UC Berkeley

This study fills some of the gaps in the literature on resource misallocation in Indian manufacturing. There are three key contributions in this study. The first is the proper measurement of misallocation in Indian manufacturing. This is achieved by incorporating data from both the formal and informal sectors and intermediate inputs in calculating misallocation. By using value added based measures of revenue productivity (TFPR) we find that there was greater misallocation in the formal sector compared to the informal sector in the period 1994-2005. We also find that resource misallcoation had increased in the formal sector during this period. Using a monopolistic competitive model with heterogeneity in firm productivity and including intermediate inputs in the production function we show that resource misallocation at the industry level can be amplified due to intermediate inputs. We show that the value added based measures of misallocation suffer from omitted variable bias and that the magnitude and sign of this bias is dependent on the covariance of the distortions to intermediate inputs and other factor inputs.

The second contribution is towards identifying the nature, magnitude and sources of misallocation. Analyzing distortions to factor inputs individually we find that the distortions to intermediate inputs to be the largest followed by the distortions to capital. We find that distortions to intermediate inputs are larger in the informal sector than in the formal sector. Using qualitative information on informal firms we find that misallocation is positively correlated with shortage of capital and poor access to intermediate inputs and negatively correlated with firm market share.

The third contribution is that we measure the magnitude of misallocation caused by a specific size dependent policy in India. A small scale firm in India can get up to 100% exemption from paying excise tax if its annual turnover is less than Rs. 10 million. Using data on formal manufacturing firms in India we show that such an exemption encourages firms to operate on a sub-optimal scale. We construct the counterfactual distribution of output without any tax distortion using maximum likelihood and non-linear least squares estimation methods. Using the empirical estimates of the scale parameter in the literature we find that there are output gains in the range of 13% to 230% under a revenue neutral flat tax regime. These gains are sensitive to the scale parameter of the production function and are explosive as the scale parameter approaches one.