Credit accessibility and labour allocation decisions of workers in rural India

Purpose This study examines the causal effect of formal credit access on labour allocation decisions in rural India, both at the extensive (workforce participation) and intensive (total working days) margins. It also explores heterogeneity between credit-constrained and unconstrained workers, along with variations by gender and landownership. Design/methodology/approach We use a sample of rural households from the second round of the Indian Human Development Survey (IHDS-II). To address unobserved heterogeneity and selection bias from non-random credit distribution and household self-selection, we employ an endogenous switching regression model. Findings We find that access to formal credit increases aggregate labour supply and enables reallocation of labour from low-productive non-agricultural wage employment to farm cultivation, where expected returns are high. If credit-constrained workers had access to formal credit, they would have benefited the most. This suggests that the existing credit distribution has distorted labour market outcomes, limiting workers to low-productivity casual employment. Additionally, we find that male workers and large landholders are better positioned to reallocate their labour towards productive activities. Social implications Our study recommends the equitable distribution of formal credit, specifically targeting credit-constrained households. This will enable them to better align work effort with productivity, enhancing the overall well-being of rural households. Consequently, it will increase aggregate labour supply and facilitate the reallocation of labour from low-productivity non-agricultural wage employment to more productive agricultural activities. Originality/value Unlike previous studies, either limited to district-level analysis or focused on microfinance in household-level research, this study is the first to examine the causal impact of formal credit access on labour allocation in rural India. Using a novel endogenous switching regression model, it also highlights the implications of inequitable credit distribution for aggregate labour supply and labour reallocation.