"No one can ignore Odisha's demand. It deserves special category status. It is a genuine right," said Odisha Chief Minister, Naveen Patnaik, earlier this month. The Odisha State assembly has passed a resolution requesting special category status and their demands follow Bihar's recent claim for special category status. The concept of a special category state was first introduced in 1969 when the 5th Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks. Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand). The rationale for special status is that certain states, because of inherent features, have a low resource base and cannot mobilize resources for development. Some of the features required for special status are: (i) hilly and difficult terrain; (ii) low population density or sizeable share of tribal population; (iii) strategic location along borders with neighbouring countries; (iv) economic and infrastructural backwardness; and (v) non-viable nature of state finances. [1. Lok Sabha unstarred question no. 667, 27 Feb, 2013, Ministry of Planning] The decision to grant special category status lies with the National Development Council, composed of the Prime Minster, Union Ministers, Chief Ministers and members of the Planning Commission, who guide and review the work of the Planning Commission. In India, resources can be transferred from the centre to states in many ways (see figure 1). The Finance Commission and the Planning Commission are the two institutions responsible for centre-state financial relations.
Figure 1: Centre-state transfers (Source: Finance Commission, Planning Commission, Budget documents, PRS)
Planning Commission and Special Category The Planning Commission allocates funds to states through central assistance for state plans. Central assistance can be broadly split into three components: Normal Central Assistance (NCA), Additional Central Assistance (ACA) and Special Central Assistance. NCA, the main assistance for state plans, is split to favour special category states: the 11 states get 30% of the total assistance while the other states share the remaining 70%. The nature of the assistance also varies for special category states; NCA is split into 90% grants and 10% loans for special category states, while the ratio between grants and loans is 30:70 for other states. For allocation among special category states, there are no explicit criteria for distribution and funds are allocated on the basis of the state's plan size and previous plan expenditures. Allocation between non special category states is determined by the Gadgil Mukherjee formula which gives weight to population (60%), per capita income (25%), fiscal performance (7.5%) and special problems (7.5%). However, as a proportion of total centre-state transfers NCA typically accounts for a relatively small portion (around 5% of total transfers in 2011-12). Special category states also receive specific assistance addressing features like hill areas, tribal sub-plans and border areas. Beyond additional plan resources, special category states can enjoy concessions in excise and customs duties, income tax rates and corporate tax rates as determined by the government. The Planning Commission also allocates funds for ACA (assistance for externally aided projects and other specific project) and funds for Centrally Sponsored Schemes (CSS). State-wise allocation of both ACA and CSS funds are prescribed by the centre. The Finance Commission Planning Commission allocations can be important for states, especially for the functioning of certain schemes, but the most significant centre-state transfer is the distribution of central tax revenues among states. The Finance Commission decides the actual distribution and the current Finance Commission have set aside 32.5% of central tax revenue for states. In 2011-12, this amounted to Rs 2.5 lakh crore (57% of total transfers), making it the largest transfer from the centre to states. In addition, the Finance Commission recommends the principles governing non-plan grants and loans to states. Examples of grants would include funds for disaster relief, maintenance of roads and other state-specific requests. Among states, the distribution of tax revenue and grants is determined through a formula accounting for population (25%), area (10%), fiscal capacity (47.5%) and fiscal discipline (17.5%). Unlike the Planning Commission, the Finance Commission does not distinguish between special and non special category states in its allocation.
On June 1, 2020, the Cabinet Committee on Economic Affairs approved a revision in the definition of Micro, Small and Medium Enterprises (MSMEs).[1] In this blog, we discuss the change in the definition as approved by the Cabinet, and examine some of the common criteria used for classification of MSMEs.
Currently, MSMEs are defined under the Micro, Small and Medium Enterprises Development Act, 2006.[2] The Act classifies them as micro, small and medium enterprises based on: (i) investment in plant and machinery for enterprises engaged in manufacturing or production of goods, and (ii) investment in equipment for enterprises providing services. As per the Cabinet approval, the investment limits will be revised upwards and annual turnover of the enterprise will be used as additional criteria for the classification of MSMEs (Table 1).
Earlier attempts to amend the definition of MSMEs
The central government has sought to revise the definition of MSMEs in the Act on two earlier occasions. The government introduced the MSME Development (Amendment) Bill, 2015 which proposed to increase the investment limits for manufacturing and services MSMEs.[3] This Bill was withdrawn in July 2018 and another Bill was introduced. The MSME Development (Amendment) Bill, 2018 proposed to: (i) use annual turnover as criteria instead of investment for classification of MSMEs, (ii) remove the distinction between manufacturing and services, and (iii) provide the central government with the power to revise the turnover limits, through a notification.[4] The 2018 Bill lapsed with the dissolution of 16th Lok Sabha.
Global trends in criteria for the classification of MSMEs
While India will now be using investment and annual turnover as the criteria to classify MSMEs, globally, the number of employees is the most widely used criteria for classifying MSMEs. The Reserve Bank of India's Expert Committee on MSMEs (2019) cited a study by the International Finance Corporation in 2014 which analysed 267 definitions used by different institutions in 155 countries.[5],[6] According to the study, countries used a combination of criteria to classify MSMEs. 92% of the definitions used the number of employees as one of the criteria. Other frequently used criteria were: (i) turnover (49%), and (ii) value of assets (36%). 11% of the analysed definitions used alternative criteria such as: (i) loan size, (ii) years of experience, and (iii) initial investment.
Evaluation of common criteria used to define MSMEs
Investment: The 2006 Act uses investment in plant, machinery, and equipment to classify MSMEs. Some of the issues with the investment criteria include:
Due to their informal and small scale of operations, firms often do not maintain proper books of accounts and hence find it difficult to get classified as MSMEs as per the current definition.5
The investment-based classification incentivises promoters to keep the investment size restricted to retain the benefits associated with the micro or small category.7
Turnover: The 2018 Bill sought to replace the investment criteria with annual turnover as the sole criteria for the classification of MSMEs. The Standing Committee agreed with the proposal under the Bill to use annual turnover as the criteria instead of investment.7 It observed that this could overcome some of the shortcomings of classification based on investment. While turnover based criteria will also require verification, the Committee noted that the GST Network (GSTN) data can act as a reliable source of information for this purpose. However, it also observed that:7
With turnover as a criterion for classification, corporates may misuse the incentives meant for MSMEs. For instance, there is a possibility that a multi-national company may produce a large quantity of products worth a high turnover and then market it through various subsidiaries registered as Micro or Small enterprise under GSTN.
The turnover of some enterprises may fluctuate depending on their business, which may result in the change of classification of the enterprise during a year.
The Committee noted that there is a wide gap in turnover limits. For instance, an enterprise with a turnover of Rs 6 crore and an enterprise with a turnover of Rs 75 crore (as proposed in 2018 Bill) would both be classified as a small enterprise, which seems incongruous.
The Expert Committee (RBI) also recommended using annual turnover as the criteria for classification instead of investment.5 It observed that turnover based definition would be transparent, progressive, and easier to implement through the GSTN. It also recommended that the power to change the definition of MSMEs should be delegated to the executive as it will help in responding to changing economic scenarios.
Number of employees: The Standing Committee had highlighted that in a labour-intensive country like India, appropriate focus is required on employment generation and MSME sector is the most suitable platform for this.7 It had recommended that the central government should assess the number of persons employed in the MSME sector and also consider employment as a criterion while classifying MSMEs. However, the Expert Committee (RBI) stated that while the employment-based definition is an additional feature preferred in some countries, the definition would pose challenges in implementation.5 According to the Ministry of MSME, employment as a criterion has problems due to: (i) factors such as seasonality and informal nature of engagement, (ii) similar to investment criteria, this would also require physical verification and has associated cost overheads.7
Number of MSMEs
According to the National Sample Survey (2015-16), there were around 6.34 crore MSMEs in the country. The micro sector with 6.3 crore enterprises accounted for more than 99% of the total estimated number of MSMEs. The small and medium sectors accounted for only 0.52% and 0.01% of the estimated number of enterprises, respectively. Another dataset to understand the distribution of MSMEs is Udyog Aadhaar, a unique identity provided by the Unique Identification Authority of India (UIDAI) to MSME enterprises.[8] Udyog Aadhaar registration is based on self-declaration by enterprises. Between September 2015 and June 2020, 98.6 lakh enterprises have registered with UIDAI. According to this dataset, micro, small, and medium enterprises comprise 87.7%, 11.8% and 0.5% of the MSME sector respectively.
Employment in the MSME sector
The MSME sector employed nearly 11.1 crore people in 2015-16. The sector was the second largest employer after the agriculture sector. The highest number of employed persons were engaged in trade activity (35%), followed by persons engaged in manufacturing (32%).
Implications of change in the definition of MSMEs
The change in the definition of MSMEs may result in many enterprises which are currently classified as Small enterprises be reclassified as Micro, and those classified as Medium enterprises be reclassified as Small. Further, there may be many enterprises which are not currently classified as MSMEs, which may fall under the MSME classification as per the new definition. Such enterprises will also now benefit from the schemes related to MSMEs. The Ministry of MSME runs various schemes to provide for: (i) flow of credit to MSMEs, (ii) support for technology upgrade and modernisation, (iii) entrepreneurship and skill development, and (iv) cluster-wise measures to promote capacity-building and empowerment of MSME units. For instance, under the Credit Guarantee Fund Scheme for Micro and Small Enterprises, a credit guarantee cover of up to 75% of the credit is provided to micro and small enterprises.[9] Thus, the re-classification may require a significant increase in budgetary allocation for the MSME sector.
Other announcements related to MSMEs in the aftermath of COVID-19
MSME sector accounted for nearly 33.4% of the total manufacturing output in 2017-18.[10] During the same year, its share in the country’s total exports was around 49%. Between 2015 and 2017, the contribution of the sector in GDP has been around 30%. Due to the national lockdown induced by COVID-19, businesses including MSMEs have been badly hit. To provide immediate relief to the MSME sector, the government announced several measures in May 2020.[11] These include: (i) collateral-free loans for MSMEs with up to Rs 25 crore outstanding and up to Rs 100 crore turnover, (ii) Rs 20,000 crore as subordinate debt for stressed MSMEs, and (iii) Rs 50,000 crore of capital infusion into MSMEs. These measures have also been approved by the Union Cabinet.[12]
For more details on the announcements made under the Aatma Nirbhar Bharat Abhiyan, see here.
[1] “Cabinet approves Upward revision of MSME definition and modalities/ road map for implementing remaining two Packages for MSMEs (a)Rs 20000 crore package for Distressed MSMEs and (b) Rs 50,000 crore equity infusion through Fund of Funds”, Press Information Bureau, Cabinet Committee on Economic Affairs, June 1, 2020.
[2] The Micro, Small and Medium Enterprises Development Act, 2006, https://samadhaan.msme.gov.in/WriteReadData/DocumentFile/MSMED2006act.pdf.
[3] The Micro, Small and Medium Enterprises Development (Amendment) Bill, 2015, https://www.prsindia.org/sites/default/files/bill_files/MSME_bill%2C_2015_0.pdf.
[4] The Micro, Small and Medium Enterprises Development (Amendment) Bill, 2018, https://www.prsindia.org/sites/default/files/bill_files/The%20Micro%2C%20Small%20and%20Medium%20Enterprises%20Development%20%28Amendment%29%20Bill%2C%202018%20Bill%20Text.pdf.
[5] Report of the Expert Committee on Micro, Small and Medium Enterprises, The Reserve Bank of India, July 2019, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/MSMES24062019465CF8CB30594AC29A7A010E8A2A034C.PDF.
[6] MSME Country Indicators 2014, International Finance Corporation, December 2014, https://www.smefinanceforum.org/sites/default/files/analysis%20note.pdf.
[7] 294th Report on Micro Small and Medium Enterprises Development (Amendment) Bill 2018, Standing Committee on Industry, Rajya Sabha, December 2018, https://rajyasabha.nic.in/rsnew/Committee_site/Committee_File/ReportFile/17/111/294_2019_3_15.pdf.
[8] Enterprises with Udyog Aadhaar Number, National Portal for Registration of Micro, Small & Medium Enterprises, Ministry of Micro, Small and Medium Enterprises, https://udyogaadhaar.gov.in/UA/Reports/StateBasedReport_R3.aspx.
[9] Credit Guarantee Fund Scheme for Micro and Small Enterprises, Ministry of Micro, Small and Medium Enterprises, http://www.dcmsme.gov.in/schemes/sccrguarn.htm.
[10] Annual Report 2018-19, Ministry of Micro, Small and Medium Enterprises, https://msme.gov.in/sites/default/files/Annualrprt.pdf.
[11] "Finance Minister announce measures for relief and credit support related to businesses, especially MSMEs to support Indian Economy’s fight against COVID-19", Press Information Bureau, Ministry of Finance, May 13, 2020.
[12] "Cabinet approves additional funding of up to Rupees three lakh crore through introduction of Emergency Credit Line Guarantee Scheme (ECLGS)", Press Information Bureau, Ministry of Finance, May 20, 2020.
