Democracy Lab

India's Missing Ingredients

Indian growth is slowing. But there are two key reforms that will help.

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.

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.

This struggle is a familiar one. In most political systems, small groups with focused, clearly defined interests can typically veto change that would serve the majority. What's more, myopia all too often trumps long term thinking. In India, after all, even privileged insiders have much to gain from rapid, sustained growth. If you doubt it, compare Indians' wages to those of South Koreans, who were among the least productive workers on earth in the 1960s.

Note, too, that luring businesses into the formal sector would broaden the tax base, generating revenue that could be used to extend the social safety net beyond the 8 to 9 percent of the workforce that is currently covered. Today, about 4 percent of Indians pay 70 percent of the total tax in India. Friendlier labor laws combined with tax reform could undoubtedly increase the tax-to-GDP ratio.

The stakes in the battle to complete the reforms sooner rather than later will be particularly high in the coming decade. As India's birth rate falls and life expectancy stabilizes, the portion of the population that is of working age will grow. This will yield what economists call a "demographic dividend" -- a period in which the burden of supporting the dependent young and old will be relatively light, leaving more income to plow back into investment.

But there's an obvious catch: To harness the dividend, jobs will have to be created to accommodate the seven million workers added annually to the workforce. The UPA introduced the New Manufacturing Policy to this end, aimed at increasing the share of manufacturing in GDP from a strikingly low 16 percent (the figure is above 45 percent in China) to 25 percent and to add 100 million jobs by 2022. This is a classic case of putting the cart before the horse -- those jobs won't be created if tough labor restrictions remain in place. An analysis by CRISIL, an Indian consulting group, concludes that, without major reforms, the share of manufacturing in GDP will only reach 17 percent.

One strategy for disarming popular opposition for further reform is to try it in individual states that are more receptive. India's 28 states, which have widely diverse political and economic cultures, could serve as mini-laboratories to test what works and to make a case for reforms accordingly. There's already some evidence of the benefits of reduced labor regulation from interstate comparisons. A 2012 survey by the Indian government's labor bureau concluded that "some of the states having pro-labor rights policies have not performed well in terms of unemployment rate."

That said, the best of worlds would still be one in which labor and tax reform law were fast-tracked. But is that world possible? The state of Indian politics offers little room for optimism. Consider, for example, the fate of the initiative for opening Indian retailing to foreign direct investment by big-box establishments like Walmart and Tesco that could dramatically cut consumer costs.

When Prime Minister Manmohan Singh introduced the foreign direct investment (FDI) initiative in 2011, nobody was surprised when parties of the left denounced it. What was dismaying, though, was the opposition of the Bharatiya Janata Party (BJP), the leading right-wing opposition party. It had championed FDI when it was in power in 2004, but apparently couldn't resist the chance to attack the government in a moment of vulnerability. The government did prevail -- but only after a year of delay. And the battle, needless to say, bodes ill for passage of even more controversial -- but necessary -- labor law reform.

In September 2010 The Economist predicted that the Indian economy would soon outshine China's, considering its advantages in "democracy" and "demography." Two years later it seems that, once again, Indian politicians have snatched defeat from the jaws of victory. A billion people are worse off for their incompetence and venality. It would be a shame if India had to wait for another crisis and another intervention by the IMF to unleash reforms when we already know what needs to be fixed.    

Photo by SAM PANTHAKY/AFP/GettyImages

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