Thinking small

Preference for small-scale firms isn't a good idea

The drafters of the Union Budget 2017-18 would have been mindful of the pressure being faced by many small companies and entrepreneurs as a consequence of the decision to withdraw high-value currency notes from circulation. The demand destruction in demonetisation’s wake has made doing business difficult. It is understandable, therefore, that the Budget has targeted the micro, small and medium enterprise (MSME) sector for special attention — most clearly through its decision to create a different tax slab, with a 25 per cent tax rate, for companies with an annual turnover of below Rs 50 crore. The rest of corporate India will continue to pay tax at 30 per cent rate. The finance minister is correct to point out that his tax break covers 96 per cent of taxpaying companies. But that is, in itself, the biggest signifier of the problem. India’s economy is already a landscape of too-small-to-compete firms. This special singling out of small firms in the Budget is uncomfortably reminiscent of the failed strategies of the past. It recreates a small-scale preference that India should have grown out of by now.

For decades, India kept certain products reserved for MSMEs, provided them lighter regulation, and enshrined various other forms of protection into law. This small-scale preference had a perverse, although not surprising, consequence: Indian companies stayed small. In India, 84 per cent of workers in the manufacturing sector are employed in MSMEs, as opposed to just a quarter in China. When politicians declare that MSMEs are job creators and thus deserve support, they are going backwards. In fact, because MSMEs are supported and larger companies overtaxed and over-regulated, only MSMEs are free to create jobs. Worse, they have no incentive to grow larger. The most efficiently-run MSMEs in a market economy should be able to increase in size and benefit from economies of scale. Their greater productivity will thus allow them to employ more workers and pay them more. But if the government creates a two-track economy, with coddled, lower-tax MSMEs and larger businesses that still have to pay higher rates or indulge in rent-seeking if they wish to lower it, then India will be stuck in a low-productivity trap. And, as a consequence, it will continue to struggle to provide employment to its young people.

Instead of going for the easy target, Finance Minister Arun Jaitley should have focused on the disincentives for Indian companies to grow big. Of course, one big aspect of this is the differing tax rules and administrations across state boundaries in India — a problem that the goods and services tax (GST) is supposed to solve. A GST that is truly uniform – with a single window and assessment authority, wherever you are paying – will help MSMEs to scale up. So will lighter regulation of large firms. Differential tax rates – the creation of two classes of firms – does not help MSMEs to scale up. The FM should have just bitten the bullet and moved forward on his promise to cut the overall corporate income tax rate to 25 per cent while closing exemption-related loopholes. What appears to be a progressive corporate income tax is actually, from a historical point of view, regressive.