Is Small Beautiful? Not for Driving Job Growth…

It is widely believed that small and medium enterprises (SMEs) are engines of job creation and help spur economic growth. Such thinking has led to lots of incentives for small enterprises and also — in countries such as India — the reservation of entire categories of products being “reserved” for production by small firms. But how true are these beliefs? That is the question that Wharton management professor Ann Harrison and her co-authors, Shanthi Nataraj of the RAND Corporation and Leslie A. Martin of the University of Melbourne, set out to answer in their research. Their conclusion: Large and young firms generate far more jobs than small ones do.

In a paper titled,In with the Big, Out with the Small: Removing Small-Scale Reservations in India,” Harrison and her co-authors also examine India’s policy of reservation of some items for SMEs and the impact of de-reservation ushered in as part of economic reforms enacted in recent years. The researchers found that districts more exposed to de-reservation experienced higher employment and wage growth. The results suggest that promoting employment growth in the Indian case was not achieved through small-scale sector reservation policies. This can be extrapolated to other parts of the world. In this interview with Knowledge@Wharton, Harrison explains that young firms are the key innovators in India. The fact that they are also small is incidental.

An edited transcript of the conversation appears below.

On what inspired the research:

I’ve always been interested in the role of government policies in promoting well-being. India, in particular, is an interesting case because there have been extensive regulatory changes and policies to try to make people better off. The regulations that India has directed towards SMEs are typical of the policies that many countries have for their small and medium firms. So, it is a more general and important question.

“Young firms are really the key innovators in India, and probably in other countries as well.”

The key findings from this research, which is co-authored with Shanthi Nataraj and Leslie A. Martin, is that the promotion of SMEs by reserving certain products only for them didn’t have the expected result. The idea behind the Indian government’s policies, which were known as “small-scale reservation,” was to take a large number of products, maybe 1,000, and allow only SMEs to make them. It was expected that by removing these policies, firms would suffer and wouldn’t grow as quickly. The result is quite surprising. What it shows is that employment and wages actually grew faster once these restrictions were removed.

On the key findings:

What our research finds is that employment generation is really focused on young firms, new firms or large enterprises. Why is employment being generated in India by these younger firms or these larger firms when conventional wisdom suggests that SMEs would be the source of growth? We think that the reason we have these unexpected findings is because young firms are really the key innovators in India, and probably in other countries as well. Twitter  It is youth that is really important. Also, larger firms have the connections needed to enter the market. They have the connections needed to be able to access capital, knowledge and well-educated workers. So, when you think about it, it actually seems almost obvious in the end that it’s the young, larger firms that are more likely to generate employment growth.

On whether the findings are relevant outside India:

We think that our research really has much broader applications; it is relevant to many other countries, including the U.S. and France. Our research is borne out by other recent findings by, for example, John Haltiwanger, professor of economics at the University of Maryland-College Park. His research shows that in the U.S., it’s the younger, larger firms that are generating more employment. The advantage of our research is that we actually have what’s called a “natural experiment” — the elimination of a regulatory framework — which allows us to look at before and after, which other researchers have not been able to exploit to understand this problem.

On the policy implications of the research:

The policy implications are that if you want to promote employment growth, then restricting the production of certain goods for certain size firms is not the way to go. The correct policy would be to encourage entry by younger firms or larger enterprises. That is more likely to yield the kind of outcomes that governments are looking for.

“The policy implications are that if you want to promote employment growth, then restricting the production of certain goods for certain size firms is not the way to go.”

On whether small firms should get incentives:

There’s a perception among economists — among policymakers — that small is beautiful. What our research suggests is that that is clearly not the case if you’re trying to maximize employment growth. If you want to do that you have to focus on younger firms. But that’s not to say we shouldn’t be promoting SMEs. The best way to promote them is by not discriminating against them. Don’t make it harder for SMEs to enter because we want new enterprises. But explicit policies to encourage being small are not a good idea. Tax holidays that are only focused on SMEs, for example, are not the best option.

On future research projects:

I’m very excited about an ongoing research project also on India where we are looking at the effects of hundreds of regulations to try to improve the environment in India. There have been many different regulatory changes, some of them mandated by the Supreme Court, while others are done at the state and local level. We are particularly interested in trying to identify what kinds of changes — either through regulations or price changes — can make firms behave in a cleaner, more environmentally friendly way. So, that’s our ongoing project on India. I’m also doing a number of other research projects on China, looking in particular at the success of their industrial policies, which is an area that I find particularly important.

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