New Delhi: The Economic Survey 2018-19 argues that India’s small businesses are being held back from growing bigger by various regulatory incentives, a phenomenon that eventually leads to ‘old’ MSMEs (micro, small and medium enterprises) that don’t deliver well in terms of either jobs or productivity.
In doing so, the survey effectively points out that successive Indian governments have taken the wrong lessons from a strong Swadeshi economic narrative – that the backbone of the country’s economy rests on millions of MSMEs that need to be protected and carefully managed.
“A startling fact is how the bane of dwarfs, which are defined as small firms that never grow beyond their small size, dominates the Indian economy and holds back job creation and productivity,” the survey notes.
“The perception of small firms being significant job creators pervades because job destruction by small firms is ignored in this calculus: small firms destroy jobs as much as they create.”
It argues that when considering MSME policy, the Centre should deliberately see small businesses as two separate groups: younger firms that create more jobs and have the potential to grow into bigger enterprises, and older firms that are stagnant in terms of job creation and employee productivity.
In India, ‘dwarves’ account for half of all firms in the organised manufacturing sector by number, but their share in employment is only 14.1% – in sharp contrast, young, large firms (which employ more than 100 people and are not more than 10 years old) account for only 5.5% of firms by number but contribute 21.2% of employment.
“Small firms may generate a higher number of new jobs. However, they destroy as many jobs as well. Thus, higher levels of job creation in small firms co-exist with job destruction, thereby leading to lower levels of net job creation… This common perception also stems from the fact that the effect of size confounds the effect of age. Specifically, most young firms are small (though most small firms are not young, at least in the Indian context),” the survey notes.
“Absent careful distinction between the effect of age versus that of size, the notion that small firms create jobs has prevailed because it is the young firms, who also happen to be small, create the most jobs,” it adds.
Labour law reform
What doesn’t help, the survey argues, is that India has policies that create ‘perverse’ incentives for many firms to remain small – specifically on the labour law front. Companies that grow beyond the size of 100 employees come under greater regulatory scrutiny.
“Therefore, rather than grow the firm beyond the said threshold, entrepreneurs find it optimal to start a new firm to continue availing these benefits. As economies of scale stem primarily from firm size, these firms are unable to enjoy such benefits and therefore remain unproductive. The lack of productivity and growth inhibits the ability of the dwarfs to create jobs,” the survey says.
One obvious solution to prevent further coddling of old MSMEs is to introduce a ‘sunset’ clause for every government incentive that helps foster growth amongst small businesses. The idea is that after five-to-seven years, the MSME should be able to sustain itself, and thus the growth incentives will remain on ‘infant firms’ (young but small) rather than dwarf firms (old but small).
Another solution is to have state governments initiate labour reforms. However, the Economic Survey’s own analysis concludes that between 2007 and 2014, no state made attempts to enact major labour reforms. In 2014, Rajasthan started doing so, after which states like Gujarat and Uttar Pradesh followed. The survey also constructs a ‘Flexible and Inflexible’ labour law index, that scores states on reduced transaction costs.
While Assam, Jharkhand, Kerala, Bihar, Goa, Chhattisgarh and West Bengal are classified as ‘inflexible’, 14 other states are classified as flexible.