India's Missing Ingredients

Using its obligations to the IMF as political cover, India's government kickstarted the long-delayed process of liberalizing the economy back in 1991. The reforms -- and the economy -- have largely been a good news story ever since. Indeed, with growth averaging seven percent annually until the worldwide financial crisis in 2007, there was even talk that India would give China a run for its money as an emerging market powerhouse. But lost somehow in the tide of enthusiasm was the reality that two key IMF-prescribed reforms -- fundamental changes in labor and tax laws -- were left incomplete.

It's become increasingly evident by now that the bloom is off the rose. Last year, India recorded the lowest growth rate in a decade (4.9 percent). The Kelkar report on fiscal consolidation also warned of adverse consequences in light of the widening fiscal deficit (6.1 percent of GDP in 2012-13). While the failure to complete the reforms explains in part why growth has slowed to a shuffle (by Asian standards, anyway) it also represents an opportunity: Finishing the job now would sweep away a variety of barriers to business development, helping to pull the economy out of its slumping trajectory. The big question is whether the changes are possible in the teeth of rising inflation, massive corruption scandals, and populist blowback led by opportunistic politicians.

In a large fractious democracy like India, reforms are always difficult to pass. And arguably more difficult than usual given current political circumstances: India is ruled by the Congress party-led coalition, United Progressive Alliance (UPA), that has been forced to include innumerable parties that oppose reform in order to stay in power. It doesn't help, of course, that few in the UPA leadership have the motivation or communication skills to sell the benefits of reforms to a skeptical public.

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But I get ahead of myself. Since the 1991 reforms, national income has quadrupled but employment rates have stagnated. While growth has reduced poverty and added tens of millions to the middle class, a shockingly high portion of working age adults are either unemployed or underemployed in low-productivity tasks. That's in large part because India's labor laws are complex and highly restrictive.

The Industrial Disputes Act, adopted in the wake of independence by India's Fabian socialist leaders, dictates what employers can and cannot do, which can be summarized as "very little." Among other provisions, businesses employing more than 100 can't hire or lay off workers without government permission. Thus taking on workers means you probably have to keep them unless you go bankrupt -- a very good reason to make do with as little labor as possible.

By the same token, the tax laws are far from business-friendly. Rates are high and provisions are complicated enough to puzzle the lawyers in Bleak House, a reality that gives businesses incentives to develop convoluted avoidance strategies or simply to bribe the tax man. At the beginning of its second term in 2009, the current government promised to lower the corporate tax rate from 30 percent to 25 percent. However, the initiative is stalled in Parliament. Today the World Bank ranks India 152 out of 185 countries on tax practices in its Ease of Doing Business Index.

By no coincidence, a shocking 90 percent (not a misprint) of the Indian work force is employed in the informal sector, where labor laws are largely irrelevant and taxes can be easily evaded. But this flexibility comes at a high cost to both employers and employees who face, among other problems, the loss of social safety nets. Informal-sector workers also miss out on government training schemes that could increase their productivity and wages. Plainly, the government should be using labor and tax reform to coax as many informal businesses as possible into the formal sector and encouraging the growth of businesses to more efficient scale. The World Bank's 2013 World Development Report, which focuses on labor issues, surveyed businesses in 102 countries, finding (among other things) that larger firms are likely to be more productive and thus to pay more, innovate more and compete in export markets.

But deregulation is still a hard sell in India. The loudest voices in opposition are those with a vested interest in business-as-usual -- trade unions protecting job security in the formal sector, legal businesses avoiding competition from new entrants, corrupt bureaucrats preying on the informal sector. And advocates of reform have struggled to make the case for changes that will add considerable risk as well as opportunity to the lives of most.

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