Impact of Labour Laws on Wage Differentials between Formal and Informal Sectors: Evidence from the Indian Manufacturing Sector

Abstract

Labor laws in India have been a subject of contention since their inception. There are arguments against labor laws that say that an adherence to labor laws push up the wages in the formal sector and reduce employability of the labor. A hike in labor cost makes capital relatively cheaper, causing an increase in capital intensivity of the production. This study is an attempt to show that labor laws are necessary and empirically proves that it is not the labor laws that create the wedges between the formal and informal sector wages. We econometrically test the hypothesis of there being a significant difference between wages in the formal and the informal sector and its correlation with existence of labor laws in the formal sector. The Oaxaca’s decomposition technique is used to find out the difference in formal-informal sector wages that could be attributed to existence of labor laws. The results that we obtain show that 87 percent of the difference in wages between the formal and the informal sector is determined by the differences in income generating characteristics of the worker employed. We conclude that labor laws do not drive up the wages artificially, they just make employment more secure and worthwhile for the worker. We also point out the importance of public investments in human capital creation, underlining the fact that it is these investments that can reduce various inequalities among the wages of workers across employments and sectors.