Economic Survey 2019: The curious case of Indian firms starting small & staying small

In the U.S., manufacturing plants grow or die. In contrast, surviving Indian plants exhibit little growth in terms of either employment or output. Quoting a survey by University of Chicago professor Chang-Tai Hsieh and University of Stanford professor Peter J. Klenow, the Economic Survey of 2019 states Indian firms start small and stay small, forever.

Comparing employment and productivity with firm age in three countries: U.S., Mexico and India (Hseih and Klenow, 2014)the Survey found that the average employment level for 40-year old enterprises in the U.S. was more than seven times that of the employment when the enterprise is newly set up.

In contrast, the average employment level for 40-year old firms in India was only 40 per cent greater than the employment when the enterprise is newly set up. Thus, once they survive for forty years, the average 40- year old firm in the U.S. generates five times (=7/1.4) as much more employment than the average 40-year old Indian firm.


The Economic Survey says even Mexico does far better on this dimension than India. The average employment level for 40-year old firms in Mexico is double that of the employment when the enterprise is newly set up. Thus, once they survive for forty years, the average 40-year old firm in Mexico generates 40 per cent more (=2/1.4) employment than the average 40-year old Indian firm.

A similar tale unfolds with productivity as well when we compare these three countries for the effect of aging of firms on productivity. The average productivity level for 40-year old enterprises in the U.S. was more than four times that of the productivity of an enterprise that is newly set up. In contrast, the average productivity level for 40-year old firms in India was only 60 per cent greater than the productivity of an enterprise that is newly set up. Thus, once they survive for forty years, the average 40-year old firm in the U.S. is 2.5 times (=4/1.6) more productive than the average 40-year old Indian firm. Mexico does far better than India on this dimension as well. The average productivity level for 40- year old firms in Mexico is 1.7 times that of the productivity of an enterprise that is newly set up.

Thus, the comparison with other countries highlights that both employment creation and productivity do not grow adequately as firms age in India.

The why
The Survey state that policies in India have been created in such a manner that it creates a “perverse” incentive for firms to remain small. “If the firms grow beyond the thresholds that these policies employ, then they will be unable to obtain the said benefits. 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,” says the Survey.

The first regulatory hurdle for growth is around a plethora of labour laws, regulations and rules, both at the centre and the state levels that govern the employer-employee relationship. Each of these legislations exempts smaller firms from complying with these legislations. For example, the Industrial Disputes Act (IDA), 1947 mandates companies to get permission from the Government before retrenchment of employees. This restriction is, however, applicable only to firms with more than 100 employees.

The Survey also adds that The Small Scale Industries (SSI) reservation policy that was introduced in 1967 to promote employment growth and income re-distribution may also be impeding growth. The Survey calls for a re-examination on the role of the SSI reservation policy. “Together with the fact that older and smaller firms utilize the reservation policies the most, this evidence highlights further that benefits provided to small scale firms irrespective of their age create perverse incentives for firms to remain dwarfs and thereby limit their contribution to jobs,” the survey says.