After independence in 1947, centrally planned industrialisation became the guiding principle for Indian policymakers. The aim was to achieve self-reliance across all sectors, along with technological catch-up, rapid industrialisation, growth and employment generation, and poverty reduction.
In practice, the government set to achieve these goals through a plethora of regulations focussed on industrial licensing, import substitution through licensing and tariffs, emphasis on public sector enterprises and small-scale industries, and labour laws.
Most of these regulations adversely impacted private sector development in India by placing enormous restrictions on entry and expansion.
The Industries (Development and Regulation) Act of 1951 gave powers to the central government to regulate output capacity and control prices of key industries. This was essentially done through industrial licensing (also called Licence Raj), whereby a licence was required to start a new factory or product line, and even to expand capacity.
Additionally, the Industrial Policy Resolution of 1956 classified industries into three categories: (i) Schedule A – reserved for public sector enterprises, (ii) Schedule B – mostly reserved for the public sector, and (iii) Schedule C – the remaining industries in which the private sector was allowed entry, albeit with industrial licences controlled by the central government.
Another important policy lever used by the central government was the reservation of products that could exclusively be manufactured by small-scale industries (SSIs). The SSI reservation policy began in 1967, and the list of reserved products was expanded until 1996.
The trade policies from this period also focussed on the self-reliance agenda, by discouraging imports through import (and export) licensing, tariffs, and non-tariff barriers. The foreign direct investment (FDI) policies were equally protectionist. Most regulations including the Monopolies and Restrictive Trade Practices Act of 1969, and the Foreign Exchange Regulation Act of 1973, imposed a multitude of restrictions on foreign investment.
Furthermore, another regulatory constraint on the growth of the private sector in India was the onerous labour laws. The Industrial Disputes Act (IDA) of 1947 is the core of labour laws in India and covers various aspects such as the resolution of industrial disputes by setting up tribunals and labour courts, hiring and firing workers, closure of establishments, strikes and lockouts in the formal sector.
Importantly, sections V-A and V-B of the IDA, that applies to firms above 50 and 100 workers respectively, made it excessively hard to fire permanent employees.
Although IDA is a federal government regulation, states are allowed to amend these laws. Some amendments have made the states more employer-friendly by making it easier to hire and fire workers and some have made them more worker-friendly by increasing job security for labourers.
Policy commentators and academics have largely attributed the overall “Hindu rate of growth” of 3.5% from the 1950s to 1980s and the dismal performance of the private sector in India to the centrally planned regime and the regulations therein. During the 1980s and the 1990s, there were two main waves of reforms. The first in 1985, under Rajiv Gandhi, and the second was launched in 1991 under the regime of Narasimha Rao.
The 1991 liberalisation was prompted by a balance-of-payments crisis and by the external pressure of the IMF (International Monetary Fund) that imposed a structural adjustment programme. The 1985 reforms began dismantling the Licence Raj and removed both entry and size constraints for private sector firms in a particular subset of industries while relaxing size restrictions across the board (Chari 2011).
The 1991 trade liberalisation included removal of most licensing and other non-tariff barriers on all imports of intermediate and capital goods and significant reductions in both input and output tariffs. Furthermore, restrictions on FDI were relaxed and a new industrial policy was established that, among other things, virtually abolished the Licence Raj.
It also gave directives to reduce government ownership to 26% of equity, in all State-owned firms outside of the defence, atomic energy, and railway sectors (Krishna and Mitra 1998, Topalova 2010, Gupta 2005).
End of Licence Raj:
The end of Licence Raj brought about many changes in the Indian economy. Following the end of delicensing, industries located in states with pro-employer labour regimes grew more quickly relative to those in pro-worker environments (Aghion et al. 2008). Resource misallocation declined and there was an increased entry by small firms, although the large incumbent firms remained dominant and grew in size.
This resulted in a shrinking middle in the firm size distribution in Indian manufacturing (Alfaro and Chari 2014). The 1985 reforms also resulted in an aggregate productivity improvement, a majority of which can be attributed to the relaxation of entry constraints (Chari 2011).
1991 Trade Liberalisation:
The 1991 trade liberalisation, however, remains the most widely studied reform in India. Krishna and Mitra (1998) find that it led to an increase in industrial competition, and in the growth rate of firm productivity. Khandelwal and Topalova (2011) also find that the trade reforms increased firm-level productivity in the formal sector, mostly as a result of lower input tariffs.
For informal sector firms, however, Nataraj (2011) finds increases in their productivity due to the reductions in final goods tariffs after 1991. The access to new imported inputs due to lower input tariffs post-1991 also resulted in an increase in new products being introduced by domestic firms (Goldberg et al. 2010). De Loecker et al. (2016) find an increase in firm-level mark-ups as firms lowered factory-gate prices, but these price declines were much smaller than the reductions in their marginal costs.
Furthermore, the trade liberalisation episode led to widespread changes in the labour markets – a decline in the bargaining power of workers (Ahsan and Mitra 2014), higher labour demand elasticities1 in the manufacturing sector (Hasan et al. 2007), a decline in likelihood of unemployment in net-exporter industries (Ahsan et al. 2012), an increase in schooling and a decline in child labour (Edmonds et al. 2010), and a slower decline in poverty and consumption growth in more liberalisation-exposed districts (Topalova 2010).
Finally, Gupta (2005) studies the post-1991 reductions in government equity ownership in State-owned firms and finds that such partial privatisation has a positive impact on profitability, productivity, and investment for firms.
De-Reservation and Change in Size Cutoffs for Small-Scale Industries:
After the end of the licensing era, the Indian government also started dismantling the SSI reservations, beginning in 1997. De-reserving products that were earlier reserved for exclusive manufacture by SSIs, encouraged overall employment and output growth. Both new entrants into these product spaces as well as previously size-constrained incumbents drove this growth (Martin et al. 2017). Size-dependent regulations have been the hallmark of the SSI sector in India. These size cutoffs have changed over time, and in the same vein, the Indian government passed the Micro, Small, and Medium Enterprises Development (MSMED) Act in 2006.
These size cutoffs, often based on firms’ investment in plant and machinery, are used for defining what constitutes an SSI. These cutoffs are then used for various government programmes aimed at this sector.
For example, all banks are required to lend to the ‘priority sector’ that includes SSIs, based on these definitions. Banerjee and Duflo (2014) look at two such changes in the size definition for directed credit in 1998 and 2000. They find that a subset of firms that became eligible in 1998 for priority sector credit had increases in sales and profits, and these trends reversed, as they lost eligibility in 2000. Rotemberg (2017) studies the MSMED Act, 2006 that expanded the eligibility criteria for SSIs to receive priority sector credit and finds that newly eligible firms grew their sales by 35%.
Many have criticised the inflexible labour laws in India as a major reason for the lack of manufacturing growth. A large literature has found negative economic impacts of amending the IDA regulations in pro-worker directions, thereby making it harder to fire permanent workers — lower output, employment, investment, and productivity within formal manufacturing (Ahsan and Pages 2009, Besley and Burgess 2004), lower sensitivity of industrial employment to local demand shocks (Adhvaryu et al. 2013) and lower employment in the retail sector (Amin 2009).
A further consequence of these inflexible labour laws has been the increased use of contract workers, who are not subject to IDA regulations (Chaurey 2015, Ramaswamy 2013, Sen et al. 2013). These workers have temporary contracts and are very often hired indirectly through a contracting agency. Recent work has shown that and an increased reliance by firms on contract labour is associated with an increase in their size, a decrease in the average product of labour, an increase in employment variability, and a decrease in the average cost of labour (Bertrand et al. 2017).
Despite adding flexibility to firms’ hiring decisions, there may be productivity costs of hiring contract workers. This may be because these fixed-term workers are unable to accumulate firm-specific human capital. Soundarajan (2017) finds an increase in contemporaneous firm productivity with hiring contract workers, but the average productivity effects are negative after one period. This shows the potential undesirable dynamic effects of hiring excessive contract workers.
Tackling Regional Economic Disparities:
Regional economic disparities have remained persistent across India, with some states exhibiting accelerated growth rates, while others growing sluggishly. In fact, BIMARU states, a term coined by Ashish Bose to describe the poor economic conditions across Bihar, Madhya Pradesh, Rajasthan, and Uttar Pradesh, has become common parlance. The Indian government has tried to address regional economic imbalances by using place-based industrial policies that provide tax exemptions, infrastructure grants, subsidies, and other incentives to firms to locate to backward districts, and “special category states.”
Furthermore, the Special Economic Zones (SEZs) Act, 2005 provided further impetus to regional economic development in India. Overall, the results from these place-based policies have been promising for firm entry and firm growth, for example, in Uttarakhand and Himachal Pradesh (Chaurey 2017), in backward districts (Chaurey and Le 2018, Hasan et al. 2018), and for SEZs (Hyun and Ravi 2017).
Despite the reforms and overall productivity growth in the Indian economy after 1991, several challenges remain. Resource misallocation across firms continues to be pervasive. Hsieh and Klenow (2009) find large gaps in the marginal products of both capital and labour across plants in India. Their quantitative exercises show that there could be 40-60% increases in manufacturing total factor productivity (TFP) if capital and labour could be reallocated to equate the marginal products observed in the US.
There is, however, some evidence that infrastructure investments (especially highways) have increased the allocative efficiency of industries in India (Ghani et al. 2016, Asturias et al. 2017).
The firm size distribution remains skewed towards very small firms, with no evidence of a “missing middle” in the sense of a bimodal distribution in firm sizes (Hsieh and Olken 2014). Large and old firms in India also grow much slower than similarly aged firms in the US, suggesting lower investments in process efficiency, quality, and in accessing markets at home and abroad (Hsieh and Klenow 2014).
India recently jumped 30 spots and was ranked 100th by World Bank’s Doing Business Report 2018. Reforms related to insolvency resolution (Bankruptcy and Insolvency Act, 2017) and the Goods and Services Taxes (GST) are impressive and will result in long-term gains for the industrial sector.
However, electricity shortages and prices (Allcott et al. 2016, Abeberese 2016), credit constraints (Banerjee and Duflo 2014), high unit labour costs due to labour regulations (Amirapu and Gechter 2017), political interference (Asher and Novosad 2017, Alok and Ayyagari 2017), and other regulatory burdens continue to remain challenges for firm growth in India.
Labour demand elasticity refers to change in employment associated with a given percentage change in the wage.
Views expressed are of the author and do not necessarily reflect the views of League of India or of any of its partners.
Published with permission from Ideas For India (www.ideasforindia.in), an economics and policy portal.