What kind of reformer will Narendra Modi be?
The government must consider pivotal reforms, rather than luxuriate in the current economic recovery
Analysts and commentators have handed in their 100-day report cards for the Narendra Modi government. Most of these assessments have been mixed: high marks for administrative dynamism, but middling grades on the broader economic policy front for not matching, in action and articulation, the rhetoric and expectations of the election campaign.
On the economy, if one were to distil the new dispensation’s priority areas of focus—based on the intent it has signalled (either by pronouncements or by action)—four inter-related areas emerge: improving governance, reviving private sector activity, achieving fiscal consolidation, and attracting foreign capital. In each of these areas, barring a few exceptions, the government has thus far proceeded cautiously and in piecemeal fashion, refraining from outlining an overarching vision. Now it faces a choice: to continue with incremental improvements or to push for pivotal changes.
It is difficult to divine which way the prime minister is leaning. Supporters suggest that he will pick up the pace of reform once state elections pass and after he has evaluated the Delhi landscape—in time for his first full budget in 2015. Sceptics, however, believe that Modi is more pro-business than pro-market and has no intention of fundamentally reshaping the government’s role in the economy. They aver that Modi’s strength is primarily in easing hassles for big business, but he is not ideologically oriented towards wider pro-market reforms that enable substantial creative destruction of current businesses to improve overall efficiency. Though the actual policies pursued will depend on many factors, there is a wide spectrum of choices in each area, ranging from the incremental to the pivotal. These choices will have lasting consequences for the Indian economy.
Modi has spoken with greatest clarity about improving governance and decision-making. One of his first acts was to abolish the convoluted cabinet committee structures put into place by the previous government. He followed this up by announcing the abolition of the Planning Commission; directing ministers to refrain from nepotistic hiring; improving working conditions in government offices; and enforcing strict adherence of office hours.
These are important changes, but are only the tip of the iceberg. If Modi continues with such steps, the government will reap efficiency gains but risk missing the forest for the trees. The bolder option will be to build on these gains to redefine the government’s role in the economy and to improve government capacity to fulfil this role. The role of the government could be limited to efficient supply of quality public goods (e.g. public infrastructure, defence, law and order, contract enforcement, etc.) and regulation to address specific market failures (for consumer and environmental protection). Improving government capacity involves reforming the bureaucracy by implementing tailored programmes focused on improving agency-specific constraints, incentives and accountability mechanisms. Since agencies are creatures of their laws, this will require redrafting laws to codify best practices of public administration. Amending the laws and rules, instead of issuing quick administrative fixes, will also ensure lasting impact because it would make these reforms more immune from “gaming” or reversal by the adversely affected.
The second priority is reviving private sector activity, especially in manufacturing. The new government has moved to swiftly process project applications, instituted rapid (perhaps too rapid?) environmental clearances, and pledged restraint on retrospective taxation. While much of the work here remains with state governments, the Union government has expressed its desire to support decentralized experimentation.
If Modi were to double down on this strategy, India could see modest improvements in the ease of doing business. Though the government would continue to ration licenses, it will likely increase their number. It will also continue to participate directly in many lucrative sectors, though with some attempt to achieve competitive neutrality in regulation.
What will a pivotal change in private sector policy look like? It will include the following: a substantial retreat from centralized economic planning, reform of tax legislation (enacting the goods and services tax and the original direct tax code) and administration, financial sector reforms (legislating the draft Indian Financial Code), rationalizing frameworks for resource acquisition (eg. land acquisition), reforming the bankruptcy code, and ambitious disinvestment and privatization. Such alterations will be an acknowledgement of the need to expand economic freedom, and improve rule of law in government-market interface. There was much truth in Modi’s complaint that until now governments made development a government programme. Economic development needs reasonably free individuals and firms applying themselves in their respective contexts. This will not happen unless the state partially relinquishes the “commanding heights” it occupies in the economy.
On fiscal consolidation, the government’s first budget demonstrated resolve in adhering to the ambitious deficit targets. While the budget did not include any big expenditure reforms, it announced the creation of an expenditure management commission to recommend ideas on how to reform public finances.
Proceeding incrementally, the government could improve the efficiency of expenditure through better beneficiary identification and authentication in welfare schemes, and seek better price discovery in auctions to reduce the money government pays for procurements. Going for pivotal changes will involve government reducing its functions and expenditure heads. For example, it could replace certain subsidies and entitlements, such as food and fertilizer subsidies, with cash transfers, or eliminate subsidies it considers non-essential for welfare enhancement (e.g. fuel subsidies).
The final priority for the new administration is attracting foreign capital, best encapsulated by Modi’s plea to investors: “Come, make in India.” As with his successful trip to Japan and meeting with China, the upcoming dialogue with the US is expected to focus on raising capital to finance India’s yawning infrastructure gap. Though these visits have grabbed headlines, the government has only cautiously moved on lifting foreign direct investment (FDI) caps in sectors such as defence and insurance and has roundly criticized the previous government’s decision to allow 51% FDI in multi-brand retail.
Modi could continue with the current approach by expanding outreach to foreign governments who can marshal resources, but without making a clear break on the hawkish tax treatment of investors or further revisions to FDI limits. Pivotal change will involve quickening the pace of FDI liberalization, moving to mostly residence-based taxation with improved clarity on permanent establishment, substantially reframing bilateral investment treaties, and changing the way India regulates sectors such as nuclear energy and defence.
In each of the four priority areas, sweeping change need not always be rapid. Reform could also consist of a series of phased changes, planned and implemented with a clear vision, giving individuals time to make necessary adjustments. For instance, the United Progressive Alliance (UPA) government dealt with the critical issue of diesel subsidies gradually, allowing oil companies to hike prices by 40-50 paise every month. The price increase transpired slowly, but the objective was to reach a stage where the price eventually tracks the international price.
Furthermore, incrementalism and radical reform need not be mutually exclusive. In fact, it will be a political disaster if the regime pursued simultaneous, radical shifts in each of these priority areas. The government does, however, need to choose where on the spectrum it would like to locate itself.
The government’s words and deeds, coupled with positive business cycle conditions, are having a salutary effect on economic sentiment, and the short-run prognosis for India’s economy is good. While one could thus argue that there is little political incentive for pivotal reforms, this is a limited way of looking at this government. Modi’s aspirational mandate has created the expectation and the opportunity for transformative reforms. There is, for the first time in recent memory, political space to move from “reform by stealth” to “reform from the rooftop”. On each of the priority areas, the government must at least consider the possibility of pivotal reforms, rather than luxuriate in the current economic recovery.
The choice, in the end, is a political one, as it should be in a democracy. Given the political wisdom required, it will be presumptuous to recommend a clear path, but the past offers some useful lessons. Reading most of the pre-1980s political economy literature on India must have left one with a sense of despair about the possibility of reforms. This literature suggests, reform seemed unattainable since the Indian state appeared to be captured by interest groups, and the political class and bureaucracy too suspicious of markets. More than three decades into reforms that began with baby steps in 1980s and gathered pace in 1990s, this literature makes for a touching reminder that Indian democracy is capable of springing many surprises. If the government has the intellectual capacity and political wherewithal, it has sufficient structural autonomy from interest groups to be able to implement many of the most pressing reforms. Even politically weaker governments, such as the P.V. Narasimha Rao, United Front, and the first National Democratic Alliance (NDA) governments, all were able to successfully pursue deep and difficult reforms. Of course, these governments often pursued reforms by stealth, for they did not have the political capital required. This government is much stronger, and, potentially capable of cobbling together alliances to overcome narrow interest group resistance.
In the words of Leo Strauss, “All political action aims at either preservation or change. When desiring to preserve, we wish to prevent a change for the worse; when desiring to change, we wish to bring about something better.” Discerning what deserves preservation and what must change requires deep conviction and analysis, while acting on this assessment requires a sense of political possibilities. The question for the Modi government is how it will choose to expend its political capital, with one eye on economic revival and the other on continued electoral success. This choice, more than anything else, will determine its place in history and India’s economic destiny.
Milan Vaishnav and Suyash Rai are, respectively, associate with the Carnegie Endowment for International Peace in Washington and senior consultant at the National Institute of Public Finance and Policy in New Delhi.
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