Historically, India has supported and encouraged micro, small and medium enterprises (MSMEs) through various policy initiatives by providing them with subsidized credit, technical assistance, excise tax exemptions and preference in government procurement (Expert Committee on MSMEs, RBI, 2019).

The Small-Scale Reservation Policy (1967), which attempted to shield small scale units from competition by reserving the production of a number of products for them for over three decades stands out in this context. In recent times too, the MSME sector has continued to remain a thrust area for policymakers as it is believed that the sector is the backbone of the Indian industry.

Policies designed to support MSMEs have been widely debated across developing countries. It is often argued that in efficient markets, productive firms remain in business and grow while unproductive ones leave the market. The predominance of a large number of old MSMEs is often cited as evidence of market failure as the policy support provided to these enterprises has encouraged inefficient modes of production (in the name of employment generation) and diverted scarce resources from productive investment.

However, it can be argued that in an economy such as India where there is a large pool of surplus labour (including household labour, whose opportunity cost is close to zero) the promotion of the decentralized methods of production may not only encourage greater use of labour but also contribute to greater equity. Additionally, such policies promote entrepreneurship, lack of which is often cited as a reason for inadequate competition in industrial markets.

In this context, the question of whether it is in fact MSMEs or large firms that have been significant contributors to employment in India and whether their contributions have evolved over time merits greater attention. Combining establishment-level data for the formal and informal manufacturing sector from the Annual Survey of Industries and the NSSO’s Enterprise Survey of Unincorporated Enterprises for the period between 2000-01 and 2015-16.

It is noted that the distribution of manufacturing employment across firms of different sizes in India is marked by a bi-modal distribution wherein a large share of employment is concentrated in micro-enterprises followed by large enterprises. While the existence of a “U” shaped (or bi-modal) distribution of manufacturing employment by enterprise size referred to as the “missing middle” is widely recognised in the literature, this study finds that over time there has in fact been an improvement in the employment distribution with the share of medium and large enterprises in total employment rising while that of small and micro-enterprises has been falling.

The share of micro-enterprises (defined as those hiring one to ten workers) in total employment has declined by 8.5%, while that of large enterprises (i.e., those with 250 or more workers) has increased from 20.5% in 2000-01 to 30.3% in 2015-16. The share of small enterprises (i.e., those with 10 to 49 workers) in total employment has fallen from 21.6% to 17.2% over the fifteen-year period while that of medium sized enterprises (i.e., those with 50 to 249 workers) has risen from 12.7% to 16%.

The rising employment share in medium and large enterprises (from 33.3% to 46.4% cumulatively over 15 years) in total manufacturing employment is a positive development as these enterprises offer more productive and better paying jobs compared to smaller enterprises. Importantly, the improvement in the distribution of employment is seen not just at the aggregate level but also at a more disaggregated state and industry level.

Further, examining stylized facts across firms of different sizes and age cohorts, it appears that the shift in distribution of employment towards relatively larger enterprises is driven, amongst other factors, by the expansion of some dynamic MSMEs which are graduating and moving up the size distribution.

An important implication of the above is that for policies designed to support MSMEs to be effective in employment generation, they should seek to identify the transformative enterprises, which have the potential to grow fast and provide them the necessary support to expand and graduate quickly up the size distribution. Successful policy support to micro and small enterprises must be able to target transformative entrepreneurs and help them grow and not incentivize them to remain small.

Given scarce resources, policy support must ensure that it is equipping transformative entrepreneurs with the tools they need to succeed. Many of these enterprises, also referred to as ‘constrained gazelles’ in the literature (defined as those entrepreneurs who have a high empirical probability of being top-performers given their observable characteristics) are perhaps held back by policy-fixable constraints, such as imperfect capital markets.

However, the task of identifying these high growth firms from the factory level data available in India is difficult and warrants more creative research and thought. In addition to helping ‘constrained gazelles’ expand, MSME policy support must not (inadvertently) penalize medium and large sized firms in an economy.

Further, it should also avoid indefinitely subsidizing subsistence entrepreneurs i.e., those who are compelled to resort to self-employment or own account employment as a survival mechanism to eke out a subsistence living. OAMEs (i.e., those which operate without hired labour) have persistently accounted for 85% of total enterprises in the enterprise landscape suggesting that such subsistence enterprises are not transitioning to larger size categories and are unlikely to become engines of productive job creation.

The abundance of subsistence entrepreneurs in fact reflects a failure of medium and larger sized firms to be more prevalent in the economy and generate a larger fraction of jobs. Finally, MSME policy should also seek to support and encourage linkages between MSMEs and more dynamic firms (typically medium and larger firms) and between MSMEs and dynamic markets. Effective cluster development policies can play a crucial role in fostering such linkages.

The article is by Dr Radhicka Kapoor, Senior Visiting Fellow, Indian Council for Research on International Economic Relations (ICRIER) and it was first published in the second issue of CII ARTHA, May 2022.

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