Why Indian Firms don't scale

 In the context of why Indian firms fail to scale, the sources identify the predominance of small firms as a structural bottleneck that prevents India from achieving the kind of manufacturing-led growth seen in other Asian economies. While India has the potential for large-scale operations, its industrial landscape is characterized by "bottom-heavy" structures where firms are effectively "too small to succeed" due to a regulatory environment that punishes growth.

The Statistical Reality of Smallness

The sources highlight a stark imbalance in India’s industrial distribution:

• Massive Fragmentation: Approximately 95% of India’s industrial units employ fewer than 10 workers.
• The MSME Trap: Micro, Small, and Medium Enterprises (MSMEs) constitute 96% of all industrial units, and 99% of those are micro-enterprises employing fewer than 10 people.
• Economic Inefficiency: Small firms (up to 50 workers) represent nearly 67% of operational factories but contribute only about 6.35% to net value added. In contrast, the largest firms (5,000+ employees) represent a tiny fraction (0.38%) of firms but produce over 16% of total output and nearly 20% of net value added.

Why Firms Stay Small: The "Too Much, Too Soon" Problem

The sources argue that the primary reason firms do not scale is a complex web of labor regulations that impose heavy burdens "too soon" in a firm’s life cycle.

• Low Thresholds: Most labor regulations, such as the Factories Act (1948), the Employees’ State Insurance Act (1948), and the Maternity Benefit Act (1961), apply once a firm reaches just 10 workers.
• Regulatory Cholesterol: India’s framework includes over 1,500 laws and nearly 70,000 compliance requirements. This "regulatory cholesterol" disincentivizes hiring the 11th worker, as doing so subjects a small firm to the same regulatory suite as a much larger enterprise.
• Micromanagement: Regulations go beyond safety standards to micromanage absurd details, such as the type and placement of spittoons, the specific colors for official register paper, the font size of wage slips, and the frequency of changing bed linens in worker accommodations.

The Consequences of Stunted Growth

The inability of firms to scale has profound effects on the broader Indian economy:

• Informality and Vulnerability: To avoid "regulatory cholesterol," firms choose to remain in the informal sector, which accounts for 90% of jobs created in the two decades post-liberalization. Informal firms cannot access formal credit or make large fixed investments, further stifling their growth.
• Missed Global Opportunities: Despite low labor costs and a large youth workforce, India has failed to become a primary destination for companies relocating from China (the "China Plus One" strategy). Between 2018 and 2019, only 3 out of 56 companies moving production out of China chose India, while 26 went to Vietnam.
• Lack of Economies of Scale: Small firms and cottage industries cannot reduce per-unit costs or invest in R&D, making them vulnerable to market shocks and dependent on subsidies.

Proposed Solutions for Scalability

To solve the problem of smallness, the sources recommend a "second-best" solution if wholesale repeal of laws is politically impossible: dramatically increasing employee thresholds.

• Threshold Increases: They suggest raising thresholds for most labor regulations to 1,000 workers and to 10,000 workers for industrial disputes and closures.
• Decriminalization: They argue for replacing imprisonment clauses—which exist for minor procedural lapses like not cleaning a floor weekly—with civil penalties to reduce the risk associated with business expansion.

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According to the sources, labor regulation is the primary inhibitor preventing Indian firms from scaling, creating a phenomenon where businesses are "too small to succeed". This inhibitory effect is defined by two core problems: regulations that do "too much" through micromanagement and regulations that apply "too soon" in a firm's life cycle.

1. "Too Much": Micromanagement and Regulatory Cholesterol

India’s labor laws are described as "regulatory cholesterol," consisting of 1,536 laws and nearly 70,000 compliance requirements. Instead of merely setting safety standards, these laws micromanage the internal operations of a firm in ways that significantly increase unit labor costs—by an estimated 35% across India.

• Absurd Compliance Details: Statutes like the Factories Act (1948) dictate the placement of spittoons, the specific height of glazed tiles in urinals, the type of canteen utensils, and even the font size of wage slips.
• Procedural Overload: Firms must navigate 6,632 different filings at the Union and state levels, a burden that prevents them from remaining competitive in global markets.
• Misalignment with Reality: The sources argue that these laws are based on a "Marxist argument" intended for massive 19th-century textile mills, but they are now applied to "mom-and-pop shops" with as few as 11 workers where such coordination costs are irrelevant.

2. "Too Soon": The 10-Worker Threshold

The most significant barrier to scaling is that the majority of these onerous regulations take effect at very low employee thresholds, typically starting at just 10 workers.

• The Growth Penalty: A firm with nine workers faces almost no regulatory burden, but hiring a 10th worker triggers the Factories Act, the Employees’ State Insurance Act, and the Maternity Benefit Act.
• Incentive to Stay Small: Because complying with the entire suite of regulations is prohibitively expensive, firms deliberately choose to stay below the 10-worker threshold or misreport their size. For example, 92% of firms in the garment industry employ fewer than eight workers specifically to avoid these laws.

3. The Threat of Criminalization and Inspection

The labor inspection system serves as a key inhibitor by weaponizing minor procedural lapses.

• Harassment Bribery: Inspectors hold significant discretion, leading to a system of "harassment bribery" where minor errors are used to extract payments.
• Imprisonment Clauses: Over half of the acts applying to businesses contain imprisonment clauses. A firm owner can face jail time for minor infractions such as not cleaning a floor weekly, not maintaining canteen chairs, or failing to display working hours prominently.

4. Economic Consequences of Rigidity

The sources note that these regulations lead to "jobless growth" and resource misallocation.

• Informality: To avoid "regulatory cholesterol," 90% of jobs created in the two decades after liberalization remained in the informal sector, where workers lack protections and firms cannot access formal credit to scale.
• Loss of Competitive Advantage: Despite having labor costs half those of China, India's rigid regulations mean it fails to attract companies relocating from China; for instance, between 2018 and 2019, Vietnam received 26 such companies while India received only 3.

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In the context of why Indian firms do not scale, the economic impact of labor regulation is characterized by a "bottom-heavy" industrial structure that stifles productivity, hampers global competitiveness, and creates a persistent crisis of informality.

1. Massive Resource Misallocation and Productivity Loss

The sources argue that India’s labor regulations are a primary driver of resource misallocation, which significantly lowers the country's potential output.

• Total Factor Productivity (TFP): Aggregate TFP in India would be 40% to 60% higher if resources were not misallocated across firms due to these regulations.
• The Productivity Gap: There is a stark contrast in efficiency between small and large firms. Small firms (up to 50 workers) represent roughly 67% of operational factories but contribute a mere 6.35% to net value added.
• The Power of Scale: Conversely, the largest firms (5,000+ employees) account for only 0.38% of total firms but produce over 16% of total output and contribute nearly 20% to net value added. The inability of small firms to grow prevents them from achieving the economies of scale necessary to reduce per-unit costs and compete effectively.

2. The Informality Trap and "Jobless Growth"

The economic impact of staying small is inextricably linked to the informal sector, which serves as a refuge for firms avoiding "regulatory cholesterol".

• Persistent Informality: Despite 7% annual growth in the two decades after the 1991 liberalization, 90% of jobs created remained in the informal sector.
• Barriers to Investment: Informal firms are trapped in a cycle of low growth because they cannot access formal credit or justify large, fixed investments while operating under the radar of regulators.
• Jobless Growth: Employment growth has failed to keep pace with overall economic growth. With 8 million to 12 million young Indians entering the workforce annually, the failure of firms to scale means most of these job seekers are expected to fail in finding stable employment.

3. Increased Unit Labor Costs and Corruption

Labor regulations impose a direct financial "tax" on firm operations through both compliance and "harassment bribery."

• The 35% Regulatory Tax: The suite of labor regulations increases a firm's unit labor costs by an average of 35% across India.
• Compliance vs. Bribery: Firms must choose between high compliance costs—such as hiring workers specifically to manage 70,000 possible compliance requirements—or paying bribes to inspectors to overlook minor procedural lapses.
• Criminal Risk: With over 26,000 imprisonment clauses in business laws, the threat of jail time for minor infractions (like not cleaning a floor weekly or having the wrong font on a wage slip) adds a layer of risk that deters expansion and innovation.

4. Failure to Capture Global Value Chains

Despite significant advantages, such as labor costs being half those of China, India has failed to become a primary destination for the "China Plus One" strategy.

• Missed Opportunities: Between April 2018 and August 2019, 56 companies moved production out of China; Vietnam attracted 26 of them, while India received only 3.
• Export Stagnation: Small-scale firms and cottage industries lack the specialization and efficiency required for labor-intensive exports, preventing India from replicating the manufacturing-led growth seen in other Asian economies like South Korea or Taiwan.

To address the structural problem of firms being "too small to succeed," the sources propose a series of policy recommendations ranging from ideal, wholesale reforms to pragmatic, "second-best" solutions aimed at reducing the regulatory burden that prevents scaling.

1. The Ideal Solution: Wholesale Repeal and Simplification

The primary recommendation is a fundamental shift in how the state regulates the workplace.

• Repealing Obsolete Laws: The sources argue for the repeal of the existing suite of labor regulations, particularly the Factories Act (1948), which they describe as obsolete and rooted in 19th-century industrial logic.
• Standard-Form Contracts: Instead of micromanagement, the state should create a sparse standard-form contract for basic protections and allow firms and employees to negotiate specific details themselves.
• Streamlining Standards: Regulations should be limited to setting basic health and safety standards rather than dictating internal operational details like paint colors or urinal heights.

2. The Pragmatic "Second-Best" Solution: Threshold Increases

Recognizing that total repeal is politically difficult due to "transitional gains traps" and the nature of coalition governments, the authors propose dramatically raising employee thresholds for existing laws.

• The 1,000-Worker Rule: The sources recommend increasing the threshold for most labor regulations from the current 10 or 20 workers to 1,000 workers.
• The 10,000-Worker Rule: For highly restrictive regulations involving government permission for industrial disputes, layoffs, or factory closures, the threshold should be raised to 10,000 workers.
• Incentivizing Growth: By raising these limits, firms that are currently productive with several hundred workers would no longer be forced to remain informal or stay below 10 employees to avoid the "prohibitive cost" of compliance.

3. Revamping the Inspection and Compliance System

To eliminate the "harassment bribery" associated with the current regime, the sources suggest modernizing how laws are enforced.

• Risk-Based Inspections: The state should adopt a risk-based approach, prioritizing frequent inspections for firms with poor compliance records while rewarding compliant companies with fewer visits.
• Promoting Self-Reporting: Evidence suggests that compliance rates are significantly higher when firms are allowed to self-report rather than being subject to discretionary inspections.

4. Decriminalization of Labor Law

A critical recommendation involves removing the threat of jail time for procedural errors.

• Replacing Imprisonment with Civil Penalties: The sources argue that criminal penalties should be eliminated for minor compliance lapses. Instead, the government should use civil penalties and fines, which are less damaging to a company’s reputation and continuity.
• Reserving Criminal Prosecution: Imprisonment should be reserved only for exceptional circumstances involving worker safety and gross negligence.

5. The Constitutional Pathway for Reform

Because labor is a "concurrent-list subject" in India, both the Union and state governments can legislate on it.

• State-Led Initiatives: The authors recommend that every state increase its thresholds and seek presidential approval for these changes, following the example of Rajasthan, which successfully raised thresholds for the Factories Act in 2014.
• Presidential Assent: While central laws generally prevail, states can pass amendments that take precedence if they receive assent from the President of India.