Do Size-dependent Tax Incentives Discourage Plant Size Expansion? Evidence from Panel Data in Indian Manufacturing

Abstract

The article presents a new empirical application of the idea of threshold burden of tax incentives in India. The Indian government provided tax exemption to manufacturing units with sales turnover below a specified level over the years. The turnover threshold limit was US$1 million in 2009. Whether size-based tax rules incentivise firms to reorganise their production structure in order to stay below the threshold to take advantage of fiscal incentives is the key question addressed in this article. A significant factor that is widely believed to encourage small firms to stay small has been the tax incentives in the form of excise tax (turnover tax) exemptions below a specified value of sales each year. A key strategy followed by Indian firms to stay small and below the threshold has been product subcontracting or capacity subcontracting. We provide econometric evidence on this particular mechanism. The study is based on a unique unbalanced panel data of 29,213 manufacturing plants spanning the period 1999–2008 and a panel of 4,613 manufacturing firms covering the period 1990–2010. Average subcontracting intensity was found to be significantly higher in manufacturing establishments and firms with sales turnover below the ceiling level set by the tax rules. Econometric tests supported the hypothesis that establishments take advantage of tax incentives by staying below the threshold value of output. Econometric tests for a subgroup of domestic-market-oriented firms provide additional support to the hypothesis of threshold effects. These findings are relevant for policy design in developing and emerging economies. JEL Classification: O14, O17, L60, H32, H25