#8: Double or Nothing
Legally mandated overtime wages may be harming workers instead of benefiting them.
In the year 2010, India’s goods exports stood at $230.97 billion, roughly thrice that of Vietnam. By 2020, India’s goods exports stood at $281.55 billion, which was slightly less than that of Vietnam at $282.63 billion. In the year 2010, the manufacturing sector's share in GDP stood at 17 percent in both India and Vietnam. By 2020, the manufacturing sector’s share had declined to 14 percent in India, whereas in Vietnam it had increased to 24 percent. Employment figures also tell a similar story. In the year 2010, India and Vietnam both employed about 22 percent of their workforce in the manufacturing sector. By 2020, this number had increased to 24 percent in India, whereas in Vietnam it jumped to 31 percent. These numbers indicate that Vietnam was able to achieve a greater level of industrialization in spite of the fact that its population is less than one-tenth of India’s population. One reason for India’s failure to industrialise quickly may be India’s labour regulations, which set out to protect industrial workers but actually harm the same workers, retard the growth of the manufacturing sector, and reduce workers’ earnings.
India’s law governing overtime wages is an example of such a law that aims to protect workers but may actually be harming workers and the industry. Indian law on overtime pay in the manufacturing sector is governed by Section 59 of the Factories Act (1948). This provision requires that employees be paid overtime wages at twice the rate of normal wages. The motivation may have been that if workers are working more, then the entrepreneurs are making more profit, and therefore such excess profit should be shared with the worker. However, the effect of this law may be the opposite as entrepreneurs may, instead of paying overtime, not produce at all. As a result, the workers lose the chance to even earn the regular wage as excess, let alone the double wages promised by the law.
An illustration
What happens to the entrepreneur when wages are doubled? Two databases (KLEMS and NAS) show the input costs and surplus generated by various sectors of the Indian economy. The databases track the cost of inputs like labour, capital, raw materials, services, etc., that makes it possible to create a hypothetical scenario where labour costs are doubled. In this hypothetical, the assumption is that the legislation causes a doubling of current wages for all workers across industries. Under this assumption, the compensation of employees becomes double when legislated wage rate is applied compared to when current wage rate is applied. The table below shows the differential impact of the doubling of the value of compensation of employees on profit margin for different industries.
This is a simplified illustration that overstates the decrease in profits. This is because the overtime wage law applies only to workers in a factory. Managerial/supervisory staff are not covered under the law. However, the illustration shows us the impact of double wages if they were applied as a general rule.
Unprofitable industries
As the illustration shows, some industries (like construction and trade) end up becoming loss-making industries if wages are doubled. In such cases, rational entrepreneurs will shut down production rather than pay additional wages. Consequently, instead of earning double wages, workers will make no wages.
This problem is made worse by the fact that the industries that turn loss making are the industries that employ more people. Such industries have a higher share of total production cost allocated to labour (that is why they are called labour-intensive). Consequently, these industries are also more sensitive to wage increases. For example, the construction and trade sectors are among the largest employers in India. Therefore, legislating double wages harms industries that could help employ more workers per unit of capital deployed.
Additionally, the law may be harming workers by forcing entrepreneurs towards more than optimal investment in capital goods at the expense of lowering employment. Every country has an optimal ratio between investment in machinery and investment in labour. In developed countries, labour costs are high, and therefore it is rational for entrepreneurs to invest in more machines for greater automation. In contrast, labour costs are lower in developing countries, and therefore the mix of machines to labour should tilt in favour of labour. However, the legislated double wage may distort this calculation since machines are not entitled to double wages for extra hours of work. Entrepreneurs know this. Therefore, entrepreneurs may over-invest in machines hoping that any extra work can be done with less labour. As a result, workers may lose more earning opportunities in India, even if wages are lower.
Profitable industries
Some industries (like food products and chemical products) are profitable even when legislated double wages are applied, and it may be tempting to think that entrepreneurs will continue production with double wages. However, in reality, even these industries may shut down rather than pay double wages. This is because entrepreneurs are trying to maximise risk adjusted for profit. The illustration shows that the financial sector (45.13%) creates more profit than the textile industry (9.6%). However, we do not observe all textile industries closing and converting to banks. This is because of the different risks associated with each industry. Financial sector may be more profitable, but that usually comes with higher volatility of income (risk). Textiles may have lower profit but may give more predictable returns over the long term (lower risk).
This difference in earnings is also reflected within the industry, which may lead to entrepreneurs not making products with overtime wages. The illustration shows that the textile industry made 9.6% profit in 2019–20. However, not all textile firms make a 9.6% profit; this is just the average for the entire Indian textile industry. Some entrepreneurs made more profit, while others made less. However, no entrepreneur knows at the beginning of the year which bucket they will fall into—making more than the industry average or less. When wages are doubled by law, the entrepreneur is certain that they will make less profit on products made with overtime wages. What is not certain is whether those products will sell at a profit after they are made. Each entrepreneur takes a risk when making any product. The overtime wage law increases this risk by increasing production costs but not guaranteeing sales. Entrepreneurs may think that the increased risk from overtime wages is not worth taking. Therefore, even if the industry is profitable after doubling wages, the individual entrepreneur may not consider it worth their risk and not make goods using overtime labour. Consequently, even in profitable industries, workers may lose the opportunity to earn excess wages at normal rates, let alone the double rate promised by law.
India’s competitors
International comparison suggests that India’s overtime wage provision is much more restrictive than other nations, which may have played a part in keeping the size of Indian manufacturing firms small. In India, the overtime wage premium rate is set at 100 percent, which is much higher than the rates that are observed in other countries. Overtime wage premium rates can be accessed for different countries through the ILO Travail Legal Databases. The table below shows the differences in mandatory minimum overtime wage premium rates across different countries as specified under their respective legislations.
India’s high overtime wages may be hurting the manufacturing sector by diverting production to countries with lower overtime wage premium. Consider a hypothetical scenario where there is a sudden fashion trend for a new type of hat. In the initial months/weeks there is no way to know if the trend will become permanent or fade away after a few months (like most fashion trends do). For this initial period, production will have to be done at overtime wage rates. After some time, if the trend becomes permanent, entrepreneurs will invest in new capacity or additional shifts. If the trend is transient, production will go back to normal hours. Now consider that this sudden demand is sent to factories in Vietnam and India. The Vietnamese entrepreneurs have to pay only 50% overtime wage premium, half of what is legally mandated in India. Therefore, Vietnamese entrepreneurs will be more amenable to responding to this transient demand, with Indian entrepreneurs and workers both losing the opportunity to make profit from this trend. However, the damage to Indian industry is not limited to these short-term trends. Consider a situation where this trend becomes a permanent increase in the demand for hats. In such cases, Indian labour may be cheaper than Vietnamese labour. However, for the last few months, Vietnam has been producing hats (paying overtime wages). Consequently, the Vietnamese industry (including labourers) have gained experience, proficiency, and optimization tools. Now, it is harder for the Indian textile industry to compete with Vietnam in producing these hats. Even if production is cheaper in India, Indian workers and Indian industry may lose the opportunity to earn from this new demand for hats.
This problem of India’s overtime wages is not limited to making India less competitive to other developing countries. India may even be losing out to developed countries known for higher worker protections. As the table above shows, even developed economies like Germany, the UK, and Sweden do not legally mandate overtime premium and leave it to negotiations between workers and entrepreneurs. This freedom may allow such developed countries to be more agile in responding to sudden demand spurts than India, hurting India’s manufacturing sector and the workers in it.
Another example
India’s law on overtime wages is just one example of many provisions in labour law that end up harming the interests of workers and industries. Only a few of these provisions have been studied. A common example in literature is the Industrial Disputes Act, which constrains factories from employing more than a threshold number of workers. Instead of promoting worker rights, the law has resulted in factories choosing not to expand and staying under the threshold of the law, leading to a large number of stunted firms just under the legal limit (Ahsan and Pagés, 2009; Mehrotra and Giri, 2019).
The new labour codes, introduced by the Government of India in 2020, may also fall short in achieving the objective of improving the economic condition of the workers. The objective was to bring a large section of workers under the purview of the law and foster economic growth. However, a closer examination reveals that many of the provisions that have harmed workers and employers in the past may still exist in these codes. For example, the overtime wage provision has remained the same in the Code on Wages, 2019. Employers are still required to compensate workers at double the normal rate for extra hours of work.
Way Forward
The correct strategy for overtime wages is to allow employees and employers to negotiate the wage rate. This approach has the advantage of ensuring that both workers and employers have the freedom to adjust their expectations on the basis of prevalent market conditions. Since profitability depends on market conditions, certain industries may be in a better position to afford higher overtime wage rates than other industries. If the workers are aware of the market conditions, they can themselves secure higher earnings without the need for state intervention.
For research, various labour law provisions of India require review as to the incentives they set up for employers. Mere objectives of laws are not enough to justify their existence; the outcomes such laws will create should be analysed. India’s manufacturing sector and its workforce need better-designed laws for economic growth and prosperity.
References
Ahsan, A. and Pagés, C. (2009). Are all labor regulations equal? Evidence from Indian manufacturing. Journal of Comparative Economics, 37(1): 62–75.
Bhattacharya, P. (2018). Which are the sectors that generate employment in India? Mint.
Mehrotra, S. and Giri, T. (2019). The Size Structure of India’s Enterprises: Not just the middle is missing. Working Paper, Azim Premji University.
Rousseau, F. and Caruso, L. (2016). Improving Returns in Capital-Intensive Industries. Industry Week.
Seth, S. (2012). Flip side of economic growth: Cos prefer more capital over labour, create less jobs. The Economic Times.
Suyog Dandekar and Shubho Roy are researchers at Prosperiti. We are happy to share the data collected for this study.