A quarterly magazine of the IMF

September 2006, Volume 43, Number 3

Straight Talk

From Paternalistic to Enabling

India needs to adopt a style of government that unleashes the people's entrepreneurial zeal

Raghuram Rajan

The recent volatility in the Indian stock market seems to mirror a worldwide reassessment of emerging markets, rather than reflect specific concerns about India's future growth. There is an underlying strength to the Indian economy that will likely continue. Nevertheless, it is a good time to reflect on what might constrain India's future growth. While much attention has been focused on the need for government action here or there, what is less commented on is the nature and purpose of government. In my view, it will be increasingly important for India to exchange its paternalistic, directive government, which seeks to remedy every wrong through a subsidy, a quota, or a scheme, for one that creates an enabling environment for the people and unleashes their entrepreneurial zeal. This will require a change in the mindset of the people, a change that is happening but will have to accelerate.

Why do I argue in this way? Does a poor country not need a directive government to redress past wrongs and inequities? Indeed, India's government has always tried to direct the path of economic growth. Invariably, the path realized has been different from the one intended, with mixed consequences. Even today, the government is being pressed to push the economy in this direction or that to achieve this outcome or that. But increasingly, such direction will come into conflict with the outcomes dictated by the market. Something will have to give, and if it is the market, it will come at the expense of economic growth, as India has discovered time and again. Instead, a focus on creating an enabling environment that provides access for all to education, health care, finance, and, yes, a minimum safety net—indeed, a focus on spreading opportunity rather than mandating outcomes—will be a better way to achieve both growth and social justice.

Why do I think the change in mindset is overdue? Because of past government policies that had unintended consequences, India, unlike the typical developing country, has world-class capabilities in information technology (IT), pharmaceuticals, and finance, as well as increasingly in skill-intensive manufacturing. Its young population, and the growing share of the population in the labor force, will surely prove an asset in the years to come. But its growth and success stories of the past 25 years mask two areas of serious concern.

Too few jobs

First, India is not creating enough jobs. The conventional wisdom is that the path to creating jobs is through East Asian–style, labor-intensive growth. The conventional wisdom is a recipe for direction—to identify the priority sectors, protect them from competition, and throw resources at them, for example, so that they can upgrade technology.

But could the path lie elsewhere? For instance, it may be easier for India to build on its strengths and develop a strong and well-paid export sector in finance, business processes, IT, and other skill-intensive industries than to foster export-oriented labor-intensive manufacturing. Domestic demand–led growth, including through providing services to these well-paid employees—that is, jobs in restaurants, hotels, tourism, construction, and retail—may be India's idiosyncratic path to development.

I am not implying that labor-intensive manufacturing is unlikely to be the answer, only that the enabling government would not latch onto a particular solution as the answer. Instead, it would ask what prevents a vibrant private sector from creating jobs in such a labor-abundant country and then go on a war footing to remove the constraints.

Much of the blame for the lack of job growth lies with archaic labor laws that protect a few at the expense of the many, creating the paradox of a poor country with excess unskilled labor specializing in skill- and capital-intensive sectors. If an industrialist knows that every time he hires, he hires for life, he simply is not willing to take a chance. He would rather forgo expansion unless he is absolutely certain of continued demand. And, indeed, when he expands, he would rather rely on machines, or more easily fired skilled workers. The result? Recently, Bajaj Auto opened a new factory with virtually no unskilled workers: why bother dealing with unions and the labor they represent?

But changing labor laws is not just a matter of statutory change. Social justice demands that workers have redress against arbitrary dismissal—indeed, if they have no such redress, they will seek it through extralegal means. Job flexibility is much less unattractive for workers when they know they have rapid and low-cost access to courts that can protect them against arbitrary termination. In the absence of a well-functioning judicial system, is it any wonder that workers prefer a prohibition against firing?

And, clearly, workers will resist change unless there is a minimum safety net that holds them above water when they lose jobs and helps them find new jobs. It is the government's role to create such a safety net, a net that protects individuals, not firms.

In sum, achieving true labor market flexibility, while creating a fairer, more growth-friendly environment for all workers—and not just the minority who are currently in the organized sector—will require systemic change. Let me now turn to other proximate causes for slow job growth.

Labor market flexibility will not compensate fully for poor infrastructure. In the highly internationally traded industries that typically hire unskilled labor, margins are very thin. Because poor infrastructure increases costs—if it takes 10 days to load cargo, that is 10 days more that inventory has to be carried on the books—low-margin, labor-intensive industries may continue to be uncompetitive in India unless infrastructure improves. Similarly, value-added agricultural production will also remain a pipe dream. Improved infrastructure will allow greater access to markets and, thus, to jobs, and is an essential ingredient for job growth.

Another reason for low unskilled employment may be that all available labor is not of the right quality. Workers who haven't had adequate nutrition or health care are more prone to illness and are therefore less productive. Better health care and universal primary education are necessary complements to labor market reform and improving infrastructure.

Here again, a directive government would focus only on resources. It should instead ask why, on any given day in a government school, 25 percent of teachers are playing truant, only 45 percent of teachers are teaching, the poor are willing to pay hundreds of rupees a month for a private school while avoiding the free government school, and private school teachers show up to teach as often as government school teachers even though they earn only one-eighth to one-fourth the salary. While resources are part of the answer, the government must also focus on how to improve incentives—to enable, which means, for example, confronting powerful teachers' organizations.

Also, even though the excessive past government funding of tertiary education was an aberration, industry and services have specialized in such a way as to need a steady input of qualified students. As India redresses its previous neglect of primary education, it needs to multiply institutions like the Indian Institutes of Technology and regional engineering colleges, on which its current success is based. This does not mean opening more government-aided institutions. Instead, it means enabling, by encouraging more entry by private and foreign institutions while maintaining standards through a transparent system of accreditation. Unfortunately, in India, higher education continues to be one of the last bastions of the "license-permit raj," where entry continues to be restricted and government regulations strangulate. This has to change.

Rising inequality

My second, and related, concern is rising inequality between rural and urban areas, fast-growing and slow-growing states, forward castes and backward castes. Before the economy was liberalized in the 1980s, states and communities grew at the same inefficient and sedate pace. With a more market-driven economy, economic disparities have naturally increased, bringing to the fore the concerns of those who have political power but little economic power.

These tensions result in greater fear of, and antipathy toward, market-oriented reforms, as well as a variety of demands—from populous but lagging states for a greater share of the tax revenue, from obsolete firms for subsidies to invest in new technologies, and from disadvantaged groups for more quotas in colleges and jobs in private sector firms, to name just a few. The reaction of a directive government is to give in to demands—but that is only a temporary populist solution, though it has the advantage of good optics and of being immediate. The deeper problem is that these demands will only increase in an unbounded way unless the root cause of inequality is tackled. And that is unequal access to education, to health care, to finance, to markets, and even to justice—in short, unequal access to opportunity. Inequality creates a desire to level the playing field down by mandating outcomes or socialism. That is the easy option and one that India has tried before. The best counter is to level the playing field up by expanding access to opportunity, and this is indeed a role for an enabling government.

Mindset change needed

Why is government in India so directive? I can offer only conjectures. Perhaps it is a result of India's colonial government viewing its citizens as untrustworthy children, to be minded and provided for, and the "brown sahibs" that followed, inheriting this mindset of government as mai-baap (mother and father). Or perhaps it is because the Soviet economy was the exemplar of development when India obtained independence. Whatever the historical reason, a directive government generates constituencies that want it to be directive, a society that sees government as distributing resources rather than as enabling, a society that Anne Krueger famously referred to as the rent-seeking society.

Even as some parts of Indian society have changed to embrace a market economy, large parts have not, which is why the nature and mindset of much of Indian government has not changed. Indeed, as democracy becomes ingrained in Indian society, government is becoming of the people, in that people vote to install it. In its early days, Indian politics was dominated by a few elite groups, but this is changing, so government is becoming by the people. What is less widespread is the belief that the purpose of government is to expand opportunity for all—government for the people. Instead, the purpose of capturing government is to direct its benevolence and its purse toward one's own community or group. First the elite did it; now it is the turn of the others.

Let me offer two examples of how this focus on special interests is still affecting policy in India. Consider the large fiscal deficit, which interferes with much-needed public investment. The deficit is bloated by misdirected subsidies, of which those for gasoline are the most recent egregious example. Who consumes gasoline? Largely the rich and the vocal middle class; the poor consume kerosene, which remains heavily subsidized. If subsidies for gasoline have to continue, how will they be paid for, given the limits to the fiscal deficit? By cutting back on the much-needed public investment that would benefit all. Even though key government figures recognize the costs of these subsidies, it is all too easy for politicians to accuse those who favor withdrawing them of being anti-poor. The public, it would appear, simply doesn't do the full calculus and understand that gasoline subsidies are truly anti-poor. Or segments of the public understand too well the nature of Indian polity—that it is still about rents rather than public investment—and would prefer that they capture the subsidies rather than give them up to someone else.

Consider next a laudable recent scheme to create export promotion zones where firms will have an environment, including infrastructure, that will allow them to be internationally competitive. This is indeed praiseworthy. Yet even here interest groups are pushing for tax holidays, which are being supported by some segments of government. Not only will such holidays make the government forgo revenue it can ill afford to lose, they also offer firms an incentive to shift existing production to the new zones at substantial cost to society. Of course, the government says that only new investment will benefit, but who is to judge what new investment is? The poorly paid tax inspector? And will firms not also shift all investment that would have taken place outside the zones to the new zones, thus depriving the government of revenues? India must absorb the lessons of its own past: if you create perverse economic incentives and then rely on bureaucrats to stand in the way of businesses exploiting those incentives, the outcome will be little more investment than would otherwise have happened and a lot less revenue, but much richer bureaucrats.

How will India change?

Let me conclude with lessons I draw from India's highly regulated past. First, India's past policies relating to science and education, no matter how distorted, gave it capabilities in skilled manufacturing and in services, where its comparative advantage now lies. India should not sacrifice this advantage in a blind attempt to follow the East Asian path of unskilled, labor-intensive manufacturing. In particular, it should remove distortions that hold back its areas of strength: the overregulated higher education system and the sclerotic legal system. But it also needs to remove the disincentives for the creation of unskilled jobs, not just by getting rid of archaic job protections while building a genuine safety net for all workers but also by improving infrastructure, especially in laggard states and rural areas so that they connect better to the larger economy.

Second, the government can't simply legislate outcomes or achieve them by offering resources or subsidies, especially as the economy becomes more market-oriented. Indeed, such direction can be counterproductive. What the government intends and what materializes can be very different because of the way people react to policy. The government must focus instead on getting the environment right and thereby spread opportunity.

Third, the government, by and large, will not refocus in a vacuum. I do not believe that there will be a revolutionary change in government attitudes because Indian society is not ready for it. Instead, I see a more evolutionary change: as more and more people in India obtain access to, and see opportunity in, the market economy, they will press for a more enabling government, and Indian democracy will respond. The sooner this happens though—and reformers in government can play a role in expanding access—the better it will be for India: better governance and wider opportunity—rather than turning back from market-oriented reforms—will be the way to social justice and a more prosperous, fairer India.