Promise and peril of place-based policies

Policymakers around the world are grappling with widening regional inequalities and are being confronted with the need for ‘place-based’ economic policy interventions


Economists should always be compelled to point to market failure when recommending the use of distorting taxes or subsidies. Photo: Priyanka Parashar/Mint
Economists should always be compelled to point to market failure when recommending the use of distorting taxes or subsidies. Photo: Priyanka Parashar/Mint

Recently in this newspaper, my IDFC Institute colleague, Praveen Chakravarty, and I argued that the upcoming roll out of the goods and services tax (GST) might, paradoxically, exacerbate, rather than improve, already large interstate inequalities in income per person (“Will GST Exacerbate India’s Income Divergence?”, 8 February).

In India, our research suggests that 1991 was the year of an important structural break in the data: that is, before that year, income per person was converging among the larger states, while, since that year, income per person has been diverging in a big way.

While we do not claim we can prove it in any statistically rigorous way, it is irresistible to hypothesize that the economic liberalization wrought in 1991, whose effects were realized subsequently, is causally related to the sharp uptick in regional inequality.

It is important to stress that this is in no way an indictment of economic liberalization. The reason that incomes were converging before 1991 is that income growth everywhere was low and stagnant, with poorer states slowly catching up with richer ones. By contrast, after 1991, the states of peninsular India have raced ahead of those in the hinterland. It is not at all far-fetched to argue that the turn towards a market economy is what created the opportunity for states with good infrastructure, a well-educated population, and a culture of entrepreneurship, among other things, to capitalize on new opportunities, while others caught in a statist mindset failed to adapt to circumstances in which individual initiative was now rewarded by the market rather than all differences being flattened out by the state.

A dyed-in-the-wool libertarian would argue, therefore, that those capable and willing to partake of the ups and downs of the market system and with the appetite to take the corresponding risks were able to benefit from the opportunities, while those unwilling to were not. While this logic has some merit as applied to individuals, it is incomplete, at best, when it is applied to subnational jurisdictions such as the states of India. For, whether through the accidents of history, or geography, or the different impacts of colonization on directly versus indirectly ruled regions of India, we inherited large differences in state capacity, infrastructure and entrepreneurial ethos when we emerged as a postcolonial state in 1947. Nehruvian socialism and central planning were able to efface some of these differences—at a great cost in terms of decades of retarded growth opportunities—but they re-emerged, evidently, with a vengeance, when we entered the brave new world of a market economy after 1991.

Libertarians are entitled to ignore interpersonal income differences as irrelevant, so long as they arise naturally under impartial and fair rules of the game, but we ignore wide and burgeoning interstate income and wealth inequalities at our peril, in what was always conceived of, and remains, a federal polity, not a unitary state. It is no accident that we are a union of states, and that the Central government is correctly referred to as the Union government.

Thus, widening regional disparities may foster social unrest in lagging regions due to limited opportunities for gainful employment, and resentment in leading regions, where folk may see themselves as being forced to underwrite the laggards. With discretion in excise taxes having been wrested away through the goods and services tax (GST), the governments of lagging states will ask, with more than a little justice on their side, for an increase in Central government transfers, and governments of leading states, again with some justice, will resist such transfers as unfairly burdensome to those whose only fault is being successful.

As Chakravarty and I suggested, this may be the time to consider seriously economic policy tools which are region-specific, such as targeted investment subsidies, or tax breaks mandated by the Centre, which attempt to woo mobile investments, and the jobs which follow, to regions which are being left behind.

Economists should always be compelled to point to market failure when recommending the use of distorting taxes or subsidies, or to an overarching “non-economic” objective which necessitates the use of efficiency-distorting policy tools. In this instance, preserving the social and political fabric of our Union, it seems to me, would be a legitimate rationale for intervening to try to prevent regional differences in income per person from skyrocketing.

Targeted tax or subsidy schemes are not an ideal toolbox, and they will need to be carefully monitored and evaluated, lest they become yet another avenue for rent seeking behaviour.

There may be some comfort in realizing that around the world, in advanced and emerging economies alike, policymakers are grappling with widening regional inequalities and are being confronted with the need for “place-based” economic policy interventions to ameliorate these inequalities.

Economists looking from 30,000ft above have traditionally not been well-equipped to delve into the minutiae of regional economic policies. It is worth reminding ourselves that if we do not come up with sensible policy responses to real problems, politicians will be more than happy to do so, without our advice.

Every fortnight, In the Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s previous Mint columns at www.livemint.com/vivekdehejia

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