Reforms that turn the land market dynamic could rescue owners of small farms from their trap of poverty
An important reform announced earlier this month by the Karnataka government is little known, but will improve the land market and help farmers in the state. The cabinet has decided to open the land market by allowing non-agriculturists to purchase agricultural land, remove income restrictions imposed on the buyers’ non-agricultural income (currently ₹25 lakh), and increase the maximum permissible size of holdings by an individual or family (from 10 to 20 units) and by larger families (from 20 to 40 units). The government plans to amend the Karnataka Land Reform Act, 1961, in the next legislative session to reflect these changes. This is a long due and welcome change. It will push the agricultural land market in the state from a thin one to a thick one, and help farmers trapped in low- productivity agriculture exit. Other states must follow Karnataka.
There are many reasons for thick versus thin markets, often based on the characteristics of the good or service. But in India, a thin market is often a result of bad government regulation—as seen in the case of agricultural land. To address the long shadow cast by land colonial rule and the zamindari system, post-colonial state governments in India enacted legislation to protect farmers, but ended up harming them.
First, governments in most states prevented non-farmers from buying farm land, worried that businessmen would take advantage of a bad harvest and buy land from farmers at fire-sale prices. Consequently, only farmers and not-for-profit institutions (religious, education and cooperatives) could buy farm land. The unintended outcome was a reduction in the number of potential buyers that depressed land prices. It also fragmented the land market, separating agricultural land from other land, as determined by regulation and not the land’s productivity or market potential.
Second, almost every state imposed a maximum land holding to break up the zamindari system. But over time, land holding sizes have reduced due to the division of inherited property, trapping farmers in low productivity agriculture with small holdings. India’s average farm land holding is about one hectare, making economies of scale impossible. In some states, the size of holdings became so small that governments also enacted land consolidation policies.
Third, state governments imposed income restrictions on buyers’ non-agricultural income to prevent rich zamindar families with diverse income sources from exploiting poor farmers rendered helpless by financial difficulty. But the result was to drive out richer agricultural families from the agricultural land market to other opportunities. Over the years, various states have increased the relevant income limits. But, barring rich people from a market trapped in low productivity does no favour to sellers and only depresses land prices.
Thanks to these rules, the market for farm land is narrow and under-financed. Farmers can shift from agricultural land markets to the wider land market by obtaining permission to convert agricultural land to non-agricultural use. In quickly urbanizing areas, the price after land use conversion is 30-40 times the price of the same land without conversion. Without such a certificate, a seller must sell it to another farmer in a thin market. The benefits of land-use conversion are so large that it has spun off an entire political economy of corruption and regulatory arbitrage.
Just three badly designed rules, restricting the land market based on income, holding size and occupation, can shift a potential thick market for land into a thin market. Thick markets have high trading volumes and a lot of buyers and sellers. This is not just a matter of the number of transactions, but also the characteristics of market participants. An important feature of thick markets is the difference between buyers and sellers. There are greater gains from trade to be made when buyers and sellers in the market have different preferences, productive capabilities, individual endowments, etc. By limiting the market for agricultural land to only farmers of a particular income bracket and land-holding size, states have created a homogenous market, limiting potential gains from trade.
Economists favour thick markets over thin ones. Thick markets are characterized by a lot of transactions and, therefore, create numerous opportunities to generate gains from trade. They are better regulated by competition within the market and known for moving resources from low-productivity to high-productivity uses. Thin markets have the opposite characteristics.
In India, regulation fragmented the land market, creating a narrow market that hurt farmers, which in turn brought on more regulation. What the government didn’t realize was that limiting sales to agriculturists pushed the land market in India from thick to thin. The thicker the market, the better it is regulated through market competition. The thinner the market, the greater the calls for government regulation. The regulation of agricultural land markets has now become “circular", with every intervention resulting in calls for more intervention.
The good news is that states can, with the stroke of a pen, convert an artificially thin market into a thick one. Karnataka’s reforms have the potential to unleash enormous gains from trade. More importantly, they will help farmers, otherwise trapped in low productivity and poverty, get the best possible price for their largest asset holding.
Shruti Rajagopalan is a senior research fellow with the Mercatus Center at George Mason University, US
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