Exit barriers as entry barriers: Explaining India’s odd development path

Despite an abundance of low-skilled labour, India never experienced the kind of take-off in labour-intensive manufacturing seen in other countries at similar income levels. This article argues that a central reason for this is the institutional exit barriers faced by manufacturing firms. Leveraging the variation in institutional settings across states, it shows that such barriers not only slow firm exit but also deter entry, keep unproductive firms alive, and depress aggregate output and productivity.

Earlier this year, the Supreme Court of India delivered a startling verdict: it reversed the liquidation of a steel company buyout that had been completed four years earlier. The decision sent shockwaves through the industry, not only because it upended a long-settled transaction, but because it served as a stark reminder of how uncertain and costly the process of exiting a business can be in India. Protracted insolvency resolution, cumbersome administrative clearances, and strict labour laws – particularly in manufacturing – raise the cost of adjusting labour and winding down operations.

These frictions are part of a broader institutional environment that has shaped India’s unusual structural transformation (Fan et al. 2021, Rodrik 2016). Despite an abundance of low-skill labour, India has never experienced the kind of take-off in labour-intensive manufacturing seen in other countries with similar income levels (Chatterjee and Subramanian 2020). Instead, the manufacturing sector is dominated by a long ‘tail’ of inefficient firms, limited creation of full-time jobs, and unexpectedly capital-intensive production techniques (Hsieh and Klenow 2009, Padmakumar 2023).

The manufacturing sector’s underperformance becomes even more puzzling when contrasted with India's success in other sectors. The country has excelled in high-skill services – such as software exports – despite its low average education level, aided by the presence of elite institutions like the IITs (Indian Institute of Technology) and IIMs (Indian Institute of Management).

In new research (Chatterjee et al. 2025), we argue that a central reason for this pattern lies in the institutional exit barriers that manufacturing firms face. We show that such barriers not only slow firm exit but also deter entry, keep unproductive firms alive, and depress aggregate output and productivity in manufacturing. Their impact is most pronounced in states with high institutional frictions, and in labour-intensive sectors where rigid labour adjustment limits firm growth. Our findings suggest that well-designed reforms to lower exit costs could deliver large gains in productivity, output, and employment.

Why is exiting so hard for firms in India?

India’s manufacturing exit rates are among the lowest in the world, especially in the formal sector. Figure 1 shows that while the US manufacturing sector sees an annual exit rate of around 9%, the corresponding rate in Indian formal manufacturing is just 3.1%. This low level of churn suggests significant frictions in the exit process, especially in formal manufacturing, which may be dampening the reallocation of resources to more productive firms.

Figure 1. Exit rates among firms, in selected countries and sectors

Notes/Sources: (i) Left panel: Exit rates of different countries have been calculated/taken from the following sources: India – calculated from Annual Survey of Industries dataset from survey years 2000-01 and 2015-16; Brazil and Mexico – taken from Bartelsman et al. (2009) averaged over the period 1990-1999; Chile, Colombia, and Morocco – taken from Roberts and Tybout (1996) for the year 1985; US – taken from Crane et al. (2022) for 2006; China – calculated from Annual Surveys of Industrial Production for 2006; Vietnam – calculated from Vietnam enterprise census for 2007. (ii) Right panel: Exit rates of service sector firms have been computed from the Prowess database. Other services include accommodation and food services, transport and storage services, and administrative and support services. (iii) The annual exit rate of informal manufacturing plants has been computed from NSS data for 1994-95 and 2015-16. For more details on exit calculations, please see Chatterjee et al. (2025).

Institutional and regulatory constraints make it difficult for unproductive or distressed firms to shut down. Even in ideal cases – when firms are fully compliant and not involved in litigation – voluntary closure takes an average of 4.3 years (Economic Survey of India, 2020-21). Nearly three of those years are spent navigating clearances and refunds from government departments such as the Income Tax office, GST (goods and services tax) administration, and the Provident Fund authority. When complications arise – such as outstanding debts, worker layoffs, or tax disputes – exit becomes even harder.

The exit of Nokia’s largest factory: A case study

Nokia's experience with its largest factory illustrates the challenges of firm exit in India. Nokia announced its plan to set up a plant in India in December 2004, eventually choosing Tamil Nadu due to tax incentives, the Special Economic Zone’s proximity to the Chennai International Airport, and political alignment between the state’s ruling party (AIADMK) and the central government. Production began in 2006. Between 2006 and 2012, the factory thrived – they employed close to 20,000 people and produced 15 million phones monthly for export to 80 countries.

However, troubles began for the factory in 2013 – international competition intensified, the tax holiday provided by Tamil Nadu ended, making foreign locations more attractive, cellphone technology was shifting towards smartphones, and the factory faced labour strikes demanding better employment terms. Nokia also faced two tax evasion cases – one from state authorities and another from central authorities. The Supreme Court froze Nokia’s assets in October 2013 due to the central tax dispute. Meanwhile, given the tough competition in the international market, when Nokia sold its global devices and services business to Microsoft for US$7.2 billion in April 2014, the Indian factory was excluded from the deal due to the legal challenges it was embroiled in. Production stopped, but they were required to continue paying permanent workers throughout the tax dispute. Some workers took voluntary retirement and severance payment packages offered by the company.

Nokia settled the tax dispute in 2018 by paying a penalty of 202 million euros, but even four years after production stopped, it remained uncertain whether it would be able to sell its factory owing to other litigation that arose in the interim years. Finally, in 2020, after a gap of six years, the Chinese firm Salcomp bought and started manufacturing cell phone chargers in the factory that was once the most productive cellphone factory globally.

This example illustrates three critical points about exit barriers in India. First, there is enormous political, judicial, and institutional complexity and uncertainty related to firm exit. Second, it demonstrates the gargantuan delays in administrative processes. Third, this happened in Tamil Nadu – a relatively business-friendly state – suggesting that exit barriers might be even worse in states with more restrictive institutions.

Institutions constraining firm exit

Two main institutional bottlenecks stand out when it comes to firm exit in India: bankruptcy laws and labour regulations.

First, India lacks a well-defined bankruptcy framework. Until recently, firms facing insolvency had no clear legal route to liquidation, with procedures fragmented across multiple laws, such as the Companies Act of 1956 and the Sick Industrial Companies (Special Provisions) Act of 1985. This created uncertainties – different parties could file cases under different laws, and there was no clarity on issues such as the order in which debts should be paid when a company defaults. As a result, disputes often ended up in courts and remained unresolved for years due to judicial bottlenecks and inconsistent interpretation of laws. Moreover, even seemingly final decisions could be overturned later, as the Supreme Court’s recent reversal of a completed steel company liquidation demonstrates. Since the early 1990s, various reforms such as the Debt Recovery Tribunals (DRTs), the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI), and the Insolvency and Bankruptcy Code (IBC) have been attempted, but with limited success.

Second, labour laws – particularly the Industrial Disputes Act (IDA) of 1947 – require government approval for firms with over 100 workers to fire even one worker. But it is not just the law itself; implementation is highly discretionary. Identical cases can receive different treatments depending on the official or court involved. For instance, courts have oscillated in their rulings on fundamental questions, such as which workers and industries should be covered by labour laws, whether contract workers should be protected under these laws, and so on. This uncertainty creates an environment where exit costs are higher for firms, especially those with many workers.

Exit barriers vary across states, so does firm dynamism

Institutional environments differ widely across Indian states, and so do the barriers to firm exit. Some states have relatively business-friendly environments, while others have stricter institutions that make exit difficult. We exploit this variation to document several facts on how manufacturing firms respond to different institutional settings.

First, entry and exit are positively correlated at the state level (see Figure 2 below (reproduced from Chatterjee et al. (2025)). It is clear that states with higher entry shares also tend to have higher exit shares, reflecting greater dynamism. In contrast, states with sluggish entry generally also see fewer exits. This pattern suggests that where exit is costly or uncertain, potential entrants may be discouraged by the prospect of being unable to close down if needed. Based on these patterns, we group states into high-performing (HP) and low-performing (LP) categories: HP states (denoted as red in Figure 2) have high entry and exit shares, while LP states (denoted as blue in Figure 2) have low shares of both.

Figure 2. Firm entry versus firm exit shares of states

Second, misallocation, firm responsiveness to shocks, and the effects of bankruptcy reform vary between HP and LP states. LP states have greater resource misallocation and a long tail of old and less productive firms, suggesting inefficient survival. Firms in LP states are also less responsive to negative shocks, particularly when it comes to adjusting their regular workforce. When the SARFAESI Act strengthened creditor rights in 2002, it led to significantly higher exit rates among highly leveraged and distressed firms in LP states. These patterns suggest that exit frictions are more binding in LP states.

Taken together, these facts suggest that in states where institutions make exit harder, misallocation is higher, new firms are discouraged from entering, and inefficient firms continue to operate longer than they should.

Modeling firm behaviour and policy trade-offs

In order to understand the consequences of exit barriers and evaluate potential reforms, we develop a dynamic structural model that incorporates key features of India's manufacturing sector. Firms in the model are ex-ante identical but become ex-post heterogeneous in productivity, operate under monopolistic competition, and face sunk entry costs.

Exit is costly, due to firing costs – especially for larger firms covered by the IDA – or due to direct institutional frictions, such as judicial delays and the absence of a bankruptcy procedure. We model these exit barriers flexibly to reflect both the costs embedded in the letter of the law and the uncertainty arising from discretionary implementation. We also capture state-level variation in institutional quality by distinguishing between HP and LP states. Parameter estimates confirm that exit costs and labour firing costs are quantitatively more significant in LP states, consistent with the earlier descriptive evidence. Exit costs in LP states represent 173% of average annual firm sales, compared to 111% in HP states. Firing costs for regular workers in LP states represent 358% of their average annual wage, compared to 256% in HP states.

We use the estimated model to simulate a set of counterfactual reforms that would raise India’s firm exit rate to 50% of the US level. This target can be reached through either labour market reform (reducing firing costs) or lowering direct exit costs (for example, having a well-laid-out path to bankruptcy).

Our results yield several key insights. First, raising exit rates by reducing firing costs alone raises value-added by 16.4% but lowers employment by 14.6%. This is because large, unproductive firms that were previously constrained by high firing costs will exit following this reform. While this encourages more firms to enter the market, the entering firms do not fully absorb the workers displaced by large exiting firms. However, raising exit rates by reducing direct exit costs alone facilitates the exit of low-productive firms with smaller employment levels, encourages more firms to enter the market, and hiring by the new firms more than offsets employment losses from exiting firms. As a result, both value-added and employment increase by 14.3% and 8.1% respectively, making this approach more politically feasible.

Second, making capital supply more elastic (for example, through foreign investment) significantly amplifies the gains from either reform. When capital is more elastic in supply, firm entry following either reform is less constrained by the availability of capital, leading to substantially larger increases in the mass of firms operating, value-added, and employment.

Third, there are strong synergies between the two policies. When labour and exit reforms are implemented together, employment losses from labour reform are reduced or even reversed. This suggests that sequencing matters – tackling direct exit costs (through bankruptcy reform) before reforming labour laws helps preserve jobs while improving efficiency.

We also examine the consequences of allocating reform budgets between promoting entry and facilitating exit. Governments in developing countries often focus on promoting entry through tax breaks, industrial parks, and startup subsidies. Lowering entry barriers can indeed stimulate productivity and investment (Brandt et al. 2024, Sampi et al. 2023). Our analysis shows that for a given budget, reducing exit costs generates much larger gains in value-added, especially at higher budget levels. If the objective is to maximise value-added, targeting exit costs is more effective. If the goal is to boost employment, entry subsidies will deliver better results.