No Country for Dying Firms: Evidence from India

This paper identifies exit barriers as a new reason for India’s underdeveloped manufacturing sector. These barriers not only deter entry but also trap resources in unproductive firms. We document that Indian institutions generate such barriers and provide causal evidence of their effects. Using a dynamic model that separately identifies direct exit barriers from labor and capital adjustment costs, we find that exit barriers are quantitatively significant, particularly in low-performing states and labor-intensive industries. Our analysis yields three findings. First, reducing firing costs raises value added but reduces employment, whereas relaxing direct exit barriers increases both. Second, simultaneous reform of labor firing costs and direct exit barriers yields synergies. Third, sequencing matters: addressing direct exit barriers before labor firing costs preserves employment while improving efficiency. Finally, we show that exit subsidies are more effective at raising value added, while entry subsidies are more effective at increasing employment.