The manufacturing sector has seen a sharp increase in the number of new formal firms being set up in the last few years. In the last 5 years, the number of new manufacturing firms has almost tripled – from 15k new firms in FY17 to 41k new firms in FY21. In contrast, the number of new firms in the services sector has increased by just 30% during this period. This has led some to argue that we are at the cusp of a manufacturing renaissance in India.
The bulk of this increase in new manufacturing firms has come about in the last two years. Between FY17 – 19, the number of new firms being set up annual increased by just 27%. And this increase largely reflects the overall increase in new firms. Thus, the share of new manufacturing firms in all the new firms in FY19 was lower than in FY14 or FY15. But between FY19-21 the number of new firms has more than doubled and manufacturing firms now account for over 20% of new firms as against less than 15% in FY19.
So, what happened in FY19? In September 2019, the Government sharply reduced the tax rate on new manufacturing firms to 15%. Thus, it would appear prima facie that the surge in new manufacturing firms is a direct response to the reduction in the tax rate.
Some will argue that this simply reflects entrepreneurs taking advantage of the tax arbitrage now. But this by itself is not necessarily a bad outcome. The objective behind cutting the tax rate was to encourage new formal manufacturing firms – small, informal firms is one of the key structural headwinds facing the economy. And if entrepreneurs are responding to the set of incentives being created by the government, it cannot be held against the entrepreneurs.
That said, a legitimate question to ask is whether the increase in firms simply reflects the splitting up of existing firms or real new entrepreneurial activity in the manufacturing space. One way to determine this would be to see the changing composition of output – the share of the corporate sector in overall manufacturing. But the latest data from the Annual Survey of Industries which will afford such an analysis is available only till FY19, before the policy change.
But we can make some conjecture through the geographic spread of the new firms. If simply rebadging existing firms is what is behind the increase in new firms, then one should expect the geographical distribution of firms to have remained broadly unchanged. Between FY17-19 for instance, the top three states for new manufacturing firms were Maharashtra, Gujarat, and Delhi. These 3 states accounted for 45% of new firms. But since FY19 (and till August-2021) the share of these 3 states has fallen to 41%. The share of other large states like Karnataka and Tamil Nadu has also similarly fallen during this period. On the other end, the share of states like Bihar, Jharkhand, Madhya Pradesh, Chhattisgarh, Uttar Pradesh, Uttarakhand, and Kerala has gone up from 21% to 25% during this period.
So, the data suggests not only that the number of manufacturing firms in the country has increased in the last couple of years but also that the growth is coming from states which hitherto did not have a large manufacturing base. This could either be new manufacturing activity in these regions or the existing informal firms getting formalized, the lower tax rate being a ‘tipping’ point for several entrepreneurs.
A formal enterprise has a higher cost of doing business compared to an informal enterprise – stricter regulatory environment, higher compliance cost, lower ability to evade taxes etc. Thus, unless entrepreneurs see a commensurate benefit (in most cases this benefit accrues due to higher scale associated with a formal enterprise), they would not be inclined to incur the additional cost for formalisation. What the policy change in 2019 has done is reduce some of the cost of formalisation (by lowering the tax rate). Thus, if entrepreneurs are now willing to formalize it is because they now see the benefits outweigh the costs. And that is a positive for the economy.
Food & Beverages and Chemicals dominate Manufacturing: So, in which sectors of manufacturing are these new firms being set up? Four sectors – Food & Beverages, Textiles, Chemicals and Machinery – account for almost 2/3rds of new manufacturing firms from FY17. Food & Beverages and Chemicals have seen strong growth in new firms within this 4-year period. The number of new firms in both these sectors has more than tripled between FY17-21. The share of Food & Beverages in new manufacturing firms has increased from 21% in FY17 to 25% in FY21 and that of Chemicals from 13% in FY17 to 18% in FY21.
In contrast, both the Textiles and Machinery sectors have not seen strong growth in new firms. Consequently, their share in new manufacturing firms has fallen in the case of textiles from 13% in FY17 to 10% in FY21 and the case of Machinery from 17% to 14% during this period.
So, the bottom line is that data does suggest, prima facie, that the tax rate change has given a push for of the manufacturing sectors. And entrepreneurs, especially those in hitherto less states, have responded. How soon some of these firms start to scale up and start making an impact on the economy remains to be seen.