# 1. Introduction<sup>5</sup>

There is growing evidence that factor misallocation has constrained firm performance in India. A large literature suggests that rigid industrial labor regulation reduces employment and productivity in firms. Besides labor, there has been rising interest in understanding the misallocation of land and capital, and their effects on the manufacturing sector. Some recent studies suggest that rigid land use regulation, such as land ceiling laws, have reduced productivity. Research on a related topic – the impact of policies promoting industrial parks and Special Economic Zones – is also growing.

Misallocation is important to study because it suggests that aggregate output could be increased by reallocating existing resources towards firms that can use them more productively. By one estimate, simply reallocating resources between existing Indian firms to match U.S. levels of efficiency in resource allocation could increase India’s aggregate productivity by 60%-80% (Hsieh and Klenow, 2009).

Factor misallocation could be one of the reasons for the absence of economic convergence between India’s states. The widening economic gap between Indian states has policy makers increasingly concerned.6 It is a puzzle, contradicting a basic paradigm in growth theory – the idea of convergence — and contrasting with the experience of the U.S. and Japan (cf. e.g., Barro and Sala-i-Martin, 1992; Caselli and Coleman, 2001). Since state governments have jurisdiction over many policy areas affecting factor markets, the design and implementation of factor market policies varies across states. It could be that some states remain poorer than others not because of a deficiency of resources, but because on an inefficient allocation of existing resources.

Despite the strong influence of state governments on factor market policies, there has been surprisingly little systematic analysis of how factor market misallocation and related policies vary across Indian states. This paper contributes to this policy-relevant research agenda by using Indian firm-level panel data from 1999-2014 to describe trends in factor market distortions across Indian states. We look at ‘permanent’ labor, temporary (‘contract’) labor, land and fixed capital, and establish stylized facts about how factor market distortions have evolved across Indian states.<sup>7</sup> Complementing the results of the data analysis with information learned through firms interviews in two states, we suggest areas of focus for future policy analysis. The results of this paper can also be a useful filter for identifying cases of successful reforms or good practices in individual states which could be shared with other states.

We adapt the cost-minimization approach (De Loecker and Warzynski, 2012) to measure trends in factor ‘adjustment costs’ over the years. The ‘adjustment cost’ of a factor is conceptualized as an implicit variable cost incurred by a firm in using that factor. This conceptualization is similar to the ‘implicit taxes’ on inputs modeled in Hsieh and Klenow (2009), a seminal study of factor misallocation in India. The potential causes of this implicit cost include market frictions, institutional factors and factor market regulations which make it harder for firms to employ or adjust their inputs.

The analysis indicates that at the all-India level, the adjustment costs for permanent labor, contract labor and land have fallen between 1999 and 2014. There was a small increase in the adjustment cost for permanent labor between 2004-2007, but the trend has been downwards since 2009. The decline is most

> 5 We are grateful to Amit Khandelwal for in-depth advice on how to estimate adjustment costs. We also thank Sam Asher, Leonardo Iacovone, Rinku Murgai and Bob Rijkers for helpful comments and suggestions. We thank Sarur Chaudhary, Ruifan Shi and Sargam Jain for superb research assistance.

> 6 See, for example, Chapter 10 in Government of India (2017).

> 7 We distinguish between permanent labor (workers employed directly by the firm) and contract labor (workers employed through labor contractors) as they are subject to different sets of regulation.

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