Published in Journal of Productivity Analysis, 43(1), 47-58.

Bonus Compensation and Productivity:

Evidence from Indian Manufacturing Plant-Level Data*

NATALIE CHUNa
SOOHYUNG LEEb

09 September 2013

a
Economics and Research Department, Asian Development Bank, Manila, Philippines.
Email: nchun@adb.org. Tel: +63 2 6326463. Fax: + 63 2 6362361.
b
Department of Economics, University of Maryland, College Park, Maryland, USA.
Email: LeeS@econ.umd.edu. Tel: + 1 301 405 9974. Fax: +1 301 405 3542.

*
Detailed feedback from Aashish Mehta and two anonymous referees have been integral to reformulation of this paper.
Research assistance by Glenita Amoranto was helpful in the early stages of the development of this paper.
 Abstract

This paper examines whether bonus compensation for managers and workers matter for
manufacturing plant productivity. A model based on a Cobb-Douglas production
function is set up where bonus incentives can increase worker effort and skills leading to
increases in plant productivity. Using a representative sample of Indian manufacturing
plants between 1999 and 2006 within and GMM estimation methods are used to
empirically examine the effects of bonus compensation practices. It is found that
allocating a higher proportion of compensation to bonus payments for workers has a
highly positive and significant effect on labor productivity that is robust across estimation
methods. However, the evidence that management bonuses are significantly related to
labor productivity is weaker and not robust across specifications.

Key words – India; bonus compensation; productivity; firm; manufacturing.

2
 1 Introduction

The theoretical research on efficiency wages and human resource management hypothesizes that higher
wages, bonuses and other pay-for-performance schemes are important for improving firm performance by
enticing more skilled and better matched workers to join a firm, helping to retain well performing workers
and increasing work effort and incentives to develop complementary skills (Besley and McLaren 1993;
Shapiro and Stiglitz 1984). Performance based pay policies serve as a component of a larger set of
human resource management (HRM) practices that have been found to be associated with better firm
performance in developed countries (Black and Lynch 2001, Black and Lynch 2004; Bloom and Van
Reenan 2007; Bloom and Van Reenan 2010; Lazear and Oyer 2010; Syverson 2011). The literature
which has examined high performance work practices at a more disaggregated level, however, have found
that only certain practices have any statistically identifiable positive relationship with firm performance
(Black and Lynch 2001; Capelli and Neumark 2001). In fact, with the exception of profit sharing
incentives, most other practices identified as part of high performance work organizations have been
found to have no effect on key outcomes or were identified as costly to implement and labor inefficient
such that sales per cost of labor input actually decreased (Capelli and Neumark 2001).

As management has a large role in shaping firm policy and often oversees the selection and quality of
workers that are hired an extensive amount of empirical research has focused on identifying the effects of
management compensation on firm performance. The evidence in this area has generally shown a
positive relationship between managers who receive performance based pay, where a higher weight is
based on bonuses rather than salaried wages, and firm performance (Abowd 1990; Bandiera et al. 2007;
Leonard 1990; Lin et al. 2011). As managers often face significant costs to monitoring worker effort,
performance based schemes for workers have been found to enhance output and productivity (Bloom and
Van Reenan 2006; Bryson and Freeman 2008; Chung et al. 2010; Lazear 2000; Moretti and Perloff 2002).

However, few studies have examined the effects of HRM or bonus compensation practices on firm
performance even though there is evidence that many firms in developing countries tend to be poorly
managed (e.g. Bloom et al. 2010; Bloom et al. 2012). One of the few studies to provide some evidence
that HRM practices and performance based pay for managers can significantly increase firm labor
productivity in India was Bloom et al. (2013). Employing a randomized experiment where 20 out of 28
plant managers in mid-size manufacturing firms were randomly selected to receive training on HRM in
addition to performance related pay, they found that this resulted in a 17% improvement in labor

3
productivity within the first year of training. This underscores the substantial effect that better human
resource management policies and performance related pay incentives can have on productivity.

The aim of this paper is to complement the existing research by studying the importance of bonus
compensation practices on labor productivity in the context of a large representative sample of Indian
manufacturing plants. A model that extends from a Cobb-Douglas production function where bonus
compensation can increase plant productivity by increasing a worker’s effort and incentives to develop
complementary skills related to adoption of more advanced technology is used as the basis for the
empirical analysis. The empirical formulation of this model is applied to the Annual Survey of Industries
(ASI) containing yearly data over the period from 1999 to 2006. This model is estimated using a within
estimator and GMM estimator to identify the unexplained component of labor productivity that is not due
to differences in various inputs, but may be due to differences in bonus compensation practices. Bonus
payment practices for management and workers are found to have a highly positive and significant
relationship with labor productivity and labor efficiency for the within estimator model. While the results
in the GMM estimator remain highly significant for worker bonus compensation practices, especially
those that provide bonus compensation that fall into the top quartile, the evidence is weaker for the
efficacy of bonus practices for management. Management bonus payments appear effective when
estimated on the within estimator sample, but most of these effects disappear when using the GMM
estimator sample and are shown to be sensitive to the definition of bonus payment practices and labor
productivity.

In addition to the literature on HRM and personnel economics this paper is related to the literature that is
aimed at understanding the determinants of manufacturing productivity in India. These studies have
found significant increases in manufacturing plant level efficiency over the last twenty years which is
partially explained by trade liberalization that has reduced tariffs in select manufacturing industries since
1991 (e.g. Bollard et al. 2013; Nataraj 2011; Topalova and Khandelwal 2011). However, the mechanism
through which trade liberalization has improved productivity is not completely clear and it is possible that
the adoption and diffusion of better human resource management practices may have contributed to some
of the productivity increases. Despite the increases in productivity that have occurred in the
manufacturing sector in India it has remained fairly stagnant as a percentage of GDP compared to the
service sector and continues to have productivity levels which substantially lag behind those of developed
countries (Bloom et al. 2010; Gupta and Eichengreen 2011). Given that the manufacturing sector is
capable of absorbing lower skilled labor and is important for placing developing countries on a higher

4
growth path, it is important to understand the mechanisms through which manufacturing productivity in
India can be improved (Tybout 2000; Imbs and Wacziarg 2003; Rodrik 2013).

The analysis does face some limitations. First, we only observe bonuses payments ex-post rather than
observing ex-ante bonus practices. Second, bonus payments are not broken down into those that are used
for recruitment versus those that are performance based. Third, data are at the plant-level rather than the
employee-level. This makes it difficult to isolate the channels through which bonus practices increase
productivity. In particular, it is not possible to separately identify whether bonuses enhance plant
productivity through the channel of retention and recruitment of higher skilled labor, the development of
increased complementary skills, or through the channel of greater worker effort. Nevertheless by using
ex-post bonus payments to construct measures that can capture or proxy for time invariant bonus
incentive practices, we believe our results highlight an important role of bonus compensation practices
that can provide workers with incentives that lead to improvements in labor productivity. The usage of
panel data for a wide-set of manufacturing plants allows this paper to better identify the relationship
between bonus practices and plant productivity that are related to unobserved time-invariant plant-level
effects while accounting for estimation bias that arises from the simultaneous determination of firm input
choices and measurement error. Inevitably, this topic contributes to enhancing our understanding of how
to improve plant productivity, yet has remained understudied for developing countries often due to data
constraints.

The outline for the rest of this paper is as follows: Section 2 details the data used for the analysis.
Section 3 discusses the basic empirical framework for examining the effects of bonus payments on firm
performance. Section 4 discusses the main findings of the effects of bonus compensation on productivity.
Section 5 concludes.

2 Data

The Indian Central Statistics Office (CSO) Annual Survey of Industries (ASI) is conducted on a yearly
basis and is representative of all formally registered factory and manufacturing plants in India, employing
10 or more workers using power or 20 or more workers that do not use power, within a four digit National
Industrial Classification (NIC) code at the state level. 1 The data contain a detailed breakdown of assets,

1
The census component covers 100 percent of all units employing 100 or more people for all the ASI periods covered in the
study. The census survey also applies to smaller states in the ASI where there is limited industrialization so as to more
completely capture manufacturing activities in these areas. The sample component of the ASI represents formally registered
manufacturing firm establishments employing 20-99 workers within a state at the 4 digit level of the National Industrial
Classification (NIC) code when using sample weights with at least 20% coverage of all manufacturing units and a minimum of

5
expenditures, and revenue received from the sale of products as well as basic information on plant
characteristics such as year of initial production, organizational structure and plant ownership
classification. It also provides breakdowns of time inputs and the distribution of labor expenses into
bonuses, wages, and other benefits for management and non-management workers that are directly
employed by the firm as well as contract workers. In 1998 the ASI started publishing plant-level
identifiers enabling construction of an unbalanced panel of data. 2

ASI data covering the time span from 1999-2006 is used in the analysis. Despite the growing use of the
ASI data by economic researchers (e.g. Bollard et al. 2013), the ASI is subject to non-sampling errors that
occur because a large proportion of plants have missing data even though they are included as part of the
sampling frame. A disproportionate number of missing observations inevitably occurs for smaller plants
due to non-responses, location movements that make it hard to track them down or because the plant has
gone out of business. In addition, nearly half of all plants with more than 200 employees have missing
data for at least one year over the eight year period due to non-responses even though these plants are part
of the Census data. Due to concerns over selection, especially for smaller plants in the sample, re-
distributive weights were constructed by year-state-urban designation-industry-plant size where plant size
was grouped into four broad categories based on the number of employees. The average weight across
valid years of data for each plant was then constructed and used throughout the analysis. These weights
were observed to substantially reduce the extent to which sample means and medians were skewed
toward larger plants for the within estimator and GMM estimator samples which require observing a
plant at least twice in the panel and two consecutive years in the panel respectively. Nevertheless, the
weights do not appear to be able to completely adjust for potential selection. Therefore, we perform some
sensitivity checks on a subset of the main sample to ensure that results remain largely robust to variations
in sample selection in sub-section 4.3.

To ensure comparability of compensation and input and output values from year-to-year, we deflate
employee compensation measures at the state and sector level using the consumer price index (CPI). We
also deflate measures of sales, inputs and outputs of the plant for different industries using the wholesale
price index (WPI). The base year of 2008 is used. As NIC codes vary over time, a concordance mapping
is used to convert 3-digit NIC-1998 and NIC-2004 codes into unique 2-digit NIC-1987 codes resulting in
a total of 15 aggregated manufacturing industries. 3 Capital values were obtained using the reported net

six sample units.

2
For more detailed information on the ASI panel see Government of India (2011).
3
Industries include: food products, beverages/tobacco, textiles, textile products, wood products, paper products, leather
products, basic chemicals, rubber/plastic/petroleum/coal, non-metallic products, metals and alloys, metal products, machinery
and electrical, transport, and other manufacturing. The HHI was checked for these broad categories and the highest HHI was

6
closing values at the end of each year (i.e. gross value of capital minus depreciation). We also
constructed variables representing labor productivity that is defined as sales revenue divided by labor
inputs. Labor inputs were taken to be the yearly total of (i) man-days of inputs where one man-day
represents an eight hour workday by a single worker or (ii) base labor compensation that is defined as
total expenditures on base wages and other non-monetary benefits such as insurance, but excludes
bonuses. Input shares of management workers, non-management female workers out of total non-
management, and total workers directly employed (i.e. non-contract) were also constructed based on the
labor input measures.

Table 1 displays statistics for key variables for three different samples of plants. First, the full sample for
all plants with at least one year of valid data (panel A), the within estimator sample which requires
observing a plant at least twice between 1999-2006 (panel B) and the GMM estimator sample (panel C)
which requires observing data for a plant in two consecutive years or more. The statistics provide the
weighted average of each plant over the period of 1999-2006 and is computed by taking the averages of
variables for each plant over the period and then using the average weight for each plant. The different
panels show that even with re-distributive weights there are some differences in sales output, labor input
and plant size. In panel A the median plant in the sample has sales output of 8.7 million rupees
(~$181,000 in 2008) and has 13 employees, panel B the median plant in the sample has sales output of
10.5 million rupees (~$218,000 in 2008) and 14 employees, while in panel C the median plant in the
sample has output of 11 million rupees (~$229,000 million in 2008) and has 15 employees. 4 Bonus
payments to managers occur for 41%-44% of the plants in the sample while 58%-62% of plants provided
bonus payments to workers. The share of bonus payments out of total compensation account for a fairly
small percentage of overall compensation for most workers with the median plant providing 3% of
compensation in the form of bonuses to managers while workers received about 5% of compensation in
the form of bonuses.

3 Empirical Framework

The basis for empirical analysis starts with the assumption that value production functions for plant i, in
sector j, at time t is Cobb-Douglas of the form:

0.09 in these broad categories in the cross-sectional data. The HHI for three digit industrial classification codes in the cross-
sectional data was also checked. Less than 7% of the industry-years had HHI’s greater than 0.25 indicating that a majority of
the plants are in fairly competitive industries.
4
Using the original sampling weights the median plant in panel A had 12.9 million rupees in sales. This is substantially lower
than the 24 million rupees of sales of the median plant in Panel C.

7
 α γ
Y ijt = pijt Aijt K ijt H ijt M ijt E ijt (1)

In this equation, A is a measure of total factor productivity (TFP), K denotes physical capital, H denotes
the amount of human-capital-augmented labor, and M is intermediate inputs, and Ee is effort level of
workers. α and γ denotes the output elasticities of physical capital and intermediate inputs respectively.
The inclusion of p, the relative price of the plant i’s product, results in Y representing the value of
products produced.

Human capital is assumed to be a function of differentiated labor types (e.g. Young 2003). Specifically:
β β β
H ijt =L1ijt
1
L2 2ijt … LNijt
N

Where Lkijt represents labor inputs of type k and βk is the contribution of these labor inputs to the value of
output.

Employees in the plant are assumed to face incentive policies Iijt to put in work effort which plays a role
in the value of output. First, an employees’ incentives can affect a plant’s total factor productivity (TFP)
represented by Aijt. For example, adoption of cutting-edge technology may increase learning cost for
workers, but may also increase overall plant’s productivity. If employees share in the benefits of
increased productivity they may be more likely to invest in new skills that can complement the new
technology improving their performance, while managers may have sought to adopt the new technology
and seek to hire more skilled employees that can improve productivity (Bartel et al. 2007; Bandiera et al.
2007; Bloom and Van Reenan 2007). Specifically, current TFP is a function of current and past
incentives as well as a plant’s characteristics Xijt such that:
A ijt =f ( Iijt , I ij ,t−1 ,…I ij, t−J , X ijt )
where f is an increasing function with respect to incentives. Secondly, incentive policies may raise effort
levels on production, for example through less shirking (e.g. Besley and McLaren 1993), such that:
Eijt =g( I ijt , I ij , t−1 ,…Iij , t−J , X ijt )
where g is an increasing function of incentives.

Finally we assume that the log of a plant’s price depends on industry and time such that:
ln( pijt )=ln( p j )+ln( p t )

Under these assumptions, the logarithm of sales per total labor input, log(yijt), can be expressed as:

8
 y ijt =α ln(k ijt )+∑ β k ln(l kijt )+γ ln(mijt )+(α+ ∑ β+γ−1)ln( Lijt )+
k k

ln( A( I ijt … ))+ln( E( I ijt… ))+ln( X ijt )+ln( p j )+ln( p t ) (2)

where kijt and mijt are the ratio of the value of capital to labor inputs and the ratio of materials to labor
inputs respectively.

Our hypothesis is that controlling for capital, intermediate goods, labor inputs, the value of products, a
plant’s incentive policy increases the average employees’ effort and skill which has a positive effect on
labor productivity. The specification to examine this hypothesis is discussed in further detail in the
subsequent subsection.

3.2 Model Specification

3.2.1 Bonus Pay Incentives

The bonus compensation out of total compensation, or percent bonus pay, for managers and workers is
used as a proxy for incentive practices Iijt. Ideally the bonus pay incentive variable would be a measure
that is constructed based on observing ex-ante labor contracts. Unfortunately, such data are difficult to
obtain and we are only able to observe ex-post bonus payments which are subject to reverse causality.
This arises for example when two plants pay their workers with the same baseline salary and bonuses of
up to 20 percent of the salary depending on a plants’ performance at the end of the year. It is possible that
one plant performs well and pays bonuses amounting to 20 percent of the baseline salary while the other
performs poorly due to idiosyncratic shocks and pays no bonuses. In this case, we may wrongly conclude
that a well-performing plant has a better incentive scheme using observed the ex-post share of bonus
compensation out of total compensation even though both plants having the same incentive scheme.

To minimize this concern, we assume that a plant’s labor policies are time persistent. This seems
reasonable given that Bloom et al. (2013) found that many managers were skeptical of changing practices
even after five months of providing consulting services on human resource management practices and
when they did change practices they were more likely to change those that were easier to implement.
Moreover, they found that changes that did occur to practices appeared to be time persistent with little
changes after adoption in the subsequent year.

To capture a plant’s bonus compensation policy, several measures are used based on the panel aspects of
the data: (i) average (over available years 1999-2006) of percent bonus pay for plant i, (ii) average z-

9
score of percent bonus pay defined as percent bonus pay of plant in year t minus the average percent
bonus pay of all plants in year t divided by the standard deviation in percent bonus pay (iii) average
quartile rank of a plant’s bonus pay in any given year and is indicative of the percentage of times a plant’s
bonus payments ranks in each quartile. Measures (ii) and (iii) potentially have an advantage over (i) in
that they account for the possibility that some plants may be more likely to show up either in highly
positively or highly negative economic times which would introduce additional error into the measure of
(i) and may less represent a bonus pay incentive policy while (iii) additionally can capture aspects of the
relationship of bonus payments and productivity that are non-linear.

3.2.2 Effect of Bonus Pay Incentives on Labor Productivity

We approximate the effect of bonus pay incentives on labor productivity as a linear function of bonus
pay, plant-specific time invariant unobservables, and a random shock, allowing us to express equation (2)
as follows:
ln( y ijt )=τI ij +ςZ ijt +μ j +θt +ηi +ε ijt (3)
In this equation Zijt is a vector of capital inputs per labor inputs, intermediate goods per labor inputs, share
of different types of labor inputs described in equation (2) plus time varying factors such as industry
interacted with year dummies and industry interacted with organization dummies. Industry and year fixed
effects, μj and θt, capture the value of products, and ηi is an unobserved time-invariant plant fixed effect
while εijt is the idiosyncratic component of the error term. The main coefficient of interest is τ which
represents the contribution of bonus pay incentives, Iij, which is hypothesized to be positively related to
productivity. We focus on the overall impact of incentives rather than trying to decompose the incentives
into TFP versus effort level effects which would require imposing further assumptions. In the estimation
process the two different measures of labor inputs discussed in section 2 are used. Labor inputs captured
by man-days of inputs assume that time inputs do not change, but that either increased skill or greater
effort may generate changes in labor productivity. The second measure better reflects and controls for
potential differences that may be due to changes in labor composition and skill that arises from
differences in base compensation. This potentially provides a better measure of output value per unit of
labor costs that may better reflect whether a plant’s bonus incentive policy is effective given the base cost
of labor inputs.

However, because the proxy incentive variable that is used to represent a plant’s policy does not change
over time, we cannot separately identify this effect from a plant’s unobserved time invariant fixed effect.
Following Black and Lynch (2001), a two step approach is taken to estimate τ using a within estimator

10
(fixed effects) and GMM estimator that allows us to separately identify the incentive component from the
unobserved plant fixed effects component. The within estimator takes deviations from a plant’s mean in
equation (3) and then regresses the deviations on the time-varying variables in equation (3) to obtain the
estimate of ζ and θ.

The within estimator does not constrict the sample to only observations in which we observe data from
year-to-year and therefore represents a wider set of plants. However, estimates are potentially biased due
to the dynamic nature of the production process and potential measurement errors in the explanatory
variables of capital, materials, and labor that can cause serial correlation in the errors. The GMM
estimator based on Arellano and Bover (1995) and Blundell and Bond (2000) increases efficiency of the
estimates over the closely related estimation process used by Arellano and Bond (1991) by instrumenting
endogenously determined variables using the lagged differences of the time varying variables. 5 In
particular, the dynamic representation of equation (2) assuming an AR(1) process and imposing no
restrictions on the various coefficient estimates is:

ln( y ijt )=τI ij +ρ ln( y ij , t−1 )+ςt Z ijt +ζ t−1 Z ij ,t−1 +μ j +θ t +ηi +ε ijt (4)

This specification can also easily include or account for an AR(2) process by including an additional 2-
year lagged labor productivity variable in equation (5). Similar to the fixed effects estimator, estimates
are obtained for the dynamic components of the model (i.e. ρ, ζ, and θ) to come up with the unobserved
component of labor productivity.

In the second stage, the average of the unobserved difference between predicted and actual labor
productivity over the period of 1999-2006 for both the fixed effects estimator and GMM estimator is then
taken for each plant such that:

ln( y ijt )−ς^ Z ijt −θ^ t =τI ij +μ j +ηi +ε ijt (5)

and

ln( y ijt )− ^ρ ln( y ij, t−1 )−ς^ t Zijt − ^ς t−1 Z ij ,t−1 −θ^ t =τI ij +μ j +ηi +ε ijt (6)

5
GMM estimation is performed using STATA’s xtabond2 as described by Roodman (2009). This function is used
as opposed to xtdpd because it allows for incorporating sampling weights in the estimation process.

11
This average difference is then regressed on the time invariant bonus incentive and various other time
invariant characteristics of the plant such as industry dummies, indicator for urban location, dummies
indicating whether the plant is an organization, cooperative, private plant, or family plant, dummies
indicating the Indian state where the plant is located in the second stage. The second stage standard errors
of the coefficients are computed on 100 bootstrap simulations to obtain correct standard errors due to
using predicted values in the second stage regressions. 6

4 Results

4.1 Within (Fixed Effects) Estimator

The within estimator is able to account for unobserved time-invariant characteristics of plants in the
sample. The first stage of the estimation process uses the augmented Cobb-Douglas production function
to relate factor inputs that vary over time such as the value of capital per labor, value of materials per
labor, labor, and skill type to labor productivity captured by log of sales per labor inputs. In all cases,
labor inputs are measured by man-days of work or total labor compensation. Additionally time effects
and plant fixed effects are included. This is run on the full sample of plants where at least two years of
data is observed independent of whether the years of observations observed are in consecutive years.

The estimates on the relationship between the time varying variables and labor productivity are reported
in Table 2. The estimates show that a 10 percentage point increase in the proportion of managers and
employees who are directly employed in the plant is related to a 1.9% and 1.2% increase in labor
productivity based on man-days of inputs and base compensation and this is statistically significant at the
1% level. However, a 10 percentage point higher share of non-management female workers is related to a
1.5% decline in labor productivity by man-days while there is no statistically significant effect on
productivity by base compensation. The coefficient estimates on log capital per labor and log materials
per labor are both positive and significant while the value on log labor inputs is negative and significant
since increasing labor in itself would be expected to lead to a decrease in productivity if a plant is largely
optimizing capital and materials to labor inputs.

The estimates from the labor productivity regression in table 2 are then used to compute the average
unexplained difference between actual and estimated labor productivity for each plant. These are
regressed on bonus payments captured by the percent of bonus payments out of total compensation and
6
Standard errors for 200 bootstrap simulations were initially computed for the first set of regressions, but were found to be
similar in magnitude to using only 100 bootstrap simulations.

12
other largely time invariant characteristics such as industry and state where plant is located. The results
are shown in table 3. The average unexplained difference has a mean of 0.28 and standard deviation of
0.72. Large effects of management bonus practices are found when using simply a straight average in
terms of increasing labor productivity (panel A, column 1). If an adjustment is made to bonus payments
to normalize bonus payments to adjust for year specific factors that may cause a larger proportion of
bonus payments to be given in a particular year we find that a one standard deviation in the share of
bonus payments is associated with a 12% increase in labor productivity. Measuring the quartile rank of
percent of bonus payments in a given year also verify that increasing the percent of compensation
provided in terms of bonus payments from the lowest quartile to at least one quartile higher is positively
associated with increases in labor productivity. However, the benefits from utilizing bonus payments is
the greatest for plants that move from the bottom quartile to the second quartile as opposed to moving
from the bottom quartile to the third or fourth quartile. This seems to imply that there may be reduced
benefits from a plant considering an increase in the share of bonus payments in total compensation to the
top 50th percentile compared to just increasing the share of management bonus payments to those in the
25-50 percentiles (panel A, column 3). Increasing the share of worker bonus payments also has a positive
and significant association with labor productivity although the effects appear to be smaller than those
associated with management bonuses.

The relationship between bonus payments and sales per total base compensation is seen in panel B of
Table 3. The average unexplained difference has a mean of 0.18 and standard deviation of 0.62. The
results show a similarly strong relationship between bonus payments and labor productivity. Unlike labor
productivity in Panel A, however, the return to having a larger percent of compensation in the form of
bonuses for management rises with each quartile (Panel B, column 3). However, the same is not true for
worker bonuses as those plants with bonuses that rank in the 50-75 th percentiles, in reference to the
bottom quartile, have a smaller effect on labor productivity than those in the second or top quartile.

4.2 GMM Estimator AR(1)

The within estimator can capture omitted variable bias due to unobserved plant-specific effects.
However, it is still potentially biased as many of the input measures which determine productivity are
determined simultaneously introducing upward bias into the coefficient estimates on the input variables.
However, downward bias can potentially be introduced due to measurement errors in these variables.
Running the GMM estimator allows us to capture the dynamic nature of the input process and correct for
potential measurement errors that generate serial correlation in errors, but may introduce some selection
bias into the estimation process. Table 4 shows the first stage regressions where lag of log labor

13
productivity, human capital variables, capital and materials are dynamically determined and are
instrumented using both change and lags of the various variables assuming log labor productivity
following an AR(1) process (column 1). The AR(1) process appears to be the correct specification for the
corresponding sample as the Arellano Bond test for serial correlation only rejected the null hypothesis of
no serial correlation for the first lag of errors with the null hypothesis being rejected for lag two and lag
three errors.

The coefficient estimates on the log capital to labor variables at time t are substantially larger than those
seen for the fixed effects regressions, while the estimates on materials to labor and labor variables are
smaller, i.e. closer to zero, than those seen in Table 2. Share of management and the share of directly
employed workers do not show up as significantly associated with labor productivity in the regressions,
while the share of females remained negatively related to labor productivity.

Similar to the fixed effects regressions the average unexplained difference between actual and predicted
labor productivity based on the time varying measures was obtained and then regressed on various
measures of bonus payments for both workers and employees. The average difference had a mean and
0.01 and a standard deviation of 0.45 and explains why the magnitudes of estimated coefficients on bonus
compensation variables are significantly different compared to those seen for the within estimator. The
results for the second stage of the GMM estimator are shown in Table 5. There is only weak statistical
support for the relationship of management bonus payments with labor productivity (column 1-3). Only
bonus payments in the third and fourth quartile appear compared to the bottom quartile appear to be
significantly related to sales per man-day of inputs. However, sales per base labor compensation show no
significant relationship with labor productivity. This may indicate a lack of effectiveness of bonus
practices for management for raising overall sales per base labor costs.

In comparison bonus practices for workers both using the average percent bonus payments plus the
average z-score of percent bonus payments exhibit a positive and statistically significant relationship with
labor productivity similar to the results found for the within estimator (column 4-5). However, only
bonuses for workers that are ranked in the top quartile of all plants have any statistically higher rates of
labor productivity compared to plants with bonuses in the bottom quartile (column 6).

Finally in table 6 we investigated the simultaneous inclusion of both average % of management bonuses
and average percent of workers bonuses in the second stage regressions of the GMM estimator. These

14
variables have a correlation of 0.54. In general, the effects of worker bonuses on labor productivity
remained positive and significant with little or no effect of management bonuses on labor productivity.

While it may be somewhat surprising that the share of bonus payments that are in the 3 rd quartile (50th-75th
percentile) may not be found to be significant it may arise because plants in this quartile are
representative of those that are in compliance with the Payment of Bonus Act of 1965 which mandates
that low-skilled workers get paid around 8% of their salaries in bonus payments each year, given that
certain conditions of employment are met, and are largely independent of a plant’s performance. A large
proportion of these plants may be constrained at using bonuses strategically unless raising overall bonus
payments of the plant. This still does not explain the differences for managers as most managers largely
fall outside of the threshold for mandatory bonus payments. This aspect remains a limitation of relying
on data that are based on ex-post bonus payments rather than observance of actual bonus policies and
practices. However, in general the estimates appear to confirm that there are potentially significant
benefits from having a bonus payment practices which potentially provides a higher share of total
compensation in the form of bonus payments.

4.3 Robustness Checks

4.3.1 Sample Selection
The main sample consists of plants that are surveyed at least two years over the period of 1999-2006.
Some of the results may potentially be driven by selection issues as many of the least productive plants,
or plants whose productivity have potentially declined, are less likely to be observed in the data causing
potential selection bias in the estimates of interest. While we tried to adjust for sample selection using re-
distributive weights, the weighting was not perfect and Table 1 showed there was still a slight rise in the
medians of key variables when the within estimator sample and GMM estimator sample were utilized.
Thus, as an additional robustness check we reexamined the GMM regression estimates using a random
sample of plants that have three consecutive years of data. More precisely for each plant observation
where the two previous years of observations for a plant were available we made an indicator if that
observation could be included in the sample. A random number was then assigned to all observations that
could potentially be included in the sample according to the conditions of observing the two prior years of
data. For each plant, the observations that were assigned the highest random number and the two
previous years of data were then selected for inclusion in the sample. Therefore, exactly three
consecutive years of data for every distinct plant are included in the new sample. When the median
values for this new sample were checked, the results showed that these values were lower than sample A
that included all plants where valid data was observed at least once.

15
The GMM model was re-estimated on this sample. The new estimates had virtually similar magnitudes
for the bonus payment practices variables in the second stage to the estimates seen in Table 5. This
appeared to confirm that selection issues were unlikely to be driving the majority of the prior results.

4.3.2 Other Bonus Payment Practice Variables

It is possible that constructing bonus payment practice variables using year adjusted z-scores or quartile
rankings may ignore industry-year level negative (positive) shocks that cause plants in entire industries to
be ranked on average low (high) in some years even though they may having fairly generous bonus
payment practices. It may also fail to account that different industries may have different levels of labor
market competition that causes plants to choose to apply certain bonus compensation practices. As a
result, we also examined using average adjusted bonus payments and quartile ranks of bonus payments
based on year-industry derived measures. While construction of these variables changed some of the
magnitudes they primarily exhibited the same levels of statistical significance in relationship to
productivity as those constructed on the simple year adjustments.

5 Conclusion

The past few decades has seen significant improvements in labor productivity both in developed and
developing countries. Better human resource management potentially explains nearly 10% of the
measured labor productivity growth that has occurred over 1970-2007 in a large set of developed and
developing countries (Chatzimichael and Tzouvelekas 2013). While India has also experienced
significant increases in productivity the absolute levels of productivity remain low compared to developed
countries. Absence of good human resource management practices and incentives may potentially be one
of the factors limiting manufacturing productivity. This is supported by a small scale study of
manufacturing firms in India found that there was an absence of management skills and pay for
performance incentives for managers even in mid-size firms ranging in size between 70-500 employees
(Bloom et al. 2013). Incorporating pay for performance incentives and HRM training for managers it was
found that productivity increased by 17%.

Our analysis appears to confirm that there is scope for greater strategic usage of bonus compensation, one
aspect of human resource management practices, to enhance and improve labor productivity for a
representative set of manufacturing plants in India. Providing a greater amount of worker bonuses as a

16
part of total compensation overall and in relation to other manufacturing plants is found to be
significantly related to higher amount of labor productivity captured both as sales per man-day of inputs
and sales per cost of base labor inputs. There is somewhat less support for implementing a larger amount
of bonus payment practices for management to enhance labor productivity as only management bonuses
ranked in the 3rd and 4th quartiles lead to statistically significant increases in sales per man-day. No effect
of management compensation is found in relation to sales per base compensation indicating that on a per-
unit cost basis implementing management bonuses may not be justifiable.

The results of this paper ultimately raise further questions as to why manufacturing firms in India do not
raise increase bonus incentives which can increase productivity and most likely profitability. One
possibility is that labor laws and taxes on different types of compensation may be distorting strategic use
of compensation causing firms to provide forms of compensation that are less effective at improving firm
productivity. Another possibility is that it is indicative of the need to provide managers with significant
assistance and training on HRM along with the appropriate incentives. The weaker effects of
management bonuses on productivity compared to worker bonuses may potentially be reflective of
limitations in managerial skills on how to increase plant productivity. Developing good management
practices may be a constraint to firm performance that persists in many developing countries (Bruhn et al.
2010). In addition to the findings from India, a randomized experiment in Mexico showed that small
enterprises that received management consulting services to enhance managerial capital experienced large
and positive effects on firm performance (Bruhn et al. 2013).

While our results are suggestive that strategically providing a greater amount of bonus compensation
could potentially be used to enhance productivity compensation is much more varied and complex than
the general structure of bonus compensation investigated in this paper. Understanding the usage and
timing of the distribution of bonuses either as recruitment tools or as incentives tied to performance may
provide more pointed evidence on how to maximize the use of such compensation. Thus, there are many
avenues for future investigation in regards that can help firms construct more appropriate compensation
schemes to increase firm productivity and profits. This inevitably requires obtaining more detailed and
focused data and is an open area for future research.

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Table 1: Summary Statistics for Firm Panel Pooled Data 1999-2006
Panel B (Within Estimator
  Panel A (Full Sample) Sample) Panel C (GMM Estimator Sample)
  Mean Median SD Mean Median SD Mean Median SD
592,00 1,820,00
Sales Output (thousands 2008 Rs.) 40,100 8,770 0 56,500 10,500 965,000 88,100 11,000 0
Sales Output per man-day (2008 Rs.) 5,127 2,385 11,127 5,242 2,505 11,620 5,113 2,428 11,567
Sales Output per Base Labor Compensation 30 14 61 29 14 56 27 13 50
587,00 1,640,00
Capital (thousands 2008 Rs.) 20,200 2,591 0 30,300 3,030 940,000 55,700 3,510 0
456,00 1,450,00
Materials (thousands 2008 Rs.) 26,400 5,078 0 36,800 6,154 754,000 56,600 6,498 0
Capital Per Man-Day (2008 Rs.) 2,282 774 16,212 2,128 820 12,146 2,442 846 12,263
Materials Per Man-Day (2008 Rs.) 3,452 1,401 8,275 3,488 1,478 8,348 3,368 1,410 8,491
Capital per Base Labor Compensation 13 5 74 11 5 63 12 5 65
Materials per Base Labor Compensation 20 8 44 19 8 40 18 8 39
Labor (man-days) 7,270 3,573 44,537 10,052 3,980 66,877 14,529 4,251 88,040
Labor (Base compensation thousand 2008 Rs.) 1,844 558 19,200 2,743 665 28,100 4,435 735 42,600
Firm Size (no. employees) 26 13 145 34 14 217 49 15 285
Share Management (man-days) 0.12 0.1 0.11 0.12 0.1 0.1 0.12 0.1 0.1
Share Directly Employed (man-days) 0.94 1 0.16 0.94 1 0.15 0.94 1 0.16
Share Females Employed (man-days) 0.12 0 0.23 0.11 0 0.22 0.11 0 0.22
Share Management (base compensation) 0.19 0.16 0.17 0.19 0.17 0.15 0.19 0.17 0.15
Share Directly Employed (base compensation) 0.88 0.93 0.15 0.88 0.91 0.14 0.87 0.91 0.14
Share Females Employed (base
compensation) 0.11 0 0.21 0.1 0 0.2 0.1 0 0.21
Firm Has Management Bonus Payments 0.41 0 0.46 0.43 0.5 0.43 0.44 0.5 0.44
Management Bonus (of total compensation) 0.03 0 0.05 0.03 0.01 0.04 0.03 0.01 0.04
Firm Has Worker Bonus Payments 0.58 1 0.47 0.62 0.75 0.42 0.62 1 0.43
Worker Bonus (of total compensation) 0.05 0.04 0.05 0.05 0.05 0.05 0.05 0.05 0.05
211,81 211,81 211,81
Observations 6 6 6 162,434 162,434 162,434 117,304 117,304 117,304
Number of Plants 97,806 97,806 97,806 48,422 48,422 48,422 31,957 31,957 31,957

21
Note: Average of variables for valid observations between 1999-2006 is taken for each plant. This is used to compute the sample averages where each
plant is weighted by its average weight in the sample. Re-distributive weights by year-industry-urban-plant size designations are used based on original
sampling weights to partially account for sample selection that occurs due to missing data. WPI industry level deflators for sales, capital, and materials were
used, while CPI deflators at state and sector level were used for total base compensation.

22
Table 2
Black Lynch Fixed Effects Within Estimator (First Stage Regression)

  (1) (2)
  ln(Sales/L) ln(Sales/L)
  L=Total Man-Days L=Total Base Compensation
% Management 0.093*** -0.068***
  [0.033] [0.021]
% Directly employed 0.155*** 0.119***
  [0.019] [0.020]
% Females employed -0.105*** -0.040*
  [0.023] [0.023]
ln(K/L) 0.069*** 0.060***
  [0.005] [0.004]
ln(M/L) 0.405*** 0.402***
  [0.007] [0.007]
ln(L) -0.175*** -0.160***
  [0.009] [0.007]
Observations 162434 162413
Number of Plants 48422 48422
R-squared 0.542 0.536
Robust standard errors in brackets and clustered by year and industry. *** p<0.01, ** p<0.05, *
p<0.1.
Note: Included but not shown plant size; plant size^2; indicators for organization type interacted
with time dummies; indicators for industry type interacted with time dummies; urban location; year
dummies; plant fixed effects. Within estimator limits sample to those that are observed at least two
times in the panel. Re-distributive weights for fixed effects sample used.

23
Table 3
Relationship Between Bonus Compensation and Labor Productivity
Second Stage Regression Results for Within Estimator 1999-2006

  Management Bonus Worker Bonus

  (1) (2) (3) (4) (5) (6)
Predicted Predicted Predicted Predicted Predicted Predicted
  Error Error Error Error Error Error
  Panel A (L = Total Man-Days)
% Bonus [Avg. 1999-
2006] 2.181***     1.473***    
  [0.197]   [0.122]  
Z-Score (Year) % Bonus   0.120***     0.086***  
[Avg. 1999-2006]   [0.011]     [0.007]  
Rank 2: % Bonus [Avg.   0.323***   0.349***
1999-2006]   [0.047]   [0.023]
Rank 3: % Bonus [Avg.   0.216***   0.156***
1999-2006]   [0.021]   [0.024]
Rank 4: % Bonus [Avg.   0.282***   0.284***
1999-2006]   [0.023]   [0.020]
Observations 44528 44528 44528 48630 48630 48630
R-squared 0.159 0.16 0.162 0.175 0.175 0.187
  Panel B (L = Total Base Compensation)
% Bonus [Avg. 1999-
2006] 1.842***     1.113***    
  [0.155]   [0.100]  
Z-Score (Year) % Bonus   0.102***     0.066***  
[Avg. 1999-2006]   [0.008]     [0.006]  
Rank 2: % Bonus [Avg.   0.113***   0.196***
1999-2006]   [0.035]   [0.020]
Rank 3: % Bonus [Avg.   0.114***   0.093***
1999-2006]   [0.018]   [0.020]
Rank 4: % Bonus [Avg.   0.228***   0.196***
1999-2006]   [0.018]   [0.016]
Observations 44527 44527 44527 48630 48630 48630
R-squared 0.145 0.146 0.144 0.149 0.149 0.153
Standard errors computed using 100 bootstrap simulations in brackets. *** p<0.01, ** p<0.05, * p<0.1
Note: Included, but not shown are industry fixed effects, indicator of urban, and indicators for organization
type.
Predicted error computed from first stage regressions of determinants of labor productivity with values in
second stage taken at mean over 1999-2006. Re-distributive weights for fixed effects sample used.

24
Table 4
Determinants of Labor Productivity
First Stage Regression Results from Dynamic GMM Model (AR(1) Model)

  (1) (2)
  ln(Sales/L) ln(Sales/L)
  L=Total Man-Days L=Total Base Compensation
ln(Sales/L) [t-1] 0.426*** 0.400***
  [0.046] [0.036]
% Management -0.969* -0.514
  [0.522] [0.339]
% Management [t-1] 0.254 0.165
  [0.211] [0.135]
% Directly Employed 0.008 0.345
  [0.335] [0.352]
% Directly Employed 0.051 -0.155
  [0.174] [0.136]
% Females Employed 0.066 -0.145
  [0.260] [0.266]
% Females Employed [t-1] -0.047 0.04
  [0.135] [0.124]
ln(K/L) 0.203*** 0.155***
  [0.063] [0.054]
ln(K/L) [t-1] -0.073 -0.053
  [0.049] [0.040]
ln(M/L) 0.312*** 0.294***
  [0.041] [0.060]
ln(M/L) [t-1] -0.096*** -0.064
  [0.030] [0.041]
ln(L) -0.138* -0.112*
  [0.076] [0.060]
ln(L) [t-1] 0.129* 0.123*
  [0.078] [0.065]
Observations 84011 83994
Number of Plants 31957 31955
Robust standard errors in brackets. *** p<0.01, ** p<0.05, * p<0.1.
GMM Type Variables: Log(Sales per man-day), log(Capital per man-day), log(Materials per man-day),
log(man-day), % Management, % Directly employed, % Females employed.
Note: Included but not shown firm size; firm size^2; indicators for organization type interacted with
time dummies; indicators for industry type interacted with time dummies; urban location; year
dummies; firm dummies. Re-distributive weights for GMM sample used.

Table 5

25
Relationship Between Bonus Compensation and
Labor Productivity
Second Stage Regression Results for GMM Estimator
Assuming AR(1) Process 1999-2006

  Management Bonus Worker Bonus

  (1) (2) (3) (4) (5) (6)
Predicted Predicted Predicted Predicted Predicted Predicted
  Error Error Error Error Error Error
  Panel A (L = Total Man-Days)
% Bonus [Avg. 1999-
2006] 0.214     0.838***    
  [0.156]   [0.176]  
Z-Score (Year) % Bonus   0.012     0.047***  
[Avg. 1999-2006]   [0.008]     [0.010]  
Rank 2: % Bonus [Avg.   0.071   0.035
1999-2006]   [0.042]   [0.032]
Rank 3: % Bonus [Avg.   0.061**   0.039
1999-2006]   [0.026]   [0.024]
Rank 4: % Bonus [Avg.   0.036*   0.123***
1999-2006]   [0.020]   [0.028]
Observations 29074 29074 29074 31955 31955 31955
R-squared 0.021 0.021 0.023 0.024 0.024 0.024
  Panel B (L = Total Base Compensation)
% Bonus [Avg. 1999-
2006] 0.112     0.553***    
  [0.199]   [0.140]  
Z-Score (Year) % Bonus   0.006     0.031***  
[Avg. 1999-2006]   [0.010]     [0.008]  
Rank 2: % Bonus [Avg.   0.012   -0.021
1999-2006]   [0.047]   [0.028]
Rank 3: % Bonus [Avg.   -0.009   -0.013
1999-2006]   [0.028]   [0.022]
Rank 4: % Bonus [Avg.   0.021   0.076***
1999-2006]   [0.023]   [0.022]
Observations 29072 29072 29072 31955 31955 31955
R-squared 0.008 0.008 0.009 0.011 0.011 0.013
Standard errors computed using 100 bootstrap simulations in brackets. *** p<0.01, ** p<0.05, * p<0.1
Note: Included, but not shown are industry fixed effects, indicator of urban, and indicators for organization
type.
Predicted error computed from first stage regressions of determinants of labor productivity with values in
second stage taken at mean over 1999-2006. Re-distributive weights for GMM sample used.

26
Table 6
Relationship of Bonus Compensation for Management and Workers and Labor Productivity
Second Stage Regression Results for GMM Estimator Assuming AR(1) Process 1999-2006

  (1) (2) (3) (4) (5) (6)

Predicte Predicte Predicte Predicte Predicte Predicte
  d Error d Error d Error d Error d Error d Error
  L=Total Man-Days L=Total Base Compensation
% Bonus [Avg. 1999-2006]
Management -0.222 -0.229    
  [0.189] [0.255]  
% Bonus [Avg. 1999-2006] 0.787** 0.615**
Worker * *  
  [0.183] [0.167]  
Z-Score (Year) % Bonus [Avg.
1999-2006] Management -0.011   -0.011  
  [0.00]   [0.014]  
Z-Score (Year) % Bonus [Avg. 0.044** 0.034**
1999-2006] Worker *   *  
  [0.010]   [0.009]  
Rank 2: % Bonus [Avg. 1999-
2006] Management 0.074*   0.026
  [0.041]   [0.049]
Rank 3: % Bonus [Avg. 1999-
2006] Management 0.053*   -0.005
  [0.029]   [0.030]
Rank 4: % Bonus [Avg. 1999-
2006] Management 0.007   0.002
  [0.023]   [0.028]
Rank 2: % Bonus [Avg. 1999-
2006] Worker -0.001   -0.022
  [0.034]   [0.032]
Rank 3: % Bonus [Avg. 1999-
2006] Worker -0.001   -0.021
  [0.024]   [0.025]
Rank 4: % Bonus [Avg. 1999- 0.080** 0.061**
2006] Worker *   *
  [0.025]   [0.022]
Observations 29072 29072 29072 29072 29072 29072
R-squared 0.026 0.026 0.027 0.012 0.012 0.013
Standard errors computed using 100 bootstrap simulations in brackets. *** p<0.01, ** p<0.05, * p<0.1
Note: Included, but not shown are industry fixed effects, indicator of urban, and indicators for organization
type.
Predicted error computed from first stage regressions of determinants of labor productivity with values in
second stage taken at mean over 1999-2006. Re-distributive weights for GMM sample used.

27