city characteristics (population and income), and other investment climate indicators, including city and industry fixed effects, firm performance is still significantly better in city-industry cells that feature a higher share of nonpermanent workers. This is consistent with the notion that labor flexibility allows firms to adjust more easily to changing economic circumstances and to be more productive<sup>18</sup> —keeping in mind that other city-industry-specific variables may still account for the positive correlation between firm performance and our proxy of labor market flexibility. Why does labor flexibility improve firm performance in China? Facing adverse demand shocks, firms with more nonpermanent workers find it easier to adjust their labor forces and, therefore, to reduce costs and restore optimal factor allocations. Furthermore, firms with a flexible labor force do not have to fear labor hold-up when considering technology choices and capital investment decisions, and the choices of technology and capital-labor ratio would thus be more efficient.

Relatedly, cumbersome labor regulations are found to be associated with smaller firm sizes and more informality in India (Amin 2009a).<sup>19</sup> Using World Bank Investment Climate data on retail sectors, Amin proxies cumbersome labor regulation as the state share of firms viewing labor regulation as minor or major obstacles. He finds that this measure is robustly correlated with smaller firm sizes and informality,<sup>20</sup> even after a series of sensitivity checks: controlling for development level, store characteristics, city- and state-level variables, and a proxy of general regulation burden. His results are also robust for small and large firms. A caveat for his study is that this regulation proxy may merely capture the effect of related state-level variables.

Facing bad labor regulations, firms do adjust on other margins. Relying on the World Bank data of 2000 retail stores in India, Amin (2009b) find that stores located in states with more 18 Indeed, around the turn of the century, China underwent the most dramatic labor-restructuring program in the world (Dong and Xu 2008 and 2009). Between 1995 and 2001, more than 35 million state workers had been laid off. In examining the enterprise restructuring in the early 2000s, Dong and Xu (2008 and 2009) found that firms were more likely to undergo downsizing when they were SOEs; when the SOEs were older, larger, and had more excess capacity; and when product prices dropped, indicating that the labor restructurings tend to be efficiency-enhancing. Moreover, the patterns of labor adjustments for private enterprises and SOEs were similar (such as reducing labor demand when output prices drop and when wages increase), indicating an increasingly integrated Chinese labor market.

> 19 Fernandes and Pakes (2008) also find evidence of labor misallocation in India by using the World Bank Investment Climate Survey data. They find that the growth rate of the Indian manufacturing sector is significantly lower than its growth rate in the services sector or in China. They compute the ratio of labor under-utilization and find that under-utilization is widespread in Indian states, especially in those states with lower income levels and for productive firms.

> 20 Policies that increase the informal sector likely reduce the average productivity and income of the economy. Recent evidence suggests that the informal sector tends to attract low-productivity workers who have a low likelihood of ever being promoted to the formal sector (Bruhn forthcoming; Maloney 2004; de Mel et al. 2008; and La Porta and Shleifer 2008). The most important determinants of the size of the informal sector across countries include the stringency of labor regulations and their enforcement (Johnson et al. 1998; Loayza et al. 2005b).

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