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Revised MSME definition is a long-awaited reform but not enough to address bloating sector

Complex labour laws & regulations were responsible for the creation of dwarf entities in India. MSMEs will need many reforms to scale up and be competitive.

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The micro, small and medium enterprises (MSMEs) have received major relief in the form of a tailor-made stimulus package offered by the Narendra Modi government. The economic shock rendered by the coronavirus pandemic has been devastating for these business units whose contribution accounts for close to a third of India’s GDP and provides employment to almost 12 crore persons. To aid the sector combat this unprecedented shock, Finance Minister Nirmala Sitharaman has announced six relief measures as part of a larger Rs 20 lakh crore package. 

Specific measures for the MSME sector include collateral-free loans worth Rs 3 lakh crores, subordinate debt provision worth Rs 20,000 crores inclusive of a partial guarantee support through the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), equity infusion of Rs 50,000 crores, revision of the current MSME definition, disallowance of global tenders upto Rs 200 crores in government procurement tenders and lastly, payment of outstanding dues to MSMEs, by government/CPSEs within 45 days. 

The MSME sector is characterised by limited accessibility to formal credit and coloured by massive informality, especially with the presence of 6.30 crore microunits (99 per cent of the total 6.33 crore MSME units fall within the micro segment) comprising oneperson business units and those that employ upto 10 persons. It is a highly heterogeneous set of business units, engaged in manufacturing, trade and service activities. It is time that MSMEs are accurately profiled through updated, comprehensive information about these unincorporated business units and workers within. 

What is apparent is that the extremely large number of micro enterprises has been propelled by perverse incentives to remain small. From priority sector allocations to collateralfree loans targeted at the micro segment, it is evident why such units would not prefer to scale. Finance Minister Nirmala Sitharaman, in her speech, highlighted how a big ticket reform to the legal classification of these enterprises would incentivise firms to grow. 


Also read: Modi govt’s Rs 20 lakh crore package is a missed opportunity for MSME credit reform


Revised definition for MSMEs: The Composite Criteria

The definition of MSMEs has been revised. Apart from an upward revision of the investment thresholds, an additional criteria of turnover is being introduced. Moreover, the distinction between manufacturing and service sectors is also sought to be eliminated. The lapsed MSME Development (Amendment) Bill, 2018 was introduced previously with the same objective.  It may be noted that the definition proposed under the lapsed Bill was solely basis turnover, unlike the recent change where a composite criteria of investment and turnover is proposed.

The objective behind the move to shift from a definition based on investment in plant and machinery was to incentivise entities to modernise without worrying about losing their MSME status, while also easing the process of verification. However, major objections have been voiced regarding the feasibility of moving to a definition based solely on turnover since it was felt that such a move would benefit traders more than manufacturers.

It was observed that the value addition done by a trader was not only lesser than that done by a manufacturer, but also the margins enjoyed by the former were greater since manufacturers would typically have costs such as loans incurred in setting up equipment and machinery. The fear is that adoption of a MSME definition solely based on turnover could erode the manufacturing industry.  

To allay these concerns, it appears that the government has retained both investment in plant, machinery and equipment as a criterion on one hand. On the other hand, it has sought to plug the Bill-envisaged turnover criterion. Thus, a composite criteria has emerged in determining whether an entity is classifiable as a micro, small or medium enterprise.  


Also read: Modi govt has been forced to rescue small businesses as banks are refusing to lend


Ascertaining turnover of entities accurately 

The adoption of a turnover based definition for MSMEs has been previously recommended by the RBI Expert Committee on MSMEs, since it was felt that this was a progressive, transparent and feasible classification criterion post the introduction of the Goods and Services Tax (GST). 

However, a key concern in estimating the turnover of entities remains. As the report has noted, the Goods and Services Tax Network (GSTN) captures turnover data of enterprises but does not capture data pertaining to investment in plant and machinery without which it is difficult to identify MSME entities registered on the GSTN. This issue remains unresolved since the revision now is based on composite criteria of both investment and turnover.

For the accurate classification of MSMEs using both investment and turnover information, the GSTN database will need to be augmented with investment information immediately. Or, like the RBI Report suggests, the introduction of a Unique Enterprise Identifier (UEI), linked to the GSTN and other databases where MSME information exists presently. For instance, the Udyog Aadhaar Memorandum (UAM) may be set in motion.    

Revisiting factors that incentivised enterprises to remain small

In the light of the Finance Minister announcing that the MSME definition revision will incentivise such units to grow, it is important to examine the various factors that have led to the micro segment ballooning over decades. 

The complexity of labour laws and regulations have been responsible for the creation of dwarf entities in India. It is estimated that there exist as many as 165 labour laws including 50 central laws. A plethora of legislations kick into effect on the basis of the number of employees an entity employs with differing compliance requirements. For instance, the Trade Unions Act, 1926 can be implemented when an entity employs seven or more workers, while the Factories Act, 1948 finds applicability when the number of employed rises to 10, and Employees Provident Fund and Miscellaneous Provisions Act, 1952 is attracted when the number of workers employed rises to 20.

Further, retrenchment of workers is extremely tricky as the dismissal of a worker in a factory and certain other specified establishments with more than 100 or more workers requires the approval of the concerned labour department. The costs of statutory compliance have been noted to be among a significant constraint in Indian MSMEs remaining small in scale and largely informal with some estimating that formal sector entities require to meet 3,000 plus annual filings alongside 60,000 plus items of compliance. The costs for an establishment, per worker, is estimated to increase by 35 per cent due to the range of regulations that find applicability once an establishment has 10 or more workers.

It is no surprise then that most MSMEs in India employ upto 10 workers, especially the 6.30 crore microunits. Importantly, these costs are noted to be the highest for privately owned establishments thus acting as a barrier for establishments achieving scale. 


Also read: CM Yogi has a roadmap for MSMEs: A loan fest followed by online handicrafts exhibition


Way forward 

The endeavour to formalise and encourage MSMEs to grow is an honourable one. The revised definition is a forward step in this direction. However, more measures may be required in order for MSMEs to scale up and be competitive. Long-standing factors that have inhibited growth need to be acknowledged and addressed through labour law reform and the augmentation of databases because information pertaining to MSMEs is available in a fragmented fashion now. Supplementing the definition change with these reforms will help these vast number of informal units transition to a formal structure, achieve economies of scale and reap productivity gains without being held back. 

Radhika Pandey is a Fellow at the National Institute of Public Finance and Policy (NIPFP), New Delhi. Amrita Pillai and Raghunath Seshadri are Research Fellows at NIPFP.  Views are personal.  

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