includes expenditure on
education, public health, water supply, sanitation, relief from natural
calamities and food subsidy.
 536 D. Mitra and B.P. Ural
Table 1. Descriptive statistics.

Time span Mean Std dev.

Output 1980–1999 45468.2 85061.27
Before (1980–1991) 36702.7 59938.76
After (1992–1999) 59224.5 112460.1
Net value added 1980–1999 8456.9 18110
Before (1980–1991) 36702.7 59938.8
After (1992–1999) 59224.5 112460.1
Output per worker 1980–1999 2.12 2.63
Before (1980–1991) 1.85 1.89
After (1992–1999) 2.54 3.45
Net value added per worker 1980–1999 0.38 0.49
Before (1980–1991) 0.33 0.36
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After (1992–1999) 0.47 0.64

Per capita development 1980–1999 7818.02 2694.42
expenditures Before (1980–1991) 7056.57 2370.95
After (1992–1999) 9159.21 2707.24
Real invested capital 1980–1999 24692.09 52235.25
Before (1980–1991) 19417.88 36434.77
After (1992–1999) 32969.34 69403.99
Number of workers 1980–1999 23281.59 45793.66
Before (1980–1991) 20960.75 32370.9
After (1992–1999) 26923.86 61019.07
Investment 1980–1999 0.50 26462.34
Before (1980–1991) 1265.90 11323.9
After (1992–1999) 71830.70 39024.2
Average tariffs 1980–1999 100.27 50.11
Before (1980–1991) 153.13 25.04
After (1992–1999) 65.09 25.83
Average non-tariff barriers 1980–1999 66..88 21.99
Before (1980–1991) 85.35 14.52
After (1992–1999) 56.44 19.44
Output share of delicensed 1980–1999 53.50 45.20
industries Before (1980–1991) 28.01 38.55
After (1992–1999) 87.35 27.83
Share of export4import 1991 0.55 0.48
industries

Notes:
1) Output and Net Value Added are deflated by WPI obtained from Reserve Bank of India
Database on Indian Economy at http://www.rbi.org.in/. Base year for WPI is 1981.
2) Development expenditures are deflated by the GDP deflator.
3) Number of workers includes direct and contracted employment.

Methodology
Our basic measure of productivity in this paper is labor productivity, which
is real net value added divided by the number of workers. This measure of
productivity is regressed on our policy and institutional variables, and their
relevant interactions.
 The Journal of International Trade & Economic Development 537
Table 2. Labor market flexibility.

State Composite measure*

Andrha Pradesh Flexible
Assam Inflexible
Bihar Inflexible
Gujarat Flexible
Haryana Inflexible
Karnataka Flexible
Kerala Inflexible
Madhya Pradesh Flexible
Maharashtra Inflexible
Orissa Flexible
Punjab Flexible
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Rajasthan Inflexible
Tamil Nadu Inflexible
Uttar Pradesh Flexible
West Bengal Flexible

*Source: Hasan et al. (2007).

We extend our analysis of productivity to total factor productivity. Our

methodology in investigating the determinants of total factor productivity
follows the general Cobb–Douglas type production function approach.
Consider the following production function:

Y ¼ AKa Lb ð1Þ

where Y is the real net value added, A is the productivity level, K is the
amount of real capital and L is the labor used in the production. Let
s ¼ 1, . . . ,S index states, i ¼ 1,..,I index industries and t ¼ 1, . . . ,T index
time in years. Our estimating equation can be written as:

ln Yist ¼ ln Aist þ a ln Kist þ b ln List i ¼ 1 . . . I; s ¼ 1; . . . ; S; t ¼ 1; . . . ; T ð2Þ

with i denoting industries, s denoting states and t denoting time. The i and s
subscripts denote the cross-section dimension and t denotes time
series dimension of panel data. Productivity Aist depends on the policy
variables:

ln Aist ¼ g0 þ g1 FLEXs þ g2 NRPit þ g3 ðFLEXs  NRPit Þ

ð3Þ
þ g4 DEVst þ g5 ðNRPit  DEVst Þ þ g7 GSDPst þ uist

and

uist ¼ mi þ lt þ eist ð4Þ

 538 D. Mitra and B.P. Ural
where mi denotes industry-specific and lt denotes time-specific unobser-
vable characteristics. eist is the remainder disturbance with IID(0, s2e ).
As can be seen, this is a three-dimensional panel data model, and we
run a fixed effects regression.14 FLEX is a state-specific dummy variable
that takes the value one for states with flexible labor markets and NRP
is the industry and time varying tariff rate. We also use non-tariff
barriers and import penetration as alternatives to NRP. DEV is defined
as the logarithm of real per capita development expenditure and
varies by state and time. GSDP is the logarithm of real Gross State
Domestic Product and is used to control for the possible existence of
economies of scale. We run our regressions with and without the GSDP
control.
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The impact of policy variables on employment and capital accumulation

is estimated using a specification analogous to the one in equation (3). In
these regressions, the dependent variable is the number of workers and real
invested capital, respectively.
We extend our analysis of the determinants of productivity to using
delicensing (along with its interaction with labor market flexibility) of
industries as an additional industry regulation variable. Another extension
was made to analyze the impact of export promotion of industries using the
interaction of export dummy, trade protection and labor market
flexibility.15

Some simple data analysis

In Figure 1, we plot the overall GDP growth rate, growth rate in
manufacturing value added and the growth rate in value added in services
(all obtained from WDI) over time for the period 1980–2004.
After the 1991 reforms, only in five of the 13 years (only in 1993, 1994,
1995, 1996 and 2000) do we find growth rates in manufactures to be higher
than in services. There is a clear acceleration in growth in the case of
manufactures from 1991 to 1994, which is followed by a sharp deceleration.
We see much lower volatility in the growth rate of service value added. In
Figure 2, we clearly see that value added in services as a proportion of GDP
has been gradually increasing over time for the period 1980–2004 from
roughly 37% to about 51%. In the case of manufactures, the proportion has
remained in the narrow range of 15% to 18%. This clearly shows that the
growth is service driven, and that manufacturing has not taken off in a big
way. Figure 3 clearly indicates that most of the trade is in goods, although
both trade overall and services trade as a proportion of GDP have been
rising.
In Figure 4, we plot the simple yearly averages of our policy and
institutional variables from our dataset. While trade liberalization clearly
starts in 1991, delicensing started in 1985.
 The Journal of International Trade & Economic Development 539
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Figure 1. Growth rates of GDP, manufacturing and services value added.

Figure 2. Sectoral value added as a proportion of GDP.

We see that output share of delicensed industries increased from 0 before

1985 to roughly 40% in 1985, which next rose to roughly 85% in 1991 and
finally to about 92% in 2000. It is also interesting to see that starting from
 540 D. Mitra and B.P. Ural
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Figure 3. Trade as a percentage of GDP.

Figure 4. Tariffs, industry regulations and development expenditures.

1981 until about 1991, there was about a 50% increase in average state per
capita development expenditure.16 While this itself may have been driven by
economic growth in the 1980s, it is also quite plausible that economic growth
itself was partly driven by per capita development expenditure growth. This
 The Journal of International Trade & Economic Development 541
may look like a virtuous circle, especially if we fail to take into account the
macroeconomic crisis of the late 1980s and the early 1990s. Our labor market
flexibility variable, namely FLEX, remains unchanged in this 1980–2000
period and there we do not plot it. It only varies across states and not over
time.
Since India is a large country with many states that are larger than the
member countries of the European Union (EU), labor mobility across these
states is probably more imperfect than within the EU. Therefore, it makes
sense to take a look at the spatial (interstate) distribution of output in
addition to looking at the interindustry distribution. So for each year, we
calculate the coefficient of variation (a measure of inequality), the ratio of
standard deviation to the mean, of output and value added across the
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different industry-state units. The unit of observation is an industry in a

state. With 18 two-digit industries in 15 major states, we have 270 such units.
While in Figure 5, output inequality has a mild positive trend, value added
inequality has a much stronger positive trend. In other words, the large units
are growing larger while the small units are growing smaller. In Figure 6, we
see that inequality in per worker output and value added also has an upward
trend, showing that labor productivity is also becoming more and more
unequally distributed over time. This clearly shows that there are barriers to
the movement of resources across states and industries, as factor returns are
not getting equalized across state and across industries. In fact, there is a
trend towards steady divergence. Thus, there is clear evidence of strong
factor market imperfections.

Figure 5. Overall inequality output and net value added.

 542 D. Mitra and B.P. Ural
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Figure 6. Overall inequality of output per worker and net value added per worker.

In Figures 7 through 10, we decomposed this inequality into

interindustry and interstate by calculating separate coefficients of variation
along the two dimensions. We find that, while output and value added

Figure 7. Inequality of output and net value added across industries.

 The Journal of International Trade & Economic Development 543
inequalities are increasing across industries (Figure 7), they are decreasing
across states (Figure 8).
Per worker output and value added inequality are increasing at both the
interstate and interindustry levels (Figures 9 and 10). In other words,
productivity is becoming increasingly heterogeneous across industries and
across states. However, we see that total income or output is becoming
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Figure 8. Inequality of output and net value added across states.

Figure 9. Inequality of output per worker and NVA per worker across industries.
 544 D. Mitra and B.P. Ural
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Figure 10. Inequality of output per worker and NVA per worker across states.

increasingly equal across states, as shown by the falling inequality in Figure

8. This means employment is rising faster in the less productive states. Thus,
from these inequality trends it is clear that there is serious interstate and
interindustry labor immobility that leads to substantial misallocation of
resources. In our regressions presented in Tables 3 to 9, we will see this is a
fairly serious problem.

Regression results
In Tables 3 to 9, we present the effects of different policy and institutional
variables and their interactions on the real value added per worker, the total
factor productivity (using a production function approach), on employment,
on capital and on investment. The variable ‘NRP’ denotes annual average
nominal rate of protection at the two-digit industry level. The variable
‘FLEX’ is a measure of labor market flexibility of a state. As explained in
the subsection on measuring labor market flexibility, this is based on the
Besley–Burgess measure of labor market flexibility combined with David
Dollar’s survey. This is a binary variable where a value of 0 represents a
state that has a rigid labor market while a value of 1 represents a state that
has a flexible labor market. There seems to be no variation in this variable
over time for the period we are looking at, i.e. it varies only across states. In
order to control for the export oriented industries, we determined two-digit
industries with exports greater than imports in each state in 1991, which is
called the ‘export dummy’ in the regressions.
 The Journal of International Trade & Economic Development 545
Table 3. Labor productivity – determinants of real net value added per worker.

Dependent variable: log (real net value added/number of workers)

(1) (2) (3) (4)
NRP 70.00468 70.00193
(74.77)*** (71.92)*
NTB 70.00414 0.00156
(71.74)* (0.62)
Development 0.27529 0.35029 0.28191 0.35757
expenditures (4.93)*** (6.16)*** (5.12)*** (6.32)***
(real, per capita, log)
FLEX 0.19286 0.054 0.13993 0.01175
(2.99)*** (0.84) (1.65) (0.14)
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NRP6FLEX 70.00176 70.0009

(73.36)*** (71.75)*
NTB6FLEX 70.00193 70.00078
(71.61)* (70.65)
NRP6development 0.000004 0.00000
expenditures (6.25)*** (2.10)**

NTB6development 0.00000 0.00000

expenditures (6.67)*** (1.43)
Gross state domestic 0.38903 0.34896
product (constant (6.52)*** (6.11)***
93 prices, log)
Constant 73.63143 710.16066 73.76063 79.74428
(76.96)*** (79.11)*** (77.10)*** (78.69)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of observations 2970 2970 2970 2970
R-squared 0.52 0.53 0.52 0.52

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.
Estimated coefficients of NRP6Development expenditures are zero up to five digits.

Our regressions are run on a three-dimensional panel. The data are by

two-digit industry across the 15 major states of India over the period 1989–
2000. Table 1 summarizes the key variables in our analysis.

The effects of protection, labor market flexibility and development expenditure

on labor productivity
Starting with Table 3, we see that the real net value added per worker is
higher in less protected industries, as seen by the statistically significant,
negative sign of the coefficient of the NRP variable in columns 1 and 2. Since
the labor productivity variable is in logarithms, the magnitude of the
coefficient indicates that a percentage point reduction in the tariff rate leads
 546 D. Mitra and B.P. Ural
to a 0.2 to 0.5% increase in labor productivity in a state with a rigid labor
market.
The strength of this effect is stronger in the case of a flexible labor
market, as seen by the statistically significant negative sign on the coefficient
of the interaction term between NRP and FLEX. A percentage point
reduction in the tariff rate leads, in states with flexible labor markets, to a
0.3–0.65% increase in labor productivity. In the period 1980–1991, the
average NRP across all two-digit sectors was 153%, while it was 65% in the
post 1991 period. This reduction, of 88 percentage points, according to our
regressions, could have led to a 60% increase in average labor productivity
in the flexible states and a 45% increase in average labor productivity in the
rigid states. This estimate of an increase in productivity, attributable to tariff
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liberalization, could be an overestimate, as this effect could also be picking

up the effects of other accompanying policy changes.
Non-tariff barriers (NTBs) also turn out to have a negative effect on
labor productivity, especially in states with flexible labor markets (column
3). A percentage point reduction in the NTB coverage ratio leads to a 0.4%
increase in labor productivity in states with rigid labor markets, and a 0.6
increase in labor productivity in states with flexible labor markets. This
result indicates that the reduction in NTBs, by about 29 percentage points
(between 1980–91 and the post 1991 period), could have led to a 17%
increase in labor productivity in the flexible states and a 12% increase in
labor productivity in the rigid states. These estimates seem more plausible
than the ones related to tariffs.
FLEX by itself has a positive sign and is significant when state GDP is
not thrown in as a control. So labor market flexibility leads to higher labor
productivity. Taking into account in column 1 the sign, significance and
magnitudes of the FLEX and its interaction with NRP, a flexible labor
market state that is similar in all other respects compared to another rigid
labor market state (at an NRP of 50%) has roughly about an 11% higher
productivity. Throwing in state GDP removes the significance of the own
(level) term in FLEX, probably since richer and bigger states are also the
ones that have more flexible labor markets. However, the sign still remains
positive. The interaction between NRP and per capita development
expenditure has a positive sign and is significant, but is extremely small in
size, i.e. it is statistically significant but economically insignificant.

The effects of protection, labor market flexibility and development expenditure

on total factor productivity
In Table 4, we use a production function approach. The TFP is assumed
to be a function of time and industry effects as well as policy and
institutional variables and their meaningful interactions. Clearly, from the
coefficients of the logs of labor and capital, the production function is
 The Journal of International Trade & Economic Development 547
Table 4. Production function – determinants of TFP and real net value added.

Dependent variables: log (real net value added)

(1) (2) (3) (4)
Factors of production:
Log labor 0.5057 0.50255 0.5024 0.49859
(21.90)*** (22.00)*** (21.80)*** (21.80)***
Log real invested capital 0.5587 0.55355 0.56086 0.55674
(29.10)*** (28.40)*** (29.00)*** (28.50)***
Policy:
NRP 70.00278 70.00201
(73.40)*** (72.42)**
NTB 70.00187 70.00043
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(70.96) (70.21)
Development 0.139 0.16811 0.14906 0.17524
expenditures (3.15)*** (3.74)*** (3.50)*** (3.89)***
(real, per capita, log)
FLEX 0.07071 0.03115 70.01614 70.04965
(1.27) (0.57) (70.22) (70.66)
NRP6FLEX 70.00094 70.00069
(72.07)** (71.56)
NRP6development 0.00000 0.00000
expenditures (0.49) (1.41)*
NTB6FLEX 70.00021 0.0001
(70.21) (70.09)
NTB6development 0.00000 0.00000
expenditures (0.98) (1.09)
Gross state domestic 0.12148 0.09814
product (constant 93 (2.27)** (2.02)**
prices, log)
Constant 73.04707 75.05252 73.13712 74.78256
(77.45)*** (75.27)*** (77.70)*** (75.07)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of observations 2970 2970 2970 2970
R-squared 0.92 0.92 0.92 0.92

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.

close to being CRS (or mildly IRS). Again NRP has the right (negative)
sign and is significant. The interaction of NRP and FLEX also has the
correct (negative) sign and is very significant without the state GDP
control and is somewhat significant with the right sign using state GDP as
a control. Again, this means that the positive effect of trade reforms on
TFP is stronger in states with more flexible labor markets. While a
percentage point reduction in NRP raises TFP by 0.2–0.3% in the rigid
labor market states, this increase can be about 0.4% in the flexible states.
FLEX by itself has the right (positive) sign but is not significant. Per
 548 D. Mitra and B.P. Ural
capita development expenditure does have a positive effect on TFP. As
indicated by the coefficient of the state GDP variable, TFP also is
increasing in state size, showing economies of scale. The effect of non-tariff
barriers on TFP turned out to be insignificant (columns 3 and 4).

The effects of protection, labor market flexibility and development expenditure

on employment, capital stock and investment
In Table 5, we look at the effect on employment of the policy and
institutional variables considered above. There is mixed evidence from
these regressions that protection reduces employment and that this effect is
stronger in more flexible labor markets. In other words, trade
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Table 5. Effect of trade protection on employment.

Dependent variable: log (number of workers)

(1) (2) (3) (4)
NRP 70.0088 0.00143
(75.80)*** (0.89)
NTB 70.02000 0.00546
(76.37)*** (1.66)
Development 0.57181 0.85077 0.52373 0.85956
expenditures (7.18)*** (10.04)*** (6.50)*** (10.60)***
(real, per capita, log)
FLEX 0.36303 70.16011 0.18965 70.38845
(4.09)*** (71.84) (1.56) (73.47)***
NRP6FLEX 70.00207 0.00117
(72.47)** (1.62)
NRP6development 0.00000 0.00000
expenditures (26.60)*** (1.46)

NTB6FLEX 0.00001 0.00521

(0.01) (3.07)***
NTB6development 0.00000 0.00000
expenditures (23.04)*** (2.79)***
Gross state domestic 1.45888 1.55652
product (constant (14.30)*** (16.30)***
93 prices, log)
Constant 5.81963 718.98739 6.916 720.81352
(7.86)*** (79.87)*** (7.30)*** (711.50)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of 2970 2970 2970 2970
observations
R-squared 0.47 0.53 0.46 0.53

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.
 The Journal of International Trade & Economic Development 549
liberalization can increase employment, especially in states with more
flexible labor markets. A percentage point reduction in NRP can raise
employment by as much as 0.9% in the rigid states and up to 1.1% in the
more flexible labor markets. Once we control for state GDP, these effects
go away, as the effects of protection on industrial expansion and on
overall state GDP might be highly correlated. The positive effect of per
capita development expenditure on employment, however, is very robust
to the inclusion and exclusion of the state GDP control. One percentage
point increase in non-tariff barriers reduces employment by 2%, and this
effect is the same for all states. Once we control for state GDP, we find a
positive effect for only flexible states.
In Table 6, we find similar results with invested capital, and in Table 7
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with investment as the dependent variable. However, in the case of

Table 6. Effect of protection on invested capital.

Dependent variable: log (real invested capital)

(1) (2) (3) (4)
NRP 70.01079 0.00172
(75.75)*** (0.85)
70.02109 0.00905
NTB (75.97)*** (2.36)**
Development 0.76063 1.1016 0.71088 1.10839
expenditures (7.73)*** (10.90)*** (7.09)*** (11.00)***
(real, per capita, log)
FLEX 0.53894 70.10049 0.4725 70.21179
(5.08)*** (70.99) (3.18)*** (71.59)
NRP6FLEX 70.0033 0.00065
(73.99)*** (0.77)
NRP6development 0.00000 0.00000
expenditures (26.20)*** (2.06)**

NTB6FLEX 70.00345 0.00269

(71.66) (1.42)
NTB6development 0.00000 0.00000
expenditures (24.00)*** (2.80)***
Gross state domestic 1.78317 1.84243
product (constant (14.60)*** (15.70)***
93 prices, log)
Constant 3.94009 726.38114 4.86705 727.95589
(4.37)*** (711.30)*** (3.93)*** (712.30)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of observations 2970 2970 2970 2970
R-squared 0.57 0.61 0.56 0.61

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.
 550 D. Mitra and B.P. Ural
Table 7. Determinants of investment.

Dependent variable: log (real investment)

(1) (2) (3) (4)
NRP 70.00573 0.0042
(71.75)** (1.14)
NTB 70.01367 0.01126
(72.03)** (1.56)
Development 0.37231 0.63936 0.34014 0.64352
expenditures (2.33)** (3.89)*** (2.10)** (3.92)***
(real, per capita, log)

FLEX 0.89585 0.44488 0.98585 0.52848

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(4.81)*** (2.35)** (3.73)*** (2.09)**

NRP6FLEX 70.0046 70.00199
(72.84)*** (71.24)
NRP6development 0.00000 0.00000
expenditures (11.30)*** (0.70)
NTB6FLEX 70.00796 70.00412
(72.21)** (71.20)
NTB6development 0.00000 0.00000
expenditures (11.40)*** (1.54)
Gross state domestic 1.38968 1.50701
product (constant (6.68)*** (7.99)***
93 prices, log)
Constant 4.0057 719.61333 4.81431 721.41209
(2.67)*** (75.11)*** (3.11)*** (75.84)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of 2970 2970 2970 2970
observations
R-squared 0.39 0.42 0.39 0.42

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.

investment, the positive effects of both FLEX and per capita development
expenditure are very robust to the inclusion and exclusion of the state GDP
variable. Investment is about 40 to 80% higher in a flexible labor market
state as compared to a similar state with a rigid labor market. In addition, if
per capita development expenditure rises by 1%, investment can go up by
0.37 to 0.63%. We find negative effect of NRP and non-tariff barriers on
investment, and this effect is more pronounced in states with flexible labor
markets.

The effects of industrial deregulation

We now present our extension that includes a new independent variable,
namely industrial deregulation. We call this variable ‘delicensed’. As
 The Journal of International Trade & Economic Development 551
explained in the data section, this variable measures the extent of delicensing
that has taken place. We throw in ‘delicensed’ and the interaction of
‘delicensed’ and ‘FLEX’ into our regressions, to pick up any differential
effects across states with different labor market institutions. While the
results are sensible and economically meaningful in the case of both labor
productivity and employment, we only present the productivity results
(Table 8).
We find that delicensing of industries had a positive impact on labor
productivity in states with flexible labor markets. This effect was reversed

Table 8. Determinants of labor productivity (real net value added per worker)
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extending to the impact of industrial delicensing.

Dependent variable: log (real net value added/number of workers)

(1) (2) (3) (4)
NRP 70.00492 70.0023
(75.01)*** (72.29)**
NTB 70.00534 0.00001
(72.18)** (0.00)
Development 0.29387 0.36631 0.30691 0.37661
expenditures (5.22)*** (6.43)*** (5.53)*** (6.65)***
(real, per capita, log)
FLEX 70.01692 70.17326 70.26668 70.42862
(70.15) (71.59)* (71.92)* (73.07)***
Delicensed 70.0009 70.00104 70.0015 70.00142
(71.35) (71.58) (72.22)** (72.11)**
Delicensed6FLEX 0.00206 0.0023 0.00293 0.00324
(2.53)*** (2.87)*** (3.45)*** (3.82)***
NRP6FLEX 70.00114 70.00025
(71.92)** (70.44)
NRP6development 0.00000 0.00000
expenditures (5.99)*** (2.02)**
NTB6FLEX 0.00096 0.00235
(0.69) (1.69)*
NTB6development 0.00000 0.00000
expenditures (6.63)*** (1.32)
Gross state domestic 0.37422 0.33228
product (constant (6.28)*** (5.89)***
93 prices, log)
Constant 73.42527 79.80187 73.77734 79.68009
(76.46)*** (78.89)*** (76.98)*** (78.53)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Observations 2970 2970 2970 2970
R-squared 0.52 0.53 0.52 0.53

Robust t-statistics in parentheses.

*Significant at 10%; **Significant at 5%; ***Significant at 1%.
 552 D. Mitra and B.P. Ural
for the rigid states. The ‘delicensed’ variable by itself has a negative and
significant coefficient, but when it is interacted with labor market flexibility
the coefficient is positive and larger in magnitude. One percentage point
increase in the output share of delicensed industries increased labor
productivity by 1.3 to 2.1% in flexible states, and decreased labor
productivity by 1.1 to 1.5% in inflexible states. In the period 1980–1991,
the output share of delicensed industries was 28% across all two-digit
sectors, while it was 87% in the post 1991 period. According to our
results, from the pre- to the post-reform period, delicensing of industries
could have led to a 77–120% increase in average labor productivity in
flexible states and 66–90% decrease in average labor productivity in rigid
states. Again, this could be an overestimate because of the many correlated
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accompanying policy reforms. However, we believe in the signs of our

coefficient estimates.
The effects of NRP, NTB and per capita development expenditure
remain robust to the inclusion of these industrial delicensing terms. While
per capita development expenditure is positive and significant throughout
(in both columns of Tables 8 and 9, i.e. with and without the state GDP
control), the NRP/NTB is negative and significant in three of the four
columns of Table 8.

The effects of export orientation

We analyze how protection affects export-oriented industries as compared
with other industries. At the same time, we try to investigate whether, in this
relationship, labor-market flexibility matters. We look at all this using the
interaction of the export dummy (which takes the value of 1 for export-
oriented industries and 0 otherwise), trade protection and labor market
flexibility. We experimented with an alternative specification, which also
consisted of the export dummy by itself, as well as its interaction with trade
protection. However, those variables did not turn out significant and the
effect of their exclusion on other coefficients was very small. For this reason,
those regressions are not presented in the paper. As seen in Table 9, the
triple interaction terms, Export Dummy 6 NRP 6 FLEX and Export
Dummy 6 NTB 6 FLEX are negative and significant. This negative sign
shows that trade liberalization has a greater positive impact on productivity
in export-oriented industries located in states with flexible labor market
institutions.
Thus, our main results can be summarized as follows:

(1) There has been an increase in the inequality of aggregate and per
capita output and value added across industry-state units over time.
Inequality of these variables increases across industries over time.
While the inequality of the aggregate variables decreases across
 The Journal of International Trade & Economic Development 553
Table 9. Determinants of labor productivity (real net value added per worker)
extending to the impact of export promotion.

Dependent variable: log (real net value added/number of workers)

(1) (2) (3) (4)
NRP 70.00511 70.00246
(75.17)*** (72.41)**
NTB 70.00617 70.0008
(72.50)*** (70.31)
Development 0.29174 0.36439 0.30973 0.37782
expenditures (5.18)*** (6.39)*** (5.59)*** (6.68)***
(real, per capita, log)
FLEX 0.04817 70.11912 70.30207 70.45517
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(0.42) (71.04) (72.16)** (73.24)***

Export dummy6 70.00074 70.0006
NRP6FLEX (71.72)* (71.39)
Export dummy6 70.00184 70.00154
NTB6FLEX (72.61)** (72.19)**
Delicensed 70.00086 70.001 70.00158 70.00148
(71.28) (71.52) (72.31)** (72.19)**
Delicensed6FLEX 0.00156 0.0019 0.00272 0.00305
(1.82)* (2.23)** (3.19)*** (3.59)***
NRP6FLEX 70.00102 70.00017
(71.70)* (70.29)
NTB6FLEX 0.00284 0.00389
(1.83)* (2.51)**
NRP6development 0.00000 0.00000
expenditures (5.96)*** (1.97)**
NTB6development 0.00000 0.00000
expenditures (6.74)*** (1.18)
Gross state domestic 0.37205 0.32579
product (constant (6.16)*** (5.77)***
93 prices, log)
Constant 73.38429 79.74019 73.75017 79.54586
(76.37)*** (78.71)*** (76.93)*** (78.40)***
Time effects Yes Yes Yes Yes
Industry effects Yes Yes Yes Yes
Number of 2970 2970 2970 2970
observations
R-squared 0.52 0.53 0.52 0.53

Robust t-statistics in parentheses.

* Significant at 10%; **Significant at 5%; ***Significant at 1%.

states, the interstate inequality of the per capita variables has been
decreasing over time. This clearly shows imperfect interindustry and
interstate labor mobility as well as misallocation of resources across
industries and states.
(2) Trade liberalization increases productivity in all industries across all
states.
 554 D. Mitra and B.P. Ural
(3) Productivity is higher in the less protected industries.
(4) The effects in points (2) and (3) above are more pronounced in states
that have relatively more flexible labor markets, i.e. the beneficial
effects of trade reforms on productivity are stronger in states with
more flexible labor markets. In such states, there is a bigger variation
in productivity across sectors based on the protection received.
(5) Labor market flexibility, independent of other policies, has a positive
effect on productivity.
(6) Per capita development expenditure by itself seems to be the
strongest predictor of productivity.
(7) Furthermore, there is some evidence that the above effects of
policies, institutions and their interactions on productivity are both
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through their effects on factor accumulation as well as independent

of them.
(8) Industrial delicensing increases both labor productivity but only in
the states with flexible labor market institutions.
(9) The productivity-enhancing effect of trade liberalization is greater in
export-oriented industries located in states with flexible labor-market
institutions.

Concluding remarks
While India has not really been a part of the global production-sharing
network in manufacturing, her manufacturing sector has gained from
globalization. This probably has been from tougher competition from
imported products or from a larger variety of imported inputs that has led
to higher productivity through greater division of labor. That productivity,
whether labor productivity or total factor productivity, is negatively
related to trade protection, is a result we see in all our regressions and is
quite robust to specification of the regressions or the set of control
variables used. The ‘pro-competitive effect’ clearly dominates the ‘market-
size effect’. However, there seems to be some evidence from our
regressions, that a stronger beneficial effect of trade reforms on
productivity is felt in the presence of more flexible labor market
institutions. Not only is there direct impact of these variables on
productivity, there also seems to be an impact of these variables on factor
accumulation and employment. Labor market flexibility, by itself, can
improve productivity to a large extent and has a positive effect on
employment and investment as well. The trend in value added and output
inequality (both in aggregate and per worker terms) across states and
industries clearly shows resource misallocation and barriers to factor
mobility within the country. Thus, the challenge for the Indian government
is to get rid of the rigid labor laws, whose operation over several decades
has created strong vested interests. We also show in this paper that
deregulation can only be useful in the presence of better labor laws. In
 The Journal of International Trade & Economic Development 555
states with better labor institutions, deregulation has had a positive effect
on productivity, but not in other states. Even after controlling for
delicensing, trade liberalization is shown to have a productivity-enhancing
effect.
We also find that trade liberalization benefits most the export-oriented
industries located in states with flexible labor-market institutions. This
clearly shows complementarities between policies – between lowering
protection, promoting exports and having a smoothly functioning, flexible
labor market. Thus, various types of economic reforms should go hand in
hand for these reforms to generate maximum benefits.
Finally, it turns out from our econometric analysis that the most
important and robust determinant of productivity and factor accumulation
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in the last two decades has been state development spending (spending on
infrastructure, health, education, etc.). It shows that the public sector has an
important role to play here. This is so since, in this area, especially in
infrastructure provision, private returns are much below social returns and
so there could be coordination failure if the private sector alone were to
perform this function.
The positive role played by government development spending is
particularly remarkable since India is a developing country. Corruption is
a serious problem in the developing world. Even though India is better
than most developing countries in this regard, it still does not do very well
in the world corruption rankings. Thus, for government spending to
matter in a positive way in such an environment is quite impressive. It also
means that, in the absence of corruption, things could have been even
better. While trying to reduce or eliminate corruption is important, it
cannot always be done directly. Policy reforms are an important way of
cleaning the system since they reduce the incentives for corruption. The
more rigid are the rules, regulations and restrictions (associated with doing
business) that require government monitoring, the greater is the scope for
corruption.

Acknowledgements
This paper is part of a ‘Research Project on the Rise of India and China’ undertaken
jointly by the World Bank and the Institute of Policy Studies (IPS), Singapore. We
thank IPS for financial support and Will Martin of the World Bank for very useful
discussions and valuable suggestions, as well as for detailed comments on an earlier
version. We would also like to thank Carmen Pages and Rana Hasan for advice and
for sharing their data with us. The standard disclaimer applies. This paper represents
the views of the authors and does not necessarily represent those of the World Bank
or the IPS or the institutions to which they belong.

Notes
1. In many cases, the dividing line between policies and institutions is very thin.
2. In this paper, we mainly focus on the gains to producers.
 556 D. Mitra and B.P. Ural
3. See Bhattacharjea (2006) for an exhaustive and critical survey of the empirical
evidence on the relationship between industrial performance and labor-market
regulation in India. In this survey, Bhattacharjea takes issue with the measures
of labor regulation used in existing studies, and argues in favor of outcome-
based measures, especially to take into account the enforcement of labor laws.
While Bhattacharjea is extremely critical of the Besley and Burgess (2004)
measure, he is less critical of the measure we are using in this paper. While this
measure, also used in Hasan et al. (2007), is derived from Besley and Burgess
(2004), the modifications (explained later) are important and make the cross-
state variation in labor regulation look more plausible.
4. See Dutt (2003) and Krishna and Mitra (1998).
5. See Dutt (2003) for a more detailed discussion of India’s labor-market
regulations.
6. Until 1976, the provisions of the IDA were fairly uncontroversial. The IDA
allowed firms to layoff or retrench workers as per economic circumstances as
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long as certain requirements such as the provision of sufficient notice, severance

payments and the order of retrenchment among workers (last in first out) were
met. An amendment in 1976 (the introduction of Chapter VB), however, made
it compulsory for employers with more than 300 workers to seek the prior
approval of the appropriate government before workers could be dismissed. A
further amendment in 1982 widened the scope of this regulation by making it
applicable to employers with 100 workers or more.
7. The term ‘layoff’ refers to a temporary or seasonal dismissal of a group of
workers due to slackness of current demand. Retrenchments, on the other
hand, denote permanent dismissals of a group of workers. Both terms may be
distinguished from ‘termination’, which refers to separation of an individual
from his or her job.
8. ASI data covers establishments registered under the Factory Act and employing
ten or more workers (with power and 20 or more workers without power). It
provides information on 18 manufacturing industries disaggregated by their
location across India’s states.
9. The term ‘workers’ refers to production workers (permanent, contract, and
temporary). The ASI also reports the number of ‘total employees’, i.e.
production and non-production workers. Unfortunately, the ASI uses different
definitions for reporting payments to ‘workers’ (called ‘wages’) and ‘total
employees’ (called ‘total emoluments’). Total emoluments include not only
‘wages’ paid to production and non-production workers (not reported
separately), but also the imputed value of benefits in kind provided to
production and non-production workers (once again, not reported separately).
This prevents us from computing a meaningful wage rate for non-production
workers. Nevertheless, if we ignore this and compute a wage rate for non-
production workers ([‘total emoluments’ – workers’ ‘wages’]/[‘total employees’ –
‘workers’]) and include it in our labor demand regressions, the key results of our
paper regarding the relationship between trade liberalization and labor demand
elasticity go through. Additionally, the results are also unchanged if we estimate
‘total’ labor demand equations (i.e. for total employees with the wage rate now
being computed as total emoluments divided by total employees).
10. Details of mapping from their product groups to the two-digit classification are
provided in Hasan et al. (2003). We thank Pushpa Trivedi for providing us with
the data.
11. In order to be able to use all our data from 1988 onwards, we use linear
interpolation/extrapolation to fill in the years for which the data are missing.
 The Journal of International Trade & Economic Development 557
12. See Hasan et al. (2003, 2007) for details.
13. The following two-step process was carried out to use the Aghion et al.
definition for delicensed industries. First, since the manufacturing industries
listed by them are expressed in terms of the Indian National Industrial
Classification (NIC) 1987 industrial codes, we map the listed industries in terms
of their NIC 1970 classification. This step is essential given that state level
information on three-digit manufacturing industries between 1986 and 1988 is
available from the Annual Survey of Industry (ASI) in terms of NIC 1970 only.
Second, we follow Aghion et al. in dropping all three digit industries that are
either included in any given state for less than 10 years or are active in less than
five states. This step was carried out in order to maximize the comparability of
states’ experience with delicensing. We thank Rana Hasan and Jewel Cain of
the Asian Development Bank for helping us sort out this important data issue.
14. We have 270 cross-sectional units (18 industries and 15 states), and thus the
number of cross-sectional units far exceeds the number of years, which is only
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10. This allows us to ignore cointegration-related issues in our estimation.

15. We also included the export dummy by itself, as well as its interaction with
trade protection in our analysis as an alternative specification. However,
these variables did not turn out significant and the effect of their exclusion
on other coefficients was very small. For this reason, they are not presented
in the paper.
16. The logarithm of per capita development expenditure increased by 0.49 points,
which can be seen on the right axis in Figure 4.

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