Why MSMEs need society’s support

The Annual Report of the Ministry of Medium, Small and Micro Enterprises for 2018 says that the share of MSMEs in GDP was 29.8 percent in 2014. It has declined to 28.8 percent in 2016.

The MSMEs are losing ground. So why should the society support them? If large industries can manufacture cloth at Rs 20 a meter, why the consumer should buy it from the MSMEs at Rs 25 a meter? 

First reason employment. Let us say ten workers are employed in manufacturing 100 meters of cloth in the MSME sector. In comparison, only one worker is required to manufacture the same cloth in a textile mill. If the cloth being produced by 10 MSMEs were to be produced by the textile mill instead, only one worker would be required instead of the present 10.

Nine workers would be rendered unemployed. The government would have to provide them with subsidised food grains and free houses. Therefore, production in the MSME sector reduces the welfare burden upon the government. 

Second reason — entrepreneurship. The MSMEs are incubation chambers of entrepreneurship. If Dhirubhai Ambani did not get protection as a smalltime businessman, he may never have risen to put up Reliance Industries. 

These services provided by the MSMEs should be treated as payments in lieu of taxes. The direct payment of taxes by the MSMEs may be less but their ‘shadow’ contribution may be much larger. Now let us consider the counterarguments against support to MSMEs.

First counterargument — lower exemption in industrial countries. The level of exemption for MSMEs in the industrial countries is around Rs 30-40 lacs, therefore, higher exemption in India is not justified.

But this ignores the fact that India needs to generate employment and entrepreneurship at a much larger scale than the industrial countries. They can tax their large corporations and provide unemployment compensation to their unemployed. Can we?

Second counterargument — subsidy to luxury consumption. It is argued that MSME exemption has become a route for evading excise duty on goods of luxury consumption. For example, a MSME unit can manufacture air conditioners and pay no taxes on them.

The affluent classes use these air conditioners and this becomes a route to subsidise the consumption by the affluent. This problem is genuine. Indeed, the affluent must pay taxes on their consumption. But then the same logic should apply to all goods.

The soap, candle, biscuits and bread made by MSMEs are consumed by the common man and they become cheaper as well. The problem of increased consumption of luxury goods should be dealt by taxing components that are made in large companies only such as compressors in air-conditioners.

Third counterargument — tax evasion. The exemption to MSMEs leads to tax evasion in various ways. The MSMEs produce goods in No 2 because units having turnover of up to the specified limit are exempted from registration or payment of taxes to the GST authorities.

This leads to downstream evasion of GST and income tax as well. It leads to the generation of black money. This argument is not acceptable. The evasion of GST and income tax should be dealt with the respective authorities. 

These counterarguments do not hold. The conclusion is that we are caught between two contradictory pressures. On the one hand, we have to invest in employment - and entrepreneurship generation by protecting the MSMEs.

On the other hand, we have to produce goods at the least cost so as to beget highest economic growth. In order to do this, we have to adopt policies that generate employment and entrepreneurship at the least cost. One possibility is that the government should provide across-the-board incentives to employment - and entrepreneurship generation instead of sector-specific reservations for MSMEs.

India is a capital scarce - and labour surplus economy. We should create such policies that encourage the businessmen to employ more labour and less capital. We should import capital-intensive goods like computer chips and export labour-intensive goods like carpets.

The government should impose higher tax on capital-intensive industries. The government can specify a benchmark level of employment per one crore of production. Those industries that employ less labour than the benchmark should be taxed at a higher rate.

Those industries that employ more labour should be taxed at a lower rate. There will be no overall increase in taxation. Indian economy as a whole will remain as competitive as previously. But businessmen will try to employ more labour to qualify for lower tax rates. Since most MSMEs typically employ more labour they will be taxed less and be benefited. 

The present GST policy provides for tax-free clearance of goods up to a specified limit. This leads to difficulty for the MSMEs. The MSMEs pay GST on their raw materials. But since they do not pay GST on their finished goods, they do not get a refund of the same.

The large units are able to reduce their tax burden by claiming setoff of the GST paid on the raw materials. Therefore, cash refunds of GST paid on raw materials should be allowed to MSMEs.

The MSMEs are very frequently starved of credit. Reason is that the bank managers are under pressure to show profits in their branches. The Reserve Bank asks the banks to charge lower interest rates from MSMEs. MSME accounts involve higher transaction costs of managing a large number of accounts. The branch manager has no incentive to take the responsibility of sanctioning small loans.

They prefer that large amount be lent to one large borrower. Credit will not flow to MSMEs until it is profitable for the Branch. The solution is to provide a cross subsidy to the branch, not the MSME unit. Let a tax of say one percent be imposed on all large lending and a subsidy of one percent be provided on all small lending done by the bank. The Branch will then make two percent higher profit if it lent money to the MSMEs. 

The Reserve Bank has specified that all Banks should extend 40 percent of their gross credit to priority sectors. If the bank does not fulfill this obligation, then it has to buy government bonds for the amount of shortfall. The banks are anyway buying government bonds because they have much liquidity. The rates on interest on these bonds are sufficiently attractive.

This is actually an incentive for the banks not to lend to the MSMEs. It should instead be stipulated that the shortfall would be deposited with the Reserve Bank at rates much lower than government bonds. (The author is formerly Professor of Economics at IIM Bengaluru)