With the 2023 budget around the corner, former chair of the Niti Aayog, Dr Arvind Panagriya speaks with FED’s Operating Partner, Piyush Doshi, about his expectations from the last full budget before the general elections in 2024. He talks about the need for choosing capital expenditure over fiscal consolidation, diverting capital towards labour-intensive manufacturing industries for skill-upgradation, and reform measures that level the field for entrepreneurs.
Read the transcript of the interview below.
Piyush Doshi: The 2023 Budget is coming up. India has had a relatively good year but we have a long climb ahead. Every budget has been an opportunity to move the needle in the direction of progress. Given the challenges in the world economy, what are the top things that the government can look at in this budget to take India’s growth momentum to the next level?
Dr. Arvind Panagariya: In the present context the fiscal deficit becomes more important. Coming out of COVID, we have an elevated debt to GDP ratio. Pre-pandemic, the debt to GDP ratio was ~70%. Currently, it’s around about 84% of the GDP. So one of the things that the 2023 budget needs to do is to pay some attention to fiscal consolidation, an objective that is necessarily going to come in conflict with some of the expenditures given this is the last full budget prior to the next parliamentary election. Naturally, there has to be some populism in this which would enhance the expenditures on schemes that may be just as popular – like accelerated delivery of rural housing. Luckily, this government doesn’t spend on popular schemes of the kind where expenditure actually gets wasted; it usually designs them sensibly.
I also feel that the government should not compromise on capital expenditures, particularly on infrastructure expenditure. Unlike the previous governments, this government has established a fantastic record of building the country’s infrastructure. It has been effective in terms of completing the projects it has started. It has even successfully completed long-term projects which had been stalled. So there is certainly something about the way the community is organised that it is able to finish projects.
Even after 75 years, India is still not at a stage where all infrastructure is in place. We are still in the process of building we and this is a great opportunity to continue to do that. Indeed, it would be good if the government could actually increase infrastructure spending. Now that, as I said, will come into conflict with the fiscal consolidation objective. Ultimately, if that is the conflict the government needs to resolve, I would be in favour of continuing with infrastructure spending even if fiscal consolidation slows down. That is the compromise I would make between those two objectives.
This being the last full budget before elections, I’m not sure if the government is going to embark on reforms but there are certainly some things that can be done particularly those related to the tax system in direct taxation. We need to have a system in which there are no exemptions or truly minimal exemptions, and lower tax rates. I think, currently, the marginal tax rates go all the way up to 43-44%. They need to come down and the only way they can come down is we get rid of the exemptions.
One of the things about exemptions is that in effect, it introduces what economists call the horizontal inequity. Depending on how you spend your income, your tax for the same level of income can be more or less. Let’s say there are two individuals with the exact same incomes but spend their incomes differently and would end up with different tax liabilities. This is called the horizontal inequity indexation. And I think we need to eliminate that and obviously, that requires elimination of all the exemptions. And if we do that, then we can bring the tax rates down.
There are similar kinds of anomalies in the tax system on things like long-term capital gains tax…a tax rate is higher in some sectors, lower in other sectors, is higher for private equity, lower for publicly traded equity, things like that. These are all things that distort investment, because they move invest funds into assets with lower tax rates, even though the return on them may be lower. So, some of the higher end rate of return opportunities may get neglected, because the tax rates on those happen to be higher.
PD: If the choice is between cutting capital expenditure and fiscal consolidation, then the government should probably continue with capital expenditure on infrastructure building because that’s a more important priority right now. On taxation, we have some opportunity to rationalise the exemptions. On capital gains, there is an opportunity to rationalise anything, although the government doesn’t have to rely on budget for this, but often governments have used budgets for also making policy announcements.
Given the manufacturing objective of reaching 25% of GDP remains a bit far, and we’re still struggling with growing labour intensive manufacturing, what do you think the government can do by way of the budget, either on the balance sheet in inside or in general reform measures or policy initiatives?
AP: This is a long standing issue for me – I’ve been writing for almost 20 years on this issue. One of the obvious things of course, is that we need lower protective duties not higher, and in the past, we have really gone into higher protective duties, but also the current policies in effect move capital towards much more capital intensive industries.
So whether it is the import substitution that we are doing in certain industries or through PLI where we are moving capital into certain industries through subsidisation, it is largely going into capital-intensive industries. The problem we face is that ultimately the available capital is determined by the savings rate. And we already have a savings rate which is, overall the investment rate is worth 33-34% of the GDP now, with pretty decent. But much of this capital ends up in highly capital-intensive industries. So, what we are doing is that our capital, in effect, is working with very few workers. If you look at industry, whether machinery industry, or petroleum refining, pharmaceuticals industry unit cap pretty effectively, is working with very little labour.
On the other hand, where there are a lot of workers, those industries are starved of capital and that is the reason you don’t have enough capital for skill upgradation. We can talk about skill-creation and skilling of the workforce through all kinds of programmes till the cows come home. But the real skill creation actually happens in the factories, that is where workers pick up skills, because skill is not merely doing something but also working with other other workers in an environment in which production activity actually takes place. It’s a whole package, and you’re going to understand that package by being in that environment.
So when there is not enough capital for the bulk of the workforce, skill formation will not happen. And that has been the tragedy of the Indian worker – after 75 years we don’t have a skilled workforce. Constantly every government talks about skilling the workers – why do they not exist? Because for all these years a large part of the workforce has no capital to work with, because it is absorbed by very highly capital-intensive ventures. And that I think, is something that requires a correction
The focus of the government ought to be on industries like textiles, footwear industry etc. These are easy industries; you can locate (set-up) them almost anywhere. But you have to have these factories on a scale which makes them competitive in the global marketplace, and then have to have capital to work with. Even though these are labour-intensive industries, there is some capital that gets used. I should say not textile since textile is highly capital intensive itself, but the clothing industry or apparel industry, the firms that are globally connected.
It’s a long term issue but the government, if it really wants good jobs to be created for the masses, then industries in which a large number of workers can be employed, need to be given capital. There needs to be an environment in which such capital can flow into these industries.
PD: So to promote labour intensive sector, would you recommend having a version of PLA lets a greater allocation of PLA targeted towards some of the labour intensive sectors or should government think of something like an ELA employment linked incentive linked to or that could be problematic itself, but should government not worry about incentives at all it should just create a competitive environment. What is your view on directing some of the incentives towards labour intensive industries?
AP: The default is that there are going to be ESBLs games then obviously, it should be actually moved a lot more towards labour-intensive industries, because ultimately in an environment in which lots of incentives are given, then sectors that are not given the incentive become disincentivized okay. So, the way in which these incentives are being provided wholesale, not to be given an incentive is a disincentive. My inclination would be to have good policies that are neutral and flexible.
meat market is flexible labour markets, land markets, these are highly inflexible in India still, and non land markets are particularly coming out as a major challenge which unfortunately, is a subject of the state. Most of the reforms on landmark cases have to be done by the states, who have to come forward. Not all 28 states have to come forward but if we can get three or four states to come forward and try to make the necessary reforms in the land market. So, that land becomes accessible at reasonable prices to the industry that will go a long way towards industrialization.
States like Gujarat for example – you do see that manufacturing is a very vibrant activity. If one can go by the data that is available, manufacturing is a very large proportion of well over 30% of the GDP of the state (or GSDP). Tamil Nadu is another state with a relatively high share of manufacturing in the GSDP.
PD: If you were to look beyond labour-intensive manufacturing, which obviously should be the priority, are there some other sectors which the government should try and promote – like tourism, construction etc.?
AP: I think the playing field should be levelled…have flexible land, labour and capital markets, and let the entrepreneurs decide where they want to go. And of course, trade policies have to be neutralised as well, because currently trade policy is a major intervention in the price system. If you have incredibly high tariffs on certain items, then obviously, you have not levelled the playing field. That’s where I would go.. I think every government is under pressure to really show that it can produce successes. If interventions are going to be done, I would say do it in such a way that the playing field actually is tilted in favour of the labour intensive industries, so that they can at least create the kinds of jobs that are necessary.
I’ve also often talked about these special zones. These zones have existed in India, people don’t understand that the form, the manner in which the zones are actually created is extremely important. EPZs, we used to call them Export Processing Zones from the 1960s at least. So, you need to organise them in a way that authority on labour markets, land markets, rests with the local entity. When you create a zone, first of all the zone has to be large, a couple of 100 square kilometres at least. And then within that zone, whoever the administrator of the zone is – if you have a council to administer aid or whatever – It ought to have the authority to properly reject the land and labour laws within that particular zone. So that it can respond quickly locally, to the needs of the industry.
This is the kind of system that exists in China. A lot of the cities in China and most notably, Shenzhen, which is the major industrial hub particularly in Technology, the local authorities actually have the rights to choose their own labour laws and not the labour laws made by the central government or the state government. The latter have to do it (make laws) for the whole country or the entire state. And that’s a very different ballgame, but within a small jurisdiction, it is possible for the local authorities to have a much more flexible system.
And of course, there ought to be some assessment of the zones themselves also from the higher levels, of what that they are delivering in terms of the objectives. That would create an incentive for the local administrators to reject the policies within the zone in such a way that the industry flourishes within the zones. So, that is the kind of architecture one one really has to have.
PD: To sum up, beyond the spending and taxation points, two major things in terms of incentives: If they are to be given then they should be tilted towards labour intensive sectors. The PLA kind for instance, in incentives so that the playing field is not tilted against them, if at all in favour of them. In general, not a fan of incentives but a fan of liberal markets. The final point is that if you cannot create these liberal markets throughout the country, then at least have in certain economic zones with delegated and devolved authority at a local level on important areas like land and labour. And larger areas (for special zones) a few 100 kilometres?
AP: Yeah, not a few 100 hectares.
PD:Meaningful sized, devolved authority and control on on important issues like land and labour. I think these are a great set of descriptions that are well aligned with the overall FED thesis.