India’s hesitancy to embrace the private sector and to unambiguously protect property rights

public_privateExcerpts from the Economic Survey, tabled in Parliament on January 31, 2017:

There remains a niggling sense that India is not quite what it appears to be – that, despite all the data, it is not yet following the standard development model. In what ways is India different? Three lingering features capture the doubt that it has not yet traversed the distance toward some vague and unspecifiable end-point that could be described as desirable or optimal.

First, there has been a hesitancy to embrace the private sector and to unambiguously protect property rights, combined with continued reliance on the state to undertake activities that are more appropriately left to the private sector. Second, state capacity has remained weak, as can be seen from poor delivery of essential services. And third, redistribution has been simultaneously extensive and inefficient.

Ambivalence about private sector and property rights

All states, all societies, have some ambivalence toward the private sector. After all, the basic objective of private enterprises – maximizing profits – does not always coincide with broader social concerns, such as the public’s sense of fairness. But the ambivalence in India seems greater than elsewhere. It appears that that India has distinctly antimarket beliefs relative to others, even compared to peers with similarly low initial GDP per capita levels.

The symptoms of this ambivalence toward the private sector manifest in multiple ways. The most well-known example is the difficulty of privatizing public enterprises, even for firms where economists have made strong arguments that they belong in the private sector.

Consider the civil aviation sector. Defying history, there is still the commitment to make the perennially unprofitable public sector airline “world class.” Recently, airport privatization has taken the form of awarding management contracts rather than change in ownership. Moreover, policy reform in the sector has been animated as much by an interventionist as liberalizing spirit, reflected for example in restrictions on pricing.

A similar spirit pervades the policy approach to the banking sector. Discussion of disinvesting the government’s majority stake in the public sector banks is often difficult in part because of the view that they are legitimate instruments for the state to allocate and redirect resources.

Meanwhile, in the fertilizer sector, rife with distortions, public policy finds it easier to rehabilitate public sector plants than to facilitate the exit of egregiously inefficient ones. Beyond a reluctance to privatize, the ambivalence towards the private sector is manifest in many other ways.

The agriculture sector is entwined in regulation, a living legacy of the era of socialism. While progress has been made in the last two years, producers in many states are still required by the Agricultural Produce Marketing Act to sell only to specified middlemen in authorized markets (mandis). And when this system nonetheless generates price increases deemed to be excessive, the Essential Commodities Act is invoked to impose stock limits and controls on trade that are typically procyclical, thereby exacerbating the problem.

A similar legacy from the past circumscribes property rights. Initially the right to property was inscribed as a “fundamental right” in the Constitution. But during the socialist era the 44th Amendment removed Articles 19 (1) (f) and Article 31 and replaced them with Article 300-A, thereby downgrading property to that of a “legal right”.

The ramifications of this decision continue to be felt to this day, in such issues as retrospective taxation. The government has made clear its commitment not to act retroactively on tax and other issues. But the legacy issues of retroactive taxation remain mired in litigation, with uncertain prospects for early resolution.

Evidently, it seems politically difficult to uphold a widely shared – and judicially endorsed – principle against expropriation and retroactivity because of the fear of being seen as favouring the private sector, especially the foreign private sector. This is true in a number of recent cases, including Vodafone and Monsanto.

The wariness does not just extend to the foreign private sector. The twin balance sheet problem – in the corporate and banking sectors – remains a millstone around the economy’s neck, casting a pall over private investment and hence aggregate growth. One important reason this problem has not been resolved in the many years since it emerged in 2010 is the political difficulty in being seen as favoring the private sector, a problem which will necessarily arise in cases where some private sector debts have to be forgiven.

ecosurveyState capacity

A second distinctive feature of the Indian economic model is the weakness of state capacity, especially in delivering essential services such as health and education. Of course, nearly all emerging markets started off with weak state capacity at independence. But as their economies developed and prospered, state capacity improved, often at an even faster rate than the overall economy. In India, by contrast, this process has not occurred.

The Indian state has low capacity, with high levels of corruption, clientelism, rules and red tape. The deepest puzzle here is the following: while competitive federalism has been a powerful agent of change in relation to attracting investment and talent (the Tata Nano car being the best example) it has been less evident in relation to essential service delivery. There have, of course, been important exceptions such as the improvement of the PDS in Chhattisgarh and Bihar, the incentivizing of agriculture in Madhya Pradesh, the kerosene-free drive in Haryana, power sector reforms in Gujarat which improved delivery and cost-recovery and the efficiency of social programs in Tamil Nadu.

However, on health and education in particular, there are insufficient instances of good models that can travel widely within India and are seen as attractive political opportunities. To the contrary, at the level of the states, competitive populism (with few goods and services deemed unworthy of being handed out free) is more in evidence than competitive service delivery.

Aside from inhibiting service delivery, the weakness of state capacity has created another problem. Policy-making in certain areas has been heavily constrained, as a way of ensuring that decisions do not favour particular interests. The result is twofold.

First, there is now adherence to strict rules – for example auctions of all public assets – that may not necessarily be optimal public policy. In telecommunications, the judicially imposed requirement for transparency and auctioning, while responding importantly and appropriately to the previous experience of corruption, has created a public policy dilemma. In some cases, it may be socially optimal to sell spectrum at lower-than-auction prices because of the sizable externalities stemming from increased spread of telecommunications services. But the understandable distrust of discretion means that methods other than auctions could be perceived as favouring particular parties.

Second, there is abundant caution in bureaucratic decision-making, which favours the status quo. In the case of the twin balance sheet problem mentioned above, it is well-known that senior managers in public sector banks are reluctant to take decisions to write down loans for fear of being seen as favouring corporate interests and hence becoming the target of the referee institutions, the so-called “4 Cs”: courts, CVC (Central Vigilance Commission), CBI (Central Bureau of Investigation) and CAG (Comptroller and Auditor General). This encourages ever-greening of loans, thereby postponing a resolution of the problem.

Inefficient redistribution

Related to this is the third distinctive aspect of the Indian development model. All countries redistribute and must do so. The question is how effective this is and must be. Redistribution by the government is far from efficient in targeting the poor. Welfare spending suffers from considerable misallocation: the districts with the most poor suffer from the greatest shortfall of funds. This leads to: exclusion errors (the deserving poor not receiving benefits), inclusion errors (the nonpoor receiving a large share of benefits) and leakages (with benefits being siphoned off due to corruption and inefficiency).

Over the past two years, the government has made considerable progress toward reducing subsidies, especially related to petroleum products. Not only have subsidies been eliminated in two out of four products, there is effectively a carbon tax, which is amongst the highest in the world.
However, even on subsidy reform, while technology has been the main instrument for addressing the leakage problem (and the pilots for direct benefit transfer in fertilizer represent a very important new direction in this regard), prices facing consumers in many sectors remain largely unchanged.

While strictly not an instrument of redistribution, even the design of the Goods and Services Tax (GST) reveals the underlying tensions. On the GST, the political pressures from the states to keep rates low and simple – resulting in an efficient and effective GST – were minimal. Apart from the general desire to ensure that the future structure of rates would mimic the complicated status quo, much of the focus was on ensuring that rates on essentials were kept low and on luxuries kept sufficiently high with insufficient concern for the implied consequences for efficiency and simplification.

The lack of such pressures especially from the states was surprising since they were guaranteed compensation by the Centre. Evidently, even a dream combination of being able to trumpet low taxes without suffering revenue losses was not considered politically attractive.

Download Economic Survey HERE

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