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India has a tightly regulated labour market and, as a result, about 90% of the labour force works in the informal sector. This not only affects overall output, but also forces the majority of the labour force to work on unfavourable terms.
A new paper by the International Monetary Fund argues that reforms in the product market increase the share of output in the formal sector but do not necessarily lead to higher employment in the formal sector, as labour market rigidities encourage firms to use more capital.
However, if the reforms are first implemented in the labour market, employment in the formal sector goes up—even in the short run. This results in higher investment and economic activity.
Further, significant delays in labour market reforms compared with product markets can result in higher adjustment cost as rising wages in the formal sector can lead to greater resistance to change. Therefore, it is vital for the government to pursue labour market reforms comprehensively, which will help boost employment and growth.