India's manufacturing sector has struggled to achieve labor-intensive growth despite abundant low-skilled labor, primarily due to institutional exit barriers that prevent firm closures, discourage new entries, and sustain unproductive firms, ultimately depressing productivity and output.

A dynamic structural model indicates that reducing exit costs to U.S. levels could increase value-added by 16.4% and employment by 8.1%, especially if paired with reforms like easier bankruptcy procedures and more flexible labor laws.

The high costs and delays associated with exiting a firm are driven by legal and administrative complexities, including slow insolvency processes, cumbersome clearances, and strict labor laws, with voluntary closures taking an average of 4.3 years.

Weak bankruptcy laws and discretionary labor regulations in India significantly inflate exit costs, with some states facing costs exceeding 170% of firm sales and firing costs over 350% of wages for regular workers.

A case study of Nokia’s factory in Tamil Nadu highlights these institutional hurdles, where legal disputes and delays kept the factory operational for years after production had ceased, exemplifying the challenges even in relatively business-friendly states.

State-level differences show that states with more restrictive institutions experience higher resource misallocation, a larger presence of unproductive older firms, and less responsiveness to economic shocks, which worsens overall inefficiency.

Research suggests that lowering exit barriers has a more significant impact on productivity and growth than encouraging new firm entry, and implementing combined reforms can enhance both employment and efficiency.