Deregulation and firm investment: evidence from the dismantling of the license system in India

ABSTRACT

We analyse the impact of deregulatory reforms in India during the 1990s, which eliminated compulsory industrial licensing, on manufacturing firms’ investment decisions. We find an economically and statistically significant positive effect of delicensing on investment. We also show that firms in states with better credit conditions benefitted more from the removal of licences. Moreover, our analysis demonstrates that the increase in investment was predominantly driven by smaller firms.

KEYWORDS:

• Deregulation
• investment
• India

JEL CLASSIFICATION:

• E22
• O20

Disclosure statement

The views in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its executive directors or the governments they represent.

Notes

¹ The allotment of input and import licences was based on the output limit specified in the licences. See Chamarbagwala and Sharma (2011) for additional details on the industrial licensing system in India.

² While a major portion of delicensing was initiated following the 1991 crisis, some industries were delicensed in 1985 under Rajiv Gandhi, who unexpectedly became the Prime Minister upon the assassination of Prime Minister Indira Gandhi. Aghion et al. (2008) argue that both episodes of delicensing were exogenous shocks.

³ See Alesina et al. (2005) for a model of investment where regulatory reforms that result in a reduction in entry barriers and adjustment costs leads to more capital accumulation.

⁴ The normalization by capital stock naturally arises in a model with quadratic adjustment costs, and it allows us to control for the size of the firm. One can obtain a linearized Euler equation similar to the one presented in equation (1) by adopting a functional form for the adjustment costs, and taking a first-order Taylor approximation of the resulting Euler equation (see Love (2003) or Kandilov, Leblebicioglu, and Manghnani (2016) for derivation of such a model).

⁵ We report the Sargan-Hansen tests of overidentification to verify the validity of our instruments.

⁶ The 2008 National Industrial Classification is based on the International Standard Industrial Classification (ISIC) Rev.4.

⁷ This increase implies a 34.2% increase in the investment rate, given that the average investment rate for the firms in the first quartile is 11%.