The firms of middle India

Business Standard, 2 October 2023

Capital stock destruction of Soviet firms

In 1989, when the USSR first opened up to international trade, this was a crisis for Soviet firms. These firms were controlled by the goverment, they were the creatures of bureaucratic planning and not a market process. Thousands of firms and factories closed down.

A nice intuition into the consequences of such a large economy-wide shock is to think of a bombing campaign. Suppose an enemy air force had wandered around the Soviet Union, destroying factories. This would be an adverse shock to the capital stock of the Soviet Union. GDP is made from labour ("L") and capital ("K"). If the capital stock of the economy goes down through a bombing campaign, the GDP will go down. And so it was, where the old firms got disrupted by the removal of trade barriers, a great chunk of the productive capacity of the country was abruptly destroyed, and the GDP of the USSR went down.

Capital stock destruction in Indian firms

A mild version of this problem has afflicted India in recent decades. A vast number of Indian firms are fairly unproductive. India is a poor country because most Indian firms are of a low quality. Middle India is populated with firms who have weak management, weak technology, weak corporate finance and weak productivity. Internationalised firms (exporting, importing, outbound FDI, foreign debt, foreign equity capital, foreign employees) are generally more productive, but these are only a small slice of Indian firms.

Weak Indian firms make up a strong chunk of the GDP and the employment. The puzzle of economic policy is that of creating conditions where incumbent firms feel motivated to put in the effort to rise to higher productivity. It is not easy for a firm to make this jump! Every businessman in India is looking at the landscape and making this decision. If many firms close down, this harms GDP. If many business families back away from investing, if they emphasise sending their children and capital abroad, this yields slow GDP growth.

Firm capabilities are not immutable. There has long been a gradual process through which high quality firms have emerged, competition in many sectors has gone up, and the firms have gradually gotten better. The most remarkable period is that from 1991 (when the peak customs duty was 300%) to 1999 (when Yashwant Sinha announced that the peak customs rate would go down by 5 percentage points every year). Firms in India manfully responded to that set of events, and kicked off the greatest investment boom of Indian history in 1991-2011.

The choice faced by firms

From 2011 on, the compliance environment has changed. Many or most Indian firms have operated in the shadows, with a lived reality that involves violating some laws. The Indian state has been grinding away with a combination of higher tax rates, more central planning, more onerous regulation, and a more trigger happy approach to destroying firms and/or imprisoning business people.

This creates a more difficult on-ramp for firm transformation. To fix intuition, consider corporate income tax only, and compare the environment with a 40% tax vs. a 20% tax:

Corporation tax at 40%
Suppose a firm has traditionally operated while violating corporation tax and faces an increasingly difficult environment where this approach is less feasible. In this case, the firm faces a difficult transition, from its lived experience of 0% vs. the formal sector tax rate of 40%. This is a big jump that it is asked to make. At a low level of productivity, many a firm may find this a difficult jump to make. Many an informal sector firm might then choose to close down and exit, or atleast to stop investing in the business.
Corporation tax at 20%
In this case, a transition path is more visible. It is more feasible for the firm to undertake improvements in productivity and get up to the point where it is in full compliance with the 20% corporation tax, and it is still generating a decent return on equity.

In this example, we have only considered one element of state action -- the corporation tax. In the real world, there are numerous elements of state action that shape this thinking of the firm. All kinds of taxation, central planning and regulation matter, and the approach to punishments matters. If a firm is asked to rapidly jump to compliance with an array of regulations (e.g. labour regulation, building regulation), dance to the tune of central planners, pay high rates of taxes, and develop the teams (lawyers, accountants, relationships) to fend off agencies or regulators, this is a difficult transformation for most firms.

The biggest firms have achieved this transformation. They have developed the teams and capabilities to operate in the Indian policy environment. But these are just a few firms and add up to a small part of the Indian economy. The beating heart of the Indian economy lies in thousands of firms, and particularly small firms all over the hinterland, who are not tooled up for this environment.

The limitations of factor reallocation

It is possible to operate on pure market economy principles: the firms who cannot handle this policy environment should just close down. This requires a bankruptcy process, for rapid firm exit. It requires the strong firms to buy out the weak firms or their assets. It requires shifting labour from the weak firms to the strong firms. it requires shifting production from low productivity locations to high productivity locations. Under good conditions, this can be done in about one generation.

However, the Indian institutional environment is not well suited to factor market reallocation. As an example, while the bankruptcy reform was well begun, it ran into myriad difficulties and is at present a flawed system. Given the frictions of factor reallocation in India, the process could be drawn out and impose a drag on growth.

The wise middle road

The wise middle road, then, lies in easing up the pressure of the state so that the firms of middle India do not lose heart. This involves low tax rates, less central planning, less regulation, reduced staffing and budgets for agencies and regulators, reduced levels of punishment, the removal of imprisonment for economic offences, and better functioning courts.

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