Do Labor Laws Discourage Borrowers? An Empirical Note.

AuthorGhosh, Saibal


The relevance of labor laws in affecting the behavior of the manufacturing sector has been well analyzed in the literature. A whole gamut of studies convincingly demonstrated that stringent labor regulations are detrimental to the growth of employment and impede productivity and innovation (Heckman & Pages, 2004; Besley & Burgess, 2004; Botero et al., 2004; Griffith & Macartney, 2014).

The majority of the literature treats all labor laws as one category. It makes no distinction among different types of such laws. This assumes relevance since the impact of laws relating to employment protection are likely to differ from those that impact firms' ability to adjust employment levels. The impact of various categories of such laws on borrower behavior remains an open question.

Another strand of literature highlights the role and relevance of various financial constraints facing the SME sector (Beck et al., 2006; Ayyagari et al., 2014). One obstacle that has attracted significant attention has been access to credit. In deed, a large body of research has affirmed the role of finance as a key constraint for SMEs (de la Torre et al., 2010; Cowling et al., 2016). However, as Kon and Storey (2003) indicate, SMEs may exercise self-restraint in many cases by not seeking financing owing to fear of denial. These so-called "discouraged borrowers" might be quite substantial (Jappelli, 1990; Freel et al., 2012). (1)

We combine these two strands of literature and assess the role played by labor laws in fomenting borrower discouragement in India. In particular, using cross-sectional data at the state-level, we examine two issues. First, how do different labor laws impact discouraged borrowers? Second, do the complementarities between different labor laws affect discouraged borrowers?

For this, we employ the coding of state-specific labor laws developed by Besley and Burgess (2004) and refined by Ahsan and Pages (2009). In particular, we distinguish between labor laws that address the dispute settlement mechanism between employers and workers and those that influence the flexibility of firms to adjust employment levels. The former is labelled as Dispute Settlement (DS) legislation and the latter as Employment Protection Legislation (EPL). Within the latter, we focus on Chapter 5B (Ch.5B) which prohibits firms with a threshold employment from retrenching workers without prior government permission. Using a case study approach, Agarwala (2012) shows that multiple measures focused on transnational activism have enabled these workers to draw the attention of the state towards local issues and a commitment to empowerment.

From an empirical standpoint, we utilize cross-section data on SMEs from the World Bank Enterprise Survey for 2014. We integrate this with information on state-level labor laws to assess its impact on discouraged borrowers. The key outcome variable is Discouraged, who is "a good borrower, requiring finance, that chooses not to apply because it feels its application will be rejected" (Kon & Storey, 2003). We control for other confounding factors by using both SME-specific (e.g., size, age, ownership, auditing, quality certification and export status, R&D activity) and state-specific (e.g., natural logarithm of state per capita income) and control for 2-digit SIC industry fixed effects as well as state-fixed effects.

The focus on the Indian scenario is important for three reasons. First, India is a federal polity comprising states, each of whom have a democratically elected government. Major public policy decisions are made and implemented at the level of states. This makes political parties to compete intensely on the right to govern at the state level. Second, labor is a policy issue that belongs to the Concurrent list--on which both the Federal and state governments can legislate--and therefore state governments focus on the rights of labor to safeguard and enhance their re-election projects. And third, SMEs have long been recognized as a vital fulcrum of industrialization and employment --accounts for close to 50% of the manufacturing output and...

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