MSMEs crisis: How to rescue India’s businesses?

As part of its Aatmanirbhar Bharat package, the Indian government announced several far-reaching reforms. One of them was a change in definition of micro, small and medium enterprises (MSME). To the earlier definition that relied solely on the book value of investments to determine their MSME status, a sales turnover criterion was added. Second, the distinction between manufacturing and service enterprises was abolished. Third, the threshold amounts were increased. Later, when the changes were notified, the government increased the investment and sales turnover thresholds for medium enterprises. These changes have the potential to be transformative, but they may not work out as expected.

As things stand, an enterprise will lose its status as a micro enterprise, for example, if it either exceeds the investment limit or the sales turnover limit. In other words, the addition of the sales turnover criterion is rendered largely infructuous by the insistence that enterprises migrate to the next higher category even if one of the criteria is met. Is it possible for micro manufacturing enterprises to achieve a sales turnover of 5 crore with an investment of 1 crore or less?

Data indicates the turnover to investment ratio, or TIR, ranges across Indian industries and sectors between 0.08 and about 3, with an average of between 1 and 1.2. Perhaps, purely micro service enterprises that rely on investment in human resources rather than in plant, machinery and equipment might have a higher TIR. But it is doubtful if even they would be able to achieve a revenue of ₹5 crore with an investment of ₹1 crore or less. Similarly, small and medium manufacturing enterprises cannot achieve a sales revenue of 50 crore and ₹250 crore with investments of 10 crore and ₹50 crore, respectively.

As they stand, the policy changes may achieve the perverse effect of keeping manufacturing units micro and small, while service-sector enterprises stand a slightly better chance of achieving growth without worrying about losing the concessions that accrue to them based on their micro or small or medium status. When the country is aiming to become self-reliant, attract businesses seeking to relocate out of China and create employment in, say, light manufacturing industries, this policy change would achieve the opposite.

On their part, developed countries adopt either employment criteria or sales turnover criteria, or both. Consider the policies of other jurisdictions. The European Union adopts a mix of sales turnover and employment criteria. The United States, for all practical purposes, has an employment yardstick. If an enterprise has less than 500 employees, it is considered a SME. Otherwise, it is large. Japan opts for investment and employment criteria. What’s important is that Japan does not make both criteria binding, as India has done. As long as one of the two is met, the enterprise can retain its SME status.

A casual look at the classifications that other developing countries like Brazil, China and Indonesia have adopted suggests that India has done better by keeping them simple and eliminating the distinction between manufacturing and services. Other countries have different ratios for different industries and for assorted purposes. The latter means, for example, that revenue authorities follow one definition and banks another. However, the principle to follow when we opt for a simple definition is to make it broad enough to subsume finer distinctions so that the purpose is not lost.

What is the purpose of classification? It is to encourage businesses to grow, generate employment, and be more productive by investing in technology, rather than focussing on remaining small to avail of special financing and tax concessions. Therefore, the government should wholeheartedly encourage them to grow without their fearing a loss of concessions consistent with their status. The myopic mindset of worrying about offering tax breaks or lower interest rates on loans extended to these enterprises for a longer period than planned should be shed.

The notional losses incurred because of these are more than offset by the employment generated, technologies obtained and prosperity achieved. In general, the government’s attitude should be not to punish them for growing but reward them. In a post-covid world of scarce growth, policy experiments need to be pursued with larger hearts and more open minds. That is what seems missing in India’s new MSME thresholds.

What should the government do now? Like Japan’s, the government of India should allow enterprises to remain MSMEs even if only one of the two criteria is met. Only when an enterprise has a higher investment and has achieved a higher sales turnover than defined should it graduate to the next category, or out of the MSME framework entirely in the case of medium enterprises.

In short, India’s policy changes on MSME classification are welcome, as they seek to end the tyranny of thresholds. But, they run the risk of falling short in translating that intent into outcomes. In the post-covid world, being bold and large-hearted is the only option available to policymakers.

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