Photo: SaiSen/Mint
Photo: SaiSen/Mint

Shift the reform debate to states

There is still a high degree of heterogeneity across Indian states, creating critical barriers to investment

There is a two-step consensus building on India’s economy. India has become the fastest-growing large country and, looking ahead, it desperately needs reforms to keep the momentum going. To make the steps consistent, the debate needs to shift to the states that are India’s Achilles’ heel for investment, jobs and growth.

The reality is that there is still a high degree of heterogeneity across Indian states, creating critical barriers to investment, entrepreneurship, property rights, trade and competition. These have created a highly uneven business and financing environment. For example, various cross-state tax barriers exist, impeding the flow of goods, increasing costs unpredictably and raising the burden on businesses that move products across barriers.

The differences in product market regulation have added to varying degrees of competition across states, effectively protecting state-run enterprises. The differences in labour laws and regulations across states have discouraged jobs being created in the formal sector, and are therefore especially restrictive for labour-intensive sectors—explaining why the formal labour sector is so small and India’s weakness in exploiting its rising labour potential in manufacturing.

Similarly, differentiation between states in land records, registration and property rights remains a key bottleneck in systematically using the latent capital in land resources. And manifold differences remain in the licences and permits system at the state level, coupled with sector-specific administrative burdens for corporations as well as for sole proprietor firms. This results in varying barriers to entrepreneurship at the state level, making India’s rating in this area among the most restrictive globally.

In sum, these add up to a domestic economy that is not well integrated, with significant negative effects on resource allocation, capital creation and efficiency.

What this means is there is negative correlation across the states with investment and productivity—states with high regulatory barriers have lower competition, investment and factor productivity. Improvements over the years have been sporadic. And where they have been made, continuing differences in enforcement and implementation have diluted their effects, effectively keeping India’s regulatory regime more restrictive than those of many other emerging markets.

The reasons why corporate investment in India has not yet responded significantly are many, but surely the continuing differences in barriers and incentives across the states is key among them.

The long-awaited step of reducing and rationalizing the various cross-state tax barriers through the goods and services tax, or GST, is one measure that should directly improve India competitiveness and help raise India’s tax to gross domestic product ratio closer to that of other emerging-market comparators.

Most importantly, rationalizing the many state and central taxes into a harmonized GST will help build a more unified domestic market. Estimates differ of its effect on growth, but they are uniformly positive—assuming it is with a single, relatively low rate, with minimal exemptions. Clearly its passage will also have a major effect on expectations.

Other initiatives with states are also underway. The government is working on labour reforms at the state level, hoping to spark competition among the states to attract investment, both domestic and foreign. And more states are planning and undertaking legislation intended to make property a more tradable resource. Rajasthan has taken the lead in both areas, sparking other states to follow.

The centre has a key role to play in incentivizing and moving the reform process forward consistently. States, of course, differ significantly in their economic, social, demographic and financing characteristics, and it will be challenging to move the process forward in an inclusive way. Eventually, these reforms need to be matched with resources; it helps that the Fourteenth Finance Commission has given states a larger share of central tax revenues. But this places more importance on fairly apportioning central and state budgets and ensuring their consistency with debt sustainability. The forthcoming review of the Fiscal Responsibility and Budget Management Act is an important step in this direction. And the government has rightly stepped up regular discussions with states on many of these matters.

Overall, a more integrated domestic economy with much more consistency across states’ governance and finances is needed to better build benefits from the reforms that are in the public debate. The needed reforms are many, among them, uplifting India’s infrastructure, reducing the public sector deficit and broadening financial markets and making them more inclusive. For their effectiveness in raising investment, productivity and employment, India needs to shift the reform debate to the states.

Anoop Singh is adjunct professor at Georgetown University and former director of the Asia-Pacific department at the International Monetary Fund.

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