Firms in India are smaller and less productive than they should be, and burdensome regulation is one important culprit
Why care about the “ease of doing business" (EoDB)? Is improving the business regulatory environment a legitimate concern for policymakers, including here in India, or a Davos-derived diversion from the real work of economic development? Given the outsized media attention that various attempts to measure EoDB routinely garner, including, in particular, the World Bank’s famous, or infamous, annual Doing Business Index, and, in the Indian context, a ranking of states created by the department of industrial policy and promotion, this is a question worth posing.
As I have argued previously in these pages, there is not, strictly, a one-to-one relationship between EoDB and good economic outcomes such as a higher level of gross domestic product (GDP) per capita or a higher growth rate. In an already largely liberal economy, ill-conceived deregulation may lead, for instance, to cronyism and political capture, which would be detrimental to the general good. However, in India and other formerly socialist economies featuring a very large overhang of a meddling and burdensome state, it is safe to take it as a working assumption that up to a certain point, which we are still far away from, what is good for business is good for everyone.
A body of research is supportive of the idea that there is an important and robust relationship between the business regulatory environment and economic outcomes. For instance, a 2016 Wall Street Journal column by economist John Cochrane showed that there is a tight correlation between GDP per capita, as measured by its natural logarithm, and the World Bank’s “distance to frontier" (DTF) index, which is derived from the better-known ranking of countries, when comparing across a large set of advanced and emerging economies at a point in time. In particular, higher GDP per capita correlates well with a higher DTF score, and vice versa. One can also show, using Indian data, a robust correlation over time: Years in which India has higher GDP per capita also correspond, for the most part, with a better DTF score.
Cochrane’s finding led to something of an academic row with economist Bradford DeLong, who contested the causal interpretation that a better business regulatory environment leads to higher GDP per capita. Without again igniting this debate, which spilled over into the blogosphere, and an earlier column of mine, suffice it to say that what is uncontested is that there is a sharp correlation in the data which is worthy of note.
The valid argument that correlation does not, of itself, imply causation has something of the force of theology among economists. Yet, this perfectly valid piece of wisdom from statistics should not obscure the fact that a correlation itself may be of interest, even if we are not with any certainty able to prove the existence, to say nothing of the direction, of causation. Thus, it might be that better EoDB leads to higher GDP per capita; that higher GDP per capita leads to better EoDB; that both are true; and that something entirely different—call it the quality of institutions—is driving the result. One could be perfectly agnostic on this and yet make a common-sense case for a better business regulatory environment in the context of over-regulated, formerly socialist economies such as India.
After all, wise economic judgement, and sound pubic policy advice and formulation, involve more than merely parroting a statistic, but require interpreting it with nuance and care; understanding that difference is one of the marks that distinguishes an economist from a technician masquerading as an economist (the profession is currently replete with the latter).
What is more, in the Indian case in particular, a large body of research clearly shows that productivity growth, the ultimate driver of economic growth, has been held back by burdensome regulation, especially labour regulation, which has choked off the growth of firms in India.
Firms in India are smaller and less productive than they should be, and burdensome regulation is one important culprit. Is it not, after all, bizarre that a labour- abundant economy such as India is not a major producer and exporter of labour-abundant manufacturing goods and features some of the most capital-intensive production techniques in the world?
One especially striking statistic captures the essence of the problem. In the apparel sector, in which India at one time had the promise of becoming a leading exporter but where we have languished, the bulk of firms have less than 10 workers. In China, most firms have 100 workers or more, in some cases 1,000 or more. It is impossible to be reap economies of scale or even make a dent as an exporter in an industry dominated by a mass of micro-enterprises.
The point is, the fragmented nature of Indian industry is not the natural result of market forces playing out; rather, this is a pathology of burdensome regulation which punishes firms that attempt to grow and need the flexibility to hire and fire workers as market conditions warrant.
Prime Minister Narendra Modi has affirmed on numerous occasions his desire to make India a global manufacturing hub and provide gainful employment to all Indians. This cannot happen unless the Union and state governments grasp the nettle of unfinished reforms of labour laws most urgently.
Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia