The emergence of a different order?

SUYASH RAI

back to issue

STATE-CAPITAL relations can be defined as the ways in which state action affects the cost of capital and the return on capital employed, which in turn determine the levels of private investment and entrepreneurship.1 State-capital relations therefore include direct, firm-specific interactions between the state and investors/firms, and indirect influences that shape the general conditions for raising and deployment of capital.

Direct interactions include, first, interactions in which the state imposes compliance burden on capital – taxation of economic activities or incomes, and regulation of factor markets and product markets. Second, interactions where the state provides a service to capital (eg. provision of public infrastructure). Third, where the state-capital relation is a mix of compliance and service (eg. trade facilitation, investment facilitation, the state contracting to private sector). The indirect influences may include: macroeconomic management (including fiscal, monetary, capital flows, trade, and macro-prudential policies); state’s shaping of the structure of markets (for example, policy choices determine whether a country’s credit system is more bank-led or market-led); and so on.

So, the state-capital relations span several laws (here, ‘law’ refers to parliamentary legislations, regulations, rules, policies and other instruments that lay down the rules of the game) and their implementation systems. This essay only picks some of them for analysis. Much of the discussion on state-capital relations is focused on the laws. There are comparative analyses of how India’s laws compare with those in other countries, eg. the Ease of Doing Business (EoDB) rankings. There are also critiques that contrast the laws with some normative expectations of what they should be, as seen in recent debates around labour laws, agriculture laws, et cetera.

 

The reality of state-capital relations, however, depends not just on what the laws say but on how they are implemented. The implementation is shaped by several factors. First, the economic incentives of implementation. In implementing a compliance-oriented law, the expected compliance cost shapes the incentives. If the compliance cost is not proportionate to the economic value of the activity, the investors/firms have a strong incentive to reduce the de facto compliance cost. For instance, the cost of full compliance in the law on inter-state migrant workers in India would make it unviable to hire such workers for most low-skill activities, but migrant workers are essential for economic activity in many states.2

In principle, the solution could be rationalization of the law or provision of subsidy to partially cover the cost of compliance. But this usually does not happen. The reality that we cannot really achieve some of these objectives without harming economic activities and vice versa is often left unrecognized by the lawmakers, but it is still a fact. Further, in a fast-changing developing economy, laws are often unable to keep up with the increasing complexity of economic systems.

Second, the capacity of the implementation agency. Laws are typically aspirational, and the lawmaking process often does not adequately consider capacity constraints. It is often assumed that capacity will somehow be built after the law is enacted. This is an important factor in democratic developing countries with relatively weak state capacity and many competing demands. As Andrews et al (2017) have argued, the mismatch between demands of the law and capacities of the state can lead to dysfunctional implementation – for instance, the implementation agency following the procedures in name only while being functionally ineffective.3

 

Third, the approach that politically powerful factions and institutions of accountability take towards capital. Shifts in the approach of political and institutional settlement can influence the stance of agencies implementing the laws. As Rodrik and Subramanian (2005) have argued, it was a change in the stance of the government and not any major legal reforms that may have led to an acceleration in India’s growth in the 1980s.4 Further, the stance of institutions – such as the judiciary, the audit institutions, etc – that can hold an implementing agency accountable, sometimes even overruling its decisions, also matters in determining the direction in which the implementation agency may tilt.

Any deviation between a law and its implementation is a difference between an idealized conception of how the law should be implemented and how it is indeed implemented. For instance, to measure this deviation, one can estimate the time to properly follow the critical path of procedures in a law, and then compare this with the actual implementation experience. One way this deviation has been measured is by considering the difference between the findings of the Ease of Doing Business (EoDB) index, which measures the de jure requirements in the laws, and Enterprise Surveys, which measure the de facto experience of firms.5 In developing countries, there are large deviations between the time taken according to the EoDB Index and the time reported by firms for completing an interaction with the state, with most firms reporting far lesser time than estimated from the laws.6 Further, there is considerable variation in the experiences of firms within a country.

 

These findings allow further differentiation between types of state-capital relations. Hallward-Driemeier et al (2014) offer two basis of differentiation – first, whether the favourable deviation from the law is available to all investors/firms, or to only influential investors/firms; and second, whether it is sustained over time, or it gets disrupted.7 One can differentiate on two more grounds – third, whether a favourable deviation strikes a balance between conflicting policy objectives or it ignores important policy objectives; and fourth, whether it leads to productivity improvements or is mainly for rent-seeking.8

Ideally, favourable deviations should: be available to all similarly placed investors/firms, sustain over time (or laws become consistent with economic and administrative realities), strike a balance between conflicting objectives, and lead to productivity improvements. Second best versions of this ideal can also achieve progress. In the long process of development, such pragmatism can help a country move forward on the path towards a more rules-based system.9 However, all deviations from the laws are not developmental, as they can also be corrupt. Pritchett et al (2017) argue that the nature of such deviations or ‘deals’ depends on the interactions between the political settlement in a country and the structure of rents in the economy.10

 

As Kelkar and Shah (2019) have argued, the ideal path for India is to seek progress based on its economic and administrative realities, by being realistic in making laws and by gradually building state capacity.11 However, it is also important to achieve a measure of pragmatism in implementing the laws. Such ‘implementation pragmatism’ could lead to quicker permissions, optimal compliance burden, more proportionality in enforcement decisions, etc. Such light touch approaches can reflect a more trusting and accommodative attitude towards capital. Although implementation pragmatism is not a substitute for reforming the laws and building capabilities, it can be socially beneficial in the short to medium term.

It is dangerous for a developing country, especially a democracy, to settle for achieving progress through implementation pragmatism at the cost of building a rules-based order. So, the objective should always be to move towards an open, rules-based order. Any implementation pragmatism is acceptable if it does not set us back in this journey.

 

Although the laws are available in public, unfortunately, a large part of the reality of state-capital relations that lies in the implementation stance remains opaque for those not directly participating in state-capital interactions. Surveys and studies give a partial and temporary glimpse of a vast, ever-changing reality. Several studies show that in India, implementation of the laws is very different from the intent of those laws. For instance, the median time for construction permits reported in Enterprise Survey conducted in 2013 and 2014 was about 33 days while the expected time based on EoDB index was 180 days.12 Such studies suggest that in India the laws are often poor descriptors of the reality of state-capital relations. This reality can be better or worse than the laws.

Going by the age-old wisdom that one should not look for one’s keys under the lamp post if it was lost in the dark alley, it is important to piece together, even if speculatively and with pitifully limited information, the realities of state-capital relations in India and how they may be changing.

For a democracy, India has had an impressive growth experience in many of the years since the 1980s, including an unprecedented investment boom in the 2000s. This happened even though, despite many reforms since early 1990s, the laws were not quite business friendly – India ranked poorly in international rankings. Also, as World Governance Indicators suggest, there was marginal improvement in the capacity of the state during the 1990s and 2000s. Growth still sustained, falling only due to exogenous shocks (eg. Asian financial crisis, global financial crisis, droughts) and then recovering quickly. There were many reasons for this performance, such as a favourable external environment, build-up of technological capabilities in the preceding decades, and so on. However, if the Indian state’s stance towards capital had not changed, perhaps the other enabling factors may have remained missed opportunities.

 

First, the political stance towards capital took a benign turn in the 1980s,13 and this showed in the way laws were implemented. The reforms of 1991 and the continuity of reforms in 1990s and 2000s sent more signals by rationalizing state intervention. This shaped the expectations about the direction in which the state-capital relations were likely to go. It was one thing for a government to announce wide-ranging reforms in an economic crisis, but quite another for the reformist stance to survive several changes in parties and coalitions in power.

Second, the state’s approach to capital became more pragmatic – focused on improving outcomes. Government routinely took decisions to enable development, even if they were politically risky and temporarily appeared unfair. Sometimes, these changes created a temporary windfall for some private investors, but they were still implemented if the larger public purpose was being served. An example of this was the reform of telecommunications policy in the National Democratic Alliance (NDA) government led by Atal Bihari Vajpayee, which gave benefits to private firms by shifting from a license fee to a revenue-sharing arrangement. The policy overhaul had positive consequences for the sector, but this concession was politically risky. In a fast-changing developing economy, such risk-taking is often necessary to reform the laws based on experience.

 

Third, the reforms in obligation-imposing laws such as tax codes and regulatory laws suggested that trust between state and capital was improving, and that the state gave more leeway to private firms to structure their businesses. Most of the product markets were reformed to remove the state’s power to intervene. The financial sector was also substantially deregulated, and private banks and their borrowers got much greater freedom to set the terms of their relationships. However, public sector banks remained under government’s control, and had to often follow government’s priorities.

Fourth, the experience of implementation of laws in India was very different from the general developing country experience. Consider the comparison between EoDB and Enterprise Surveys discussed earlier in this essay. In the average developing country, about a third of the firms reported quick construction permits (less than 15 days), a third reported a moderate amount of time (16-45 days), and a third reported longer time for permits (more than 45 days).14 In India, two-thirds of the firms reported a moderate period of time for constructions permits, 22 per cent reported quick permits, and only about 11 per cent reported a longer time for permits.15

 

If, as Kar et al (2019) have suggested, we assume that quick permits mean total neglect of laws and slow permits suggest harassment of firms, moderate time for permits seems to be the best option for a developing country.16 Perhaps a vast majority of construction permits involved some kind of a pragmatic balance between achieving the objectives of the law and enabling the economic activity. As discussed earlier, given the economic and administrative constraints, such implementation pragmatism can be socially beneficial.

Fifth, the state’s enforcement stance did not lead to many disputes, which may suggest that unreasonable demands were not being made from capital. For instance, the direct tax collection under dispute (as percentage of gross collection of direct taxes) remained low, and even fell sharply during the best of the boom period between 2004-05 and 2007-08 – from 42 per cent to 16 per cent. During those three years, the direct tax to GDP ratio rose from 4.1 per cent to 6 per cent.17

Even though a complete picture is not available, it can be argued that this political economy order had a reformist policy direction and a pragmatic implementation stance, so that investors and firms across a number of sectors could be confident about the future. This order created expectations of a continuous process of reform, iterative troubleshooting, and pragmatic implementation. This may have shaped the expectations of investors, who then made investments with the hope that over the lifecycle of the investment, things will get better. The state-capital relations were getting better.

A major limitation of that order was that, except in a few domains (eg. securities regulation, contracting for roads, etc), improvements in state capacity lagged far behind the increasing complexities and stakes in the economy. Perhaps therefore much of that order was not visible in formal arrangements, and many problems were solved by the business leaders approaching the political or policy leaders in the government informally. When the policy framework is evolving, such interactions can be socially beneficial if they lead to overall better state-capital relations, but they also open possibilities of corruption and predation.

 

Whatever the excesses and flaws of that order, and it did sometimes lead to unfair treatment and poor outcomes, it yielded many good outcomes for the Indian economy, including an unprecedented boom in investments. This experience shows the deep ambiguities of the role of the state in economic transformation, especially in the context of a democratic developing country. If a rules-based order is not yet in place, finding ways to make progress can be challenging, as the legitimacy of any other order can be easily challenged and disrupted. Many of the experiences of sustained high growth in other countries, such as Japan, South Korea and China, involved close formal and informal interactions between state and capital. Such interactions are risky but necessary. They can, at their best, help continuously identify and address the binding constraints to growth. At their worst, they sustain a predatory political economy.

In the last few years, the Indian economy has struggled to achieve and sustain high growth. Between 2016-17 and 2019-20, growth has slowed down from 8.3 per cent to 4.2 per cent. In 2019-20, gross fixed capital formation (GFCF) in the Indian economy fell by 2.84 per cent – the worst performance since 1991-92 – and the new project announcements by the private sector were at a record low. While the January-March quarter may have been affected by the Covid-19 crisis, GFCF had shrunk even in the previous two quarters. Between 2012-13 and 2019-20, the average annual growth rate of GFCF has been 4.8 per cent – well below the average GDP growth rate.

 

Some regression to mean was expected after the investment boom that India saw between 2003-04 and 2011-12, but the continued downslide is puzzling. This is even more surprising given the list of legal reforms implemented in recent years. The reforms include major overhaul of the regimes for indirect tax, bankruptcy resolution, monetary policy, fiscal policy, and so on.

The causes for the slowdown are much debated, with several plausible explanations vying for legitimacy. Perhaps a part of the reason for India’s struggles with investment and growth have to do with shifts in the state’s stance towards capital. While we do not have evidence to comprehensively understand what has changed and what remains the same, there is some evidence that things have changed.

First, the state’s stance in tax enforcement has become much more hostile. This can be seen in the sharp rise in tax claims under dispute from 2010-11 onwards, and this trend has sustained ever since. The ratio of direct tax collected under dispute to gross collection of direct taxes rose from 18 per cent in 2009-10 to 62 per cent in 2012-13. It has remained higher than 60 per cent in every year since then. The cumulative impact of these disputes is that the appellate tribunals are clogged with disputes. It has been reported that the government wins in fewer than 20 per cent of the direct tax cases it appeals.18

 

Second, several decisions suggest falling level of trust between state and capital, and a move away from a light touch approach towards capital to an intrusive approach. The tax laws were amended in 2017 to weaken checks and balances on the revenue authorities, so that they could take actions such as searches and seizures much more easily.19 Further, the heavy compliance burden, the convoluted rate structure, and inordinate delays in refunds in the GST system also point at a lack of trust. An amendment to the bankruptcy law prohibited several categories of persons from participating in a resolution. This includes any person associated with non-performing loan accounts.

Third, the stance of institutions of accountability has become less amenable to implementation pragmatism. A key aspect of this has been the stand that some enforcement agencies (eg. Central Bureau of Investigation) and the judiciary took on the issue of corruption. In some cases, officers were convicted for corruption despite absence of evidence on wrongful gain for the officer. This conflation of poor judgment and corruption shrunk the space for bureaucratic discretion.

Fourth, there has been considerable churn in the key positions among the policy leaders. Some churn is not unusual in government, but continuity of a core economic policy team is useful for pursuing multi-year agendas. Further, as this essay is being written, there is not even one macroeconomist in a leadership position in the Ministry of Finance or the Reserve Bank of India. It is not clear who is to be approached to solve problems, and whether they will be able to help.

 

Overall, it seems the political economy order has shifted towards more hostility and less trust in state-capital relations. Not all the investors/firms are facing problems, and some are probably getting what they want. But the average firm is probably facing greater uncertainties than it did earlier. We may be reading too much into these facts, but the trend on investment and growth suggests that some things are going wrong in India’s political economy. Wisdom required for solving problems in complex systems of policymaking and implementation lies in drawing useful conclusions from limited information.

If an order has indeed been unsettled, it is important to build another effective order, which is also hopefully fairer and more resilient. India needs to reform the laws and build capable organizations to implement them, while being pragmatic in implementation of laws. Recently, government has sought to address some of the problems – an amendment to the anti-corruption law in 2018; efforts to reduce tax disputes; decriminalization of certain violation in the Companies Act; and so on. Much more needs to be done for rapprochement between state and capital. However, an order is not just a promise expressed in legal changes, but a series of experiences lived over time.

 

* The author would like to thank Ajay Shah, Anirudh Burman and Rohit Chandra for useful comments.

Footnotes:

1. Ricardo Hausmann, Dani Rodrik and Andrés Velasco, ‘Growth Diagnostics’, The Washington Consensus Reconsidered: Towards a New Global Governance. Oxford University Press, 2008, pp. 324-355.

2. https://carnegieindia.org/2020/05/09/migrant-workmen-act-1979-must-be-rationalised-to-remove-requirements-that-disincentivise- formalisation-pub-81751

3. Matt Andrews, Michael Woolcock and Lant Pritchett, Building State Capability: Evidence, Analysis, Action. Oxford University Press, 2017.

4. Dani Rodrik and Arvind Subramanian, ‘From "Hindu Growth" to Productivity Surge: the Mystery of the Indian Growth Transition’, IMF Staff Papers 52.2, 2005, pp. 193-22.

5. Mary Hallward-Driemeier and Lant Pritchett, ‘How Business is Done in the Developing World: Deals Versus Rules’, Journal of Economic Perspectives 29(3), 2015, pp. 121-40.

6. Ibid.

7. Mary Hallward-Driemeier, Gita Khun-Jush and Lant Pritchett, ‘Deals Versus Rules: Policy Implementation Uncertainty and Why Firms Hate It’, African Successes, Volume I: Government and Institutions. University of Chicago Press, 2014, pp. 215-260.

8. Sometimes rent-creation can also be productivity-enhancing.

9. This can be a process of transition from limited access orders to open access orders. See for instance: Douglass C. North, John Joseph Wallis and Barry R. Weingast, Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History. Cambridge University Press, 2009.

10. Lant Pritchett, Kunal Sen and Eric Werker (eds.), Deals and Development: The Political Dynamics of Growth Episodes. Oxford University Press, 2017.

11. Vijay Kelkar and Ajay Shah, In Service of the Republic: The Art And Science of Economic Policy. Penguin Random House India, 2019.

12. S. Kar, L. Pritchett, S. Roy and K. Sen, Doing Business in a Deals World: The Doubly False Premise of Rules Reform. ESID Working Paper No. 123, The University of Manchester, 2019.

13. Dani Rodrik and Arvind Subramanian, ‘From "Hindu Growth" to Productivity Surge: the Mystery of the Indian Growth Transition’, IMF Staff Papers 52.2, 2005, pp. 193-22.

14. Ibid.

15. Ibid.

16. Ibid.

17. These numbers are author’s calculations using data from Government of India’s budget documents.

18. See the table at the top of page 39: http://164.100.47.193/lsscommittee/Finance/16_Finance_2.pdf

19. https://blog.theleapjournal.org/2017/02/notes-on-union-budget-2017-18.html

top