Dispatch #107: When good intentions backfire: The unseen cost of India's labor law reform

This dispatch unpacks how a well-meaning labor law in India backfired—driving more workers into informal jobs—and offers lessons on how thoughtful policy design can avoid unintended consequences.

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Designing policy isn’t just about aiming high—it’s about landing right. Because good intentions without good design can still miss the mark. The aim of a policy may be noble—protect workers, improve wages, boost productivity—but the outcomes can be completely different, especially in economies where informality is high. This paradox is especially clear in India’s labor market, where a law meant to protect workers ended up pushing more businesses and workers into the informal sector.

In 2003, the state government of Andhra Pradesh took what seemed like a bold and progressive step. It introduced a reform aimed at improving workers' lives by banning the use of contract labor in a company’s core operations. The intention was to encourage businesses to give workers regular jobs with better pay, job security, and benefits like health insurance and pensions. On the face of it, this seemed like a win for workers’ rights.

But nearly two decades later, we know good intentions aren’t always enough.

A new research study by economists Ritam Chaurey, Gaurav Chiplunkar, and Vidhya Soundararajan—titled “Employment Protection Legislation and Informality: Theory and Evidence from India”—tells a more complex story. The reform may have helped some workers, but it also pushed many others deeper into the shadows of India’s already massive informal economy.

The authors make a compelling case that without considering how businesses react, even well-meaning labor laws can produce the opposite of what policymakers intended.

The Informal Reality

To understand why this happened, we need to first look at the nature of work in India. Most Indians—about 85%—work in what’s known as the informal sector. These are jobs in small shops, workshops, or home-based businesses that don’t follow labor regulations. They don’t offer job security, regular pay, or benefits.

Now, within the formal sector—companies that are registered and regulated—a lot of employers also rely on contract workers. These workers are not on the company's permanent payroll. They’re hired through middlemen or for short periods, and companies use them to avoid the costs of labor laws, such as paying for severance or social security.

So, when the Andhra Pradesh government introduced a law banning contract labor in core business operations, they were trying to reduce this workaround. They wanted companies to stop treating contract workers as second-class employees and offer them the same protections as regular staff.

But as the researchers show, what followed wasn’t a straightforward transition from insecure to secure jobs.

The Reform and Its Effects

To see what changed after the 2003 reform, the researchers dug into multiple large-scale national datasets that track firms and workers across India. They used a "before-and-after" approach, comparing what happened in Andhra Pradesh after the reform with what happened in other Indian states that didn’t change their labor laws.

Here’s what they found:

The good news - Formal companies hired fewer contract workers.

The law did have its intended effect within formal companies. Firms in Andhra Pradesh cut down their use of contract labor by nearly 50%. Many of them increased the number of full-time, regular workers they hired instead. The share of contract workers in the workforce dropped, and payroll jobs went up.

The bad news - More firms and workers moved into the informal economy.

But that wasn’t the whole story.

At the same time, more businesses chose to remain informal—they avoided registering altogether to stay out of reach of labor laws. Workers in Andhra Pradesh became more likely to be hired casually or without contracts, often earning lower wages than before.

In short, while the reform reduced one type of informal work, it led to an increase in another. Many businesses, faced with higher costs of complying with the law, simply found it easier to stay outside the formal system altogether.

The Hidden Costs: When Formality Becomes a Burden

On paper, the Andhra Pradesh reform seemed like a step forward for workers’ rights. By banning the use of contract workers in a firm’s core operations, it aimed to push companies toward hiring regular, payroll employees who would enjoy greater protections and stability.

But what this approach failed to consider is how businesses actually make decisions—especially in economies where informality is not a fringe but the norm. The reform treated formality as a moral imperative rather than an economic choice. The reality? For many businesses, especially small and mid-sized ones, formality is expensive and risky.

To explain why the reform had such unintended consequences, the researchers built a theoretical model—a kind of economic simulation that helps track how firms respond to different policy environments. It’s based on real-world data and behavior, and its findings are both sobering and illuminating.

Here’s what the model shows:

1. Rising Costs, Falling Compliance

Once the Andhra Pradesh government imposed a blanket restriction on contract labor in core activities, formal firms had fewer options. Without access to flexible, short-term labor, they had to either:

• Hire regular workers, which meant higher wages and compliance with a host of laws (e.g., Provident Fund, ESI, termination protections); or

• Cut back their operations, exit the formal sector, or avoid registering altogether.

For firms already on the margins—low in capital or struggling with demand—this new constraint tipped the balance. Formality became not just harder but untenable.

2. Exit from the Formal Sector

The model predicted, and real data confirmed, that more firms chose to go informal after the reform. The authors used data from India’s Economic Census (1998 and 2005) and found a striking shift: the likelihood of a large firm (with 50 to 100 workers) being unregistered rose by over 50% in Andhra Pradesh relative to other states.

This is significant. When large firms—those typically expected to have the resources and incentives to be formal—choose to remain outside the legal fold, it suggests that something deeper is broken in the incentive structure.

3. Lower Productivity, Shrinking Wages

What happens when more firms go informal?

Productivity drops. Informal firms tend to be smaller, use less capital, and are less likely to adopt modern technologies. They also lack access to formal credit, infrastructure, and skilled labor. As more firms move into this less productive space, the entire economic engine slows down.

This was visible in the wage data, too. Using the National Sample Survey, the researchers found that average daily wages in Andhra Pradesh declined by 4.6% after the reform, relative to other states. Workers were also:

• 14% more likely to be on informal contracts;

• 9% more likely to work in an unregistered firm;

• 3.7% more likely to be casual workers (i.e., daily wagers or piece-rate workers).

In other words, instead of moving workers into better jobs, the policy pushed them into worse ones.

4. General Equilibrium Effects: A Domino Impact

Most policy evaluations look at direct impacts: fewer contract workers, more payroll workers—check. But the deeper insights in this paper come from looking at general equilibrium effects—how one change ripples through the entire system.

Here’s how it played out:

• As more firms left the formal sector, the overall demand for labor fell.

• With lower demand, workers across the board—formal or informal—had weaker bargaining power.

• Wages dropped, even for those who remained in regular jobs.

• Consumers had less to spend, further slowing down business growth.

The model predicted a 2% decline in total factor productivity (a measure of how efficiently inputs like labor and capital are used) and a 9% drop in real income, a direct hit to household welfare. These are not abstract figures. They represent real losses—reduced purchasing power, fewer opportunities, and stalled economic mobility for millions.

At its core, the Andhra Pradesh reform mistook symptoms for causes. It treated the use of contract labor as the problem, rather than understanding why firms preferred it in the first place. In doing so, it treated a structural issue as a moral one and used a stick where a smarter carrot might have worked better.

As the researchers show, if the goal was to improve job quality and worker protection, a better strategy could have been to reduce the cost of hiring formal workers—simplifying compliance, reducing red tape, and making it easier for businesses to follow the rules. The consequences of not doing so are now painfully clear: what was meant to be a step toward formality ended up reinforcing informality, hurting the very people it aimed to help.

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What Could Have Been Done Differently?

When the Andhra Pradesh government banned contract labor in core business activities in 2003, they were trying to do the right thing—stop companies from exploiting temporary workers and push them to offer regular, secure jobs instead. But as we’ve seen, the policy didn’t fully deliver on that promise. Instead of creating more good jobs, it made running a formal business harder. Many companies, especially small and mid-sized ones, responded by pulling out of the formal system entirely.

So, what could have been done differently?

That’s the question the researchers behind this study explored. And their answer is simple but powerful: instead of punishing companies for doing the wrong thing, why not make it easier for them to do the right thing?

To understand this better, let’s look at two different approaches they tested using data and simulations.

Option 1: The Path Andhra Pradesh Took – Ban Contract Workers

In this approach, the government made it harder and more expensive for companies to hire contract workers. If you were running a business and still used contract labor in your main operations, you could face penalties or even legal action.

At first glance, this seemed to work. Many companies cut back on contract workers and hired more full-time employees instead. But there was a catch. Because it became harder and more expensive to stay formal and follow the new rules, many businesses decided to avoid the system altogether. They stayed small, off-the-books, and unregistered—where the government couldn’t see or regulate them.

As a result:

• Fewer new businesses joined the formal economy.

• Wages dropped for many workers because there were fewer good jobs available.

• Overall, people had less money in their pockets, and the economy slowed down.

So even though the reform reduced the use of contract labor in some companies, it ended up hurting workers in other ways—through lower pay and more informal jobs.

Option 2: A Different Approach – Make Formal Hiring Easier

Now imagine if, instead of making it harder to use contract workers, the government made it easier to hire full-time employees. What if rules were simpler, paperwork was less, and the cost of following labor laws went down?

That’s the second option the researchers explored. And the results were much more encouraging.

In this scenario:

• Companies still reduced their use of contract workers—but did so willingly.

• More businesses stayed formal, and some informal ones even registered.

• Workers had access to better jobs and higher wages.

• The economy became more productive, and overall incomes went up.

In short, this approach didn’t scare businesses away. It gave them a reason to stay and grow within the formal system.

The big lesson from these two scenarios is clear: if you want companies to do the right thing, make it easier—not harder—for them to follow the rules.

In places like India, where the informal economy is huge and many businesses are small, labor laws need to be not just protective—but practical. If the rules are too complicated, costly, or rigid, companies won’t follow them. They’ll take the easier route and operate informally, leaving workers with no job security, no benefits, and no protections.

That’s why instead of just banning contract labor, the focus should be on:

• Simplify labor laws so they’re easier to understand and follow.

• Reducing the burden of compliance, especially for small businesses.

• Offering incentives for companies that hire workers on a regular payroll.

• Using technology to cut down paperwork and reduce middlemen.

Final Thoughts

Regulation alone doesn’t change behavior. Businesses adapt to the rules in ways that minimize their costs—even if that means avoiding the rules altogether. When enforcement is weak and the informal economy is dominant, simply punishing non-compliance won’t work. It might make things worse.

Instead, governments need to create pathways that make it easier for businesses to follow the rules. This could mean reducing red tape, offering incentives for formal hiring, or improving access to credit for small firms. Crucially, labor law reforms must account for how policies interact with informality.

At its heart, this story is about the limits of top-down policymaking in complex economies. Labor reforms are not just about laws—they’re about incentives, institutions, and everyday realities on the ground.

The Andhra Pradesh reform began with the noble goal of protecting workers. But in trying to fix one problem, it ended up deepening another. The result was a rise in low-quality jobs, a shrinking formal sector, and a missed opportunity to improve worker welfare.

If there’s a silver lining, it’s this: We now know better. With rigorous research and thoughtful design, future labor reforms in India and beyond can aim not just to punish non-compliance but to build a system where doing the right thing is also the easier thing.