Introduction and context

India is well known for its extensive set of labour laws providing job security to regular industrial workers in the formal sector. Studying the response of firms to labour regulations constitutes a key component of one's understanding of the impact of labour laws on employment growth and access to good jobs in India. How have firms in India responded to Employment Protection Legislation (EPL) in terms of their hiring strategies, entry and size expansion decisions? Has EPL affected the upward mobility of firms? These are admittedly difficult empirical questions. In this chapter I provide preliminary econometric evidence that manufacturing firms in India employ non-permanent workers (contract workers) to avoid coming under EPL. Even in advanced country contexts, EPL and other related labour regulations are widely perceived to raise the expected cost of employment adjustment in firms covered by legislation, causing discontinuity in firm growth behaviour and employment policies. Labour regulations apply rules with respect to conditions of service, lay-off, retrenchment and closure to firms above a specified employment size. This is argued to raise labour adjustment costs and create pressures on firms to stay below the legal threshold size. Note that the regulations take effect as firm size grows and it generates an implicit tax. As the regulations are defined with reference to few finite employment size levels the literature refers to them as ‘threshold effects’ (see Gourio and Roys, 2012). The analytical idea of threshold effect is that if labour legislation (or any other economic policy like tax rates) changes discontinuously at the threshold employment size (or it could be asset size or output level) then it should result in discontinuous change in firms’ behaviour. This change in behaviour of firms is directly proportional to the costs of compliance above the threshold. The discontinuous regulation can have two effects. First it could influence the propensity of the firm to expand employment above the threshold size impacting firm size distribution.