The Effects of Exit Barriers on Indian Manufacturing

Understanding the effects of exit barriers is crucial for policymakers. These impediments include stringent labor regulations that raise the cost of firing workers in sufficiently large firms (as in India and France); compulsory contributions to unemployment insurance that can rise when workers are let go (as in the United States); and protracted, costly bankruptcy proceedings (as in India). Regulations that raise exit costs reduce expected profits and thus also act as entry costs, deterring potential new firms from entering the market. In addition, exit barriers keep inefficient firms in the market, tying up assets that could be used more productively elsewhere. Hence, though high exit barriers and firing costs aim to preserve employment, they can actually lower employment and wages if the adverse effects on firm entry outweigh the benefits of preserved employment.

Existing evidence suggests that exit costs in India are high. The annual exit rate among Indian manufacturers is 3.1 percent, one of the lowest rates in the world. The Industrial Disputes Act (IDA) makes it difficult to fire workers in large plants. Exit rates in sectors that are not covered by the IDA are roughly twice as high. Many firms in India remain dormant (i.e., produce nothing) for a long time before they finally exit, regardless of whether they retain workers. Additionally, exit barriers vary across Indian states. For example, some states define large plants as those with 100 or more workers, while others set the threshold at 300 or more. This variation allowed us to examine the effects of exit barriers on manufacturing using survey data of Indian manufacturers from 1999 to 2018.

Exit delays, especially for distressed firms, burden banks heavily. Indian firms mostly borrow from public-sector banks, which often must bear firms’ costs during dormancy as they default on loan payments. Litigation is likely because Indian firms had no clear path to bankruptcy until recently. However, even without litigation and with all documentation in order, voluntary closure still takes around 4.3 years—2.8 of which are spent securing clearances and refunds from government departments, such as tax and pension authorities. In comparison, voluntary liquidation processes are significantly shorter in other countries: about 12 months in Singapore, 12–24 months in Germany, and 15 months in the United Kingdom.

Our findings reveal that firing regular workers in India is 2.7–5.4 times more costly than firing contract workers. This is because regular workers, unlike contract workers, are protected by labor laws in India. Firing costs for regular workers are greater in states with low rates of firm entry, amounting to as much as 284 percent of average annual wages in these states. Bankruptcy costs are also high. In states with high entry rates, these exit costs amount to 79 percent of the annual sales of the average firm in these states, and they account for 140 percent in states with low entry rates.

Next, our research estimates outcomes among Indian manufacturers if their exit rate increased from 3.1 percent to 4.5 percent—half that of US manufacturers. We modeled this using two hypothetical policy reforms: first, by lowering firing costs, which the government could achieve through labor reforms; and second, by increasing the scrap value of firms—the value firms can recover by selling their assets—which the government could achieve through institutional reforms, such as improving judicial performance. Our findings reveal that both policies would increase the number of manufacturers and their contribution to gross domestic product (GDP) by 14–19 percent. The average duration of dormancy would fall from 3.46 to 2.37 years. However, reducing exit costs raises the value of entering, so new firms with slightly lower productivity would enter the market. As a result, the net effect on average productivity would be a modest 3.23–3.85 percent.

The effect on employment, however, would be different under the two reforms. Lowering exit costs by increasing firms’ scrap value would increase employment by about 8 percent. Reducing firing costs, on the other hand, would reduce employment by 14 percent. The precise negative effect depends on how much the entry of new firms attracts new capital. If firm entry attracts little new capital, then fewer laid-off workers would be hired by other firms. Thus, reducing firing costs could harm employment if capital markets are rigid or overregulated. In such settings, labor laws might help preserve jobs.

Additionally, our research finds that implementing both policies simultaneously would increase manufacturers’ contributions to GDP more than implementing both in isolation. Moreover, implementing both policies simultaneously would prevent employment from falling, and it may even increase employment if scrap values rise and firing costs fall enough. These findings suggest that Indian authorities should reduce red tape to lower exit costs and increase scrap value before relaxing labor regulations to mitigate the adverse effects on employment. Finally, our analysis reveals that exit subsidies would increase manufacturers’ contributions to GDP more than spending the same amount on entry subsidies, but the reverse would be true for employment.

Although India is now one of the largest and fastest-growing economies, our research helps explain several puzzles related to India’s economic development. Exit barriers have contributed to India’s premature deindustrialization and underperformance in key lower-skilled manufacturing sectors by making manufacturing, especially labor-intensive manufacturing, less attractive. Furthermore, exit barriers induce firms that want to exit to remain, which helps explain the existence of many unproductive firms in the country.

Although our research studies India, the economic factors involved have broad relevance. For example, they are central to current debates about the diverging economic trajectories of the US and European economies, particularly since the COVID-19 pandemic. Some have argued that the different pandemic responses between the two regions may partly explain the stronger rebound in the United States. Europe’s strategy focused on preserving jobs and firms by reducing hours worked per employee and compensating workers for their earnings losses, which inadvertently caused economic rigidity. In contrast, the United States unconditionally subsidized firms that claimed to have suffered due to the pandemic and provided direct payments to laid-off workers. This gave workers a safety net that enabled them to search for a better job and allowed the labor market to adjust. This difference may have enabled greater economic flexibility and resilience in the United States.

Note
This research brief is based on Shoumitro Chatterjee et al., “No Country for Dying Firms: Evidence from India,” National Bureau of Economic Research Working Paper no. 33830, May 2025.