Why do firms stay small in India?

The header of this blog was my search string in Google search engine this morning. It led me to this link – an article in Business Standard in September 2013. The article, in turn, led me to a good, comprehensive study of labour market practices undertaken by the ExIm Bank of India. As an aside, one must state that the ExIm Bank research appears to be one of the best kept secrets in India. Their ‘thought leadership’ (a strange consultant-speak) is quite impressive. They have their annual commencement day lecture for the last several years. The website gives you the link to at least seven years of lectures. This year’s lecture was delivered by Barry Eichengreen in March. You can find it here.

The paper I was looking for was found here. The paper is Occasional Paper No. 160,  ‘Comparison of Labour Laws: Select Countries’ published in August 2013. The paper had a good statement in the ‘Executive Summary’:

An analysis of these reference studies and statutes of the identified countries reveals that at a macro level the degree of intent of labour protection is similar in most countries and not very different from that of India. However, the  distinguishing feature is that the administrative processes which are framed under Indian labour statues are complicated hindering flexibility in labour market.

One of the interesting references in that paper was to the Economic Survey of the Government of India 2012-13. I think Raghuram Rajan was the Chief Economic Advisor to the Government of India, then. This paragraph drew my attention:

On the export front, India’s exports are majorly low and medium-tech oriented, and only a small portion is hi-tech oriented. According to industry sources, our peer countries like China, Malaysia, Singapore and Thailand, enjoy either cost advantage (due to the large scale of manufacturing), or technology advantage (due to hitech manufacturing) in select product groups. In contrast, a majority of players in the manufacturing sector in India are largely MSMEs. This fact has also been articulated in the Economic Survey (2012-13) citing that Indian manufacturing sector has a presence of large number of small-scale units in most of  the manufacturing sub-segments. The low level of large-scale investments in Indian manufacturing is one of the prime reasons for the sector’s share remaining stagnant at 15% to 16% of GDP for several decades.

The relevant chapter was Chapter 2 on India’s demographic dividend. It was a rich chapter. It had a good discussion. Probably, boxes were one too many. But, I am quibbling. It was rigorous. Sometimes, one does not have to reinvent the wheel. It is enough if we assemble the wheels out there into a vehicle. In other words, our intellectual contribution is to fire from others’ shoulders. That might sound lazy but in today’s world where there are many fine minds focused on India’s growth challenges, it is unlikely that one comes up with something new and original. One can be a good aggregator, assembling arguments and findings from disparate sources cogently, adding a bit of one’s own perspective too. Sometimes, the value addition comes from finding sources and evidence that others don’t.

Chapter 2  of the Economic Survey 2012-13 had this rather useful table:

Government of India towards small and big

Schemes and interventions based on tightly defined classifications create an incentive structure that might prevent firms from growing. Service tax exemptions for firms with less than Rs 10 lakh revenue and exemption from central excise duty for firms with an annual turnover of less than Rs 1.5 crore are examples of these schemes. The jump from ‘small’ to ‘medium’ enterprise especially entails loss of several perks (see Figure 2.14). – the Table above. [Link – page 13]

The discussion on whether India’s labour laws and regulations hamper job creation was also well done. Sample these:

Some economists however, dispute the evidence that establishes the importance of labour regulations in determining economic outcomes. In the case of India, for example, one of the first and most frequently cited studies on the topic, Besley and Burgess (2004), has come under criticism, most extensively from Bhattacharjea (2006). While more work has been done that addresses some of these criticisms, the evidence on the effects of  labour regulations outside of India is also mixed.

According to World Bank (2013), ‘A careful review of the actual effects of labor policies in developing countries yields a mixed picture. Most studies find that impacts are modest— certainly more modest than the intensity of the debate would suggest.

One gets the impression from the above that far too much energy has been and is expended on tilting at labour market constraints and rigidities in India that hamper job creation. But, in my view, it misses the point for two reasons. One is the impossibility of counter-factual and the other is the indirect evidence:

If indeed labour laws constrain firms, they would respond in predictable ways, (i) relying more on capital instead of labour, (ii) resorting to informal arrangements / limiting their scale in order to remain outside of the formal sector altogether, and/or (iii) hiring contractual labor.

Indeed, Indian firms engage in all of the above so much so that they do not mention labour laws and regulations as the binding constraint to industrial performance and employment growth. See the two charts below.

employment in the apparel industry

capital labour ratio in india

Once they have done their ‘workarounds’ they cease to worry about it. In other words, we get used to the ‘second best’ and ‘third best’ worlds allowing the ‘first-best’ world to fade from their consciousness. That is the famous Indian ‘acceptance’ and ‘reconciling to reality’ mindset.

Alan Krueger gets it right:

As pointed out in Krueger (2007), the counterfactual of whether labour laws would constrain firms that would emerge in the absence of strict labour laws cannot be captured in the surveys.

Some of the charts below are interesting and convey the picture. To argue that India does not have a problem with job creation in the formal sector is merely being argumentative. The worst form of protection for labour is not to employ them and leave them to waste or make them work in unprotected environment. India is an outlier even with respect to countries at similar stage of economic development. See the chart below on wage employees working without a contract. Shameful, actually.

workers without contract

The survey nails it:

India has the dubious distinction of having some of the most comprehensive labour laws in the world, even while having one of the largest fractions of the working population unprotected.

The consequence of all of these is a rather inefficient economy in terms of output and productivity with very little job creation, protection and wages for the working class! That is indeed something that only the perversely egalitarian Indian mindset can achieve.

Output in labour intensive industries

Look at the right-hand panel in the following chart:

employment share by labour regulation

value added per worker

Earlier in September, we heard that Assam had passed a law that allowed firms to be able to retrench workers without government approval, up to 300 workers. The previous limit was 100. Given the scale of the issues that India faces with respect to production, productivity, employment and growth, this is a small step. There are many other issues when one talks of labour market rigidities such as payroll taxes, administrative procedures to comply with labour laws, apprenticeships, etc.

Postscript: The EXIM Bank Occasional Paper No. 160 has the following disturbing information:

Various research studies have concluded that employment elasticity of output in India has come down over the years – from 0.53% (during the period 1977-78 to 1983), to as low as 0.01% during the period (2004-05 to 2009-10). It implies that with every percentage point of growth in GDP, employment increases by just one basis point (0.01%)….

….. Employment elasticity of output in India has come down to as low as 0.01% during the period 2004-05 to 2009-10 according to research findings by Institute (*) for Applied Manpower Research, New Delhi. …

………. in the United States, in 35 years of existence, a company grows ten times both in terms of operations and employment. In contrast, in India, the productivity
of a 35 year-old firm merely doubles, while its headcount actually falls by a fourth. (World Bank World Development Report 2013)…

… Our analysis of comparison of factory employment in select countries using UNIDO data revealed that average number of workers in an Indian firm is low at 75, in comparison to China’s 191 and Indonesia’s 178. [Link]

(*) This Institute has been renamed as the National Institute of Labour Economics Research and Development and is now an autonomous institution under NITI-Aayog. I could not find this report nor does the EXIM Bank paper provide the exact citation.

An email response from a friend prompts me to add the following explanation:

There is no presumption on my part as to the exclusivity of this (labour laws and regulation) as an explanatory factor. There is a figure earlier in the blog which mentions financial and non-financial incentives that keep firms small. I do not discount the possibility that there are more important explanations for the extraordinary Indian phenomenon of small and mini enterprises. Taxes and regulations in general, for example.

Also, this was a blog post that arose out of the sequence of HITS that my ‘Search’ took me this morning.  I found the discussion in Chapter 2 of the ‘Economic Survey 2012-13’ interesting and hence wrote this post.

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