# **4. Conclusion**

This paper has explored the magnitude and patterns in noncompliance with India’s Factories Act, a key piece of legislation which is the anchor for the distinction between the “organized” and the “unorganized” sectors. It begins by arguing that responses to regulation fall into four categories—compliers, evaders, avoiders and outsiders. Using two complementary data sources, the paper provides recent estimates and trends for the number of enterprises in each of these categories. The central conclusion is that noncompliance is significant. The number of noncompliant firms (Evaders) exceeds the number of compliant firms, and it exceeds an upper bound estimate of the number of firms that have adjusted out of the regulation (Avoiders). However, the category of firms that are not affected by the regulation at all (Outsiders) far exceeds all other categories put together.

Our paper is also a contribution to the “missing middle” literature. The Factories Act is one of the candidate explanations for the lack of medium size enterprises in the size distribution of manufacturing firms in India. Our analysis presents a specific estimate of the contribution of the Factories Act to this phenomenon. Furthermore, it distinguishes between and quantifies two aspects of the missing middle—enterprises that adjust out of the regulation and enterprises that evade the regulation. Clearly, the analysis needs to be quite different for these two types of the “missing middle.” The extent of noncompliance raises the question of enforcement. We have shown considerable variation in noncompliance across industries and across states. The impact of enforcement resources on compliance is thus an interesting research question. It is also an important question since such widespread noncompliance can undermine trust and belief in the legal and regulatory system. How can one make sense of nonenforcement of a regulation by a government which has itself passed that regulation? Of course enforcement costs are a possible explanation as are the preferences of the government, as suggested by the theory in Basu, Chau and Kanbur (2010). Responses to the Factories Act present an opportunity to test these theories of optimal enforcement, and this is an interesting area for further research.

However, if the regulation itself is thought to be inappropriate, then perhaps no enforcement is the best answer. This takes us into the current debates on regulation and its impact on informality and productivity. The policy discourse on regulation has been tied up with views on the magnitude and nature of informality, and its consequences for growth and efficiency. Thus, for example, _The Economist_ (September 9, 2010), in a survey of Latin America, argues as follows: “Thanks largely to baroque regulation, half the labor force toils in the informal economy, unable to reap the productivity gains that come from technology and greater scale.” This statement contains theory (regulation is the cause of informality) and an estimate of the magnitude (half the labor force). However, it attributes the whole of informality to regulation, whereas the theory of Section 2 says that it is the evaders and the avoiders who are responding out of the regulation. The outsiders were not affected by it in the first place. As Chen and Doane (2008) argue in their review of South Asia: “....labor market rigidities alone cannot explain the extent of informal employment...”.

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