Based on the research of Sumit Agarwal, Shashwat Alok, Yakshup Chopra and Prasanna Tantri
A new study of the Indian government’s employment guarantee scheme looks at its impacts on labour movement and supply, and firm productivity, investment and profitability, both in the short and long term.
The paper uses establishment-level employment and operating data to examine the potential effects of the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), an employee guarantee programme, on labour and private firms. It studies the ways in which this programme affects employment, wages, investment in plant and machinery, and firm profitability. The authors find that the programme led to an exodus of workers from formal employment in factories towards the employment guarantee scheme, resulting in a labour supply shortage. Factories responded to this shortage by increasing mechanisation, often sub-optimally, as evidenced from an immediate drop in profitability. These effects are seen most prominently in firms with lower labour productivity and higher output volatility. For employees, the effects are observed for those at the lower end of the wage spectrum and those working in pro-employer states. Overall, there is a mass shift of labour from corporate employment to the MGNREGA.
The MGNREGA, a Government of India initiative, was launched in February 2006. The stated objective of the programme was to provide “livelihood security in rural areas by providing at least 100 days of guaranteed wage employment in a ﬁnancial year to every household whose adult members volunteer to do unskilled manual work.” By 2008, 5.8 million families had completed 100 days of work, with an initial outlay of USD 3.41 billion (USD 1 = INR 67). In terms of man days provided and the proportion of government revenue allocated, this is the largest ever employment guarantee programme in history. Currently, it provides employment to approximately 50 million households annually, generating about 2,300 million person-days of employment.
The MGNREGA is a form of fiscal intervention. The empirical evidence of large welfare programmes on labour market frictions, firm output and capital expenditure, specifically in the corporate sector, is scant at best. This paper, attempts to bridge this gap in the literature. The phase-wise implementation of the programme facilitates the use of difference-in-difference methodology across time periods and treatment groups, thus absolving the impact of any other macro-economic shocks. The programme is not a temporary measure; in fact, it is a permanent one with no end date. It is thus expected to have long-lasting effects on the movement of both labour and capital.
In the paper, the authors examine the impact on both the permanent and temporary workforce in the private sector. They also determine the effect of this labour supply shock on the capital investments made by firms. They test the theory that these effects are a function of ﬁrm-speciﬁc factors, such as access to ﬁnance, ex-ante wages, labour productivity, cash ﬂow volatility as well as the labour law regime in the ﬁrm’s state. Finally, they study how these changes in labour and capital impact firm productivity. The primary data source for this empirical study is the Annual Survey of Industries (ASI) from 2002 through 2010.
MGNREGA and Labour Supply
There are three broad categories of workers: contract, permanent and managerial. The number of contract workers remains unaffected by the implementation of the MGNREGA. This is plausible, since contract workers can work in factories while taking advantage of the programme during off-work periods. Managerial staff employment is also found to be unaffected by the implementation of the programme. This aligns with the goals of the MGNREGA, which is targeted toward the poor, low-skilled labour force. It is the 10% drop in the permanent workforce that warrants an explanation. Although average wages in a factory are higher than the MGNREGA wage, the wages vary along a spectrum. The workers that leave permanent employment are at the lower end of the wage distribution scale. Also, the non-pecuniary benefits of MGNREGA employment - less effort required due to poor monitoring, working closer to home, lower incidental expenses and lower chances of accidents due to the nature of the work — render higher factory wages minus these benefits unattractive relative to lower MGNREGA wages, prompting the movement of permanent workers towards MGNREGA employment.
MGNREGA and Capital Investments
Capital expenditure is measured as gross value additions to fixed capital and additions to plant and machinery. Results show that capital investments have increased significantly with the advent of the MGNREGA, and that the increase is cumulative over time. This reinforces the idea that firms respond to labour supply shock by resorting to increased mechanisation instead of increasing wages to attract more labour. Thus, the MGNREGA leads to the crowding out of private employment in favour of increased mechanisation.
What is the critical factor in the choice between increased investment and increased wages? The answer is access to finance.Capital expenditures need to be met up front. Access to finance is thus a necessary pre-requisite for factories moving towards increased spending on plant and machinery. The authors find that SMEs that are eligible for priority sector lending in areas with low bank penetration mechanise more than those that are not eligible for specialised lending. The latter, on the other hand, respond by increasing wages. SMEs that are eligible for such lending, but which have greater access to finance via greater bank penetration, show negligible change in either mechanisation or wages.
Impact of the MGNREGA on Labour Retention and Capital Investment
Wage Level and Productivity Impact
A cross-sectional analysis of these formal sector establishments confirms that the drop in permanent workers is restricted to factories that pay lower wages. Also, where labour productivity (as measured by output per unit labour) is lower, there is a greater exodus of permanent workers (a decline of 3.85%) relative to factories with higher output per labour (and consequently higher wages) where there is no change in permanent worker employment.
In the context of capital investment as well, a cross-sectional analysis of factories based on wages paid shows that lower-wage factories respond to the loss of labour supply with greater mechanisation. Factories with lower labour productivity (and consequently lower returns to labour) also respond with an increase in gross fixed assets and plant and machinery.
Factories with higher output volatility also lend themselves to uncertain employment. In this scenario, the MGNREGA, with its guaranteed 100 days of employment, may seem like a safer bet. The authors observe a 3.2% decline in permanent workers in factories with higher output volatility. Factories with lower output volatility are unimpacted by the MGNREGA.
The larger decline of permanent workers in factories with greater output volatility results in a larger percentage increase in mechanisation. Factories with lower volatility in output are unaffected.
Workers in pro-employee states are guaranteed a higher level of job security and protection against actions taken by employers. These workers have less incentive to leave their secure jobs for MGNREGA, regardless of wages. On the other hand, workers in pro-employer states with lower job security and stricter monitoring by employers would be inclined to move toward MGNREGA employment. Results of a cross-sectional analysis show this to be true. Permanent employment falls by 3% in pro-employer states. Investment in fixed assets and plant and machinery goes up as factories respond to the dip in labour supply with increased mechanisation. In pro-employee states, neither of these variables are significantly affected.
Stratifying further, we find that factories with lower labour productivity, lower wages and higher output volatility within pro-employer states are the most affected by the MGNREGA. In these states, factories at the other end of the spectrum are hardly impacted.
MGNREGA and Factory Level Performance
The marginal productivity of factory labour is positive in India. As we see above, the MGNREGA compels factories that are not yet ready for mechanisation (since the marginal productivity of labour is still positive) towards it. Moreover, if the factories found mechanisation more profitable, they wouldn’t be waiting for the MGNREGA to make the shift. Despite the potential increase in operational efficiency, the switch from labour to capital is expected to result in a fall in operating profits, at least in the short run. Regression results show that while the cost of production increased by 7.5%, profitability declined 50 basis points, and the output-input ratio deteriorated significantly.
The paper concludes that “workfare programs may adversely impact the corporate sector by weening away a productive workforce and thereby creating a labor shortage”, which has consequences on hastening technology adoption. While the paper is an empirical study of the short-run impact of the MGNREGA, it points to its long-term implications as well. The MGNREGA provides low skill employment, with infrequent monitoring and low effort. The move of formally employed labour towards such employment hampers their ability and motivation to gain skills, thus potentially making them dependent on the welfare programme for life. This is further exacerbated by increased mechanisation in factories, which increases the demand for skilled labour in the future, making the current workforce ineligible for such employment even in the long run.
For factories, though profitability suffers in the short run due to the unanticipated increase in capital investments, this would likely be reversed in the long run since these investments typically increase operational efficiency, and hence, factory performance.
 Workers in pro-employer states face relatively low job security and stricter monitoring from their employers, based on labour regulations.  Less than INR 50 million investment in plant and machinery  Workers in pro-employee states enjoy a higher level of job security and protection against actions taken by employers, in accordance with the labour laws of that state.
About the Authors:
Shashwat Alok is Assistant Professor of Finance at ISB.
Sumit Agarwal isProfessor of Finance at the McDonough School of Business, Georgetown University.
Yakshup Chopra is Researcher at the Centre for Analytical Finance at ISB.
Prasanna Tantri is Senior Associate Director at the Centre for Analytical Finance at ISB.
About the Research:
Agarwal, Sumit, Alok, Shashwat, Chopra, Yakshup, and Tantri, Prasanna L. (January 2017). Government Employment Guarantee, Labor Supply and Firms’ Reaction: Evidence from the Largest Public Workfare Program in the World. Georgetown McDonough School of Business Research Paper No. 2880629.
This research has been supported by the Centre for Analytical Finance at ISB.
About the Writer:
Aditi Mitra is a PhD Economics from the University of Washington, Seattle and a freelance writer with the Centre for Learning and Management Practice at ISB.