#186 Of Magnitude and Littleness*

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While excellent newsletters on specific themes within public policy already exist, this thought letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways.

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Sep 18

#186 Of Magnitude and Littleness*

Fiscal Centralisation, The Economic Opportunity, and Competitive Federalism

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		Pranay Kotasthane

India Policy Watch #1: The Anatomy of Decentralisation

Insights on topical policy issues in India

— Pranay Kotasthane

The human-made floods in some parts of Bengaluru generated much furore. Writing about it in our previous edition, RSJ remarked:

The way the political economy is structured right now, it is difficult to see how there will be enough devolution of power and finances to a city. A big city most often is a bankrupt political orphan in India. It doesn’t look like changing any time soon.

I share his anguish. However, I remain hopeful because there are many global examples of cities first committing themselves to and then rescuing themselves from the tyranny of half-hearted decentralisation.

Decentralisation: Take 1

The term decentralisation is a catch-all term in public policy. There was a time when it was touted as the solution to all ills. But many PhD dissertations, journal papers, and World Bank projects later, we understand it better now. Throwing some light on this concept can help us put a finger on what’s exactly wrong with Indian cities.

Let’s begin by understanding the three forms of decentralisation — deconcentration, delegation, and devolution. Deconcentration is the simplest form of decentralisation. As the name suggests, it means decentralising functions and responsibilities. For example, if you can submit a passport application in Mysuru instead of having to come to the state capital, this function can be said to have been deconcentrated. The various government branch offices and grievance centre kiosks are examples of deconcentration.

Delegation means that specific functions are carried out by another organisation or the government nearest to the citizen on behalf of the more distant government. In the Indian case, the plethora of state public sector enterprises (SPSEs) for public transport, power distribution, and water distribution are examples of delegation. For example, BESCOM is a Government of Karnataka company tasked with the responsibility of supplying electricity to the state capital.

Devolution is the most comprehensive form of decentralisation. Devolved units hold defined spheres of autonomous action. Policy implementation and authority shift to the government nearer to the citizen. This typically means having elections at the subnational level. For example, Indian states are devolved units with clearly defined responsibilities, and tax revenue handles in the Constitution.

With these definitions at hand, we have one way to diagnose the dismal performance of our city governments: the Union-State government relationship is characterised by devolution, while the State-local government relation is characterised by delegation and deconcentration.

Elections do take place at local government levels. After the 74th Amendment in 1992, some more functions were devolved to urban local bodies. And yet, they hardly enjoy autonomy and authority in any defined sphere. State governments tightly control resources, personnel and plans, treating local governments as deconcentrated implementing agencies.

Decentralisation: Take 2

There’s another way to see the Indian experience in light of decentralisation theories. Decentralisation can happen along three dimensions — political, administrative, and fiscal. These dimensions are further characterised by four factors: authority, autonomy, accountability, and capacity. The USAID Democratic Decentralisation Programming Handbook has a helpful framework that combines these three dimensions and four characteristics. In the chart below, here’s how I think India’s urban governments fare on the twelve parameters at their intersection.

Adapted from The *USAID Democratic Decentralisation Programming Handbook*

My crude classification into three categories is subjective and based on my understanding of local government public finances. Even so, this framework can offer valuable insights into India’s urban governments. First, they are characterised by poor capacity across all three dimensions of decentralisation. Hardly surprising. But here’s something more interesting: urban governments in India do pretty okay on administrative decentralisation, not so well along the political dimension, but score a big zero on the fiscal dimension.

Devesh Kapur writes, “At the heart of state-building is a fiscal story”. And so, it’s not unexpected that the sorry state of fiscal decentralisation is a powerful reason behind the abject failure of our urban governments.

The Way Ahead

And so, to fix our cities, we need energy and focus on improving along the fiscal decentralisation dimension. And how exactly do we get there? In this talk below, organised by the Bengaluru Navanirmana Party, I propose a few ideas for the Bengaluru government:

“Wherever possible, charge”: underpricing leads to overconsumption. Cities ought to get better at generating non-tax revenues.
Strengthen the State Finance Commissions. It’s amazing how bad they are, despite the example of the stellar performance of Union Finance Commissions. Untied grants through the state finance commissions are imperative for devolving critical political and administrative functions to urban local governments.
Rent out property owned by city governments.
Simplify laws for regulating businesses in the city so that trade license fees can go up.
Capitalise on the property tax potential.

India Policy Watch #2: This Moment is Precious

Insights on topical policy issues in India

— RSJ

The more perceptive among you, dear readers, might have espied a certain pattern in my posts over the past six months. On the one hand, my tone has been steadily bullish on the medium-term prospects of the Indian economy. Almost four months back, in edition #168, I concluded that the then-nascent Ukraine war and the inflation roiling the developed world have put India in a sweet spot among global economies. I wrote:

“I’m not often optimistic on these pages. But the way the stars have aligned themselves, India does have an opportunity to revive its economy in a manner that can sustain itself for long.”

Then in edition #182 (Aisa Mauka Phir Kahan Milega?), I sort of doubled down on this:

“For India, all of this is a golden opportunity. China will remain busy with these transitions that it has wrought upon itself. The jury is still out on whether it will have a soft landing on them. Global businesses that started seeking more resilient and cost-effective alternatives to China during COVID-19, are now convinced that they must employ a ‘China + 1’ model to safeguard their long-term interests. There are only that many economies that have the labour pool, capital and a business environment that can take advantage of this shift away from China, however gradual.
There is a high likelihood of a golden decade ahead for MSMEs in India if it plays its cards right.”

In the past couple of weeks, there has been a flurry of reports from global research firms echoing the same sentiments. IMF, usually the last to know what’s happening around the world, also seems to have cottoned on to this trend. This week its chief Kristalina Georgieva said that “despite global uncertainty and headwinds, India continues to be a bright spot in the global economy.”

The proximate reasons are evident all around. Domestic demand is strong, inflation isn’t the runaway kind, the bank balance sheets are stronger and cleaner than ever, and we seem to be seeing off the peak of the commodity cycle.

The other large emerging markets have their own troubles. South America is in the throes of one of its ‘how to shoot yourselves in the foot’ scenarios. Brazil is going through its most fractious election campaign ever, with the hard-left rhetoric of Lula seemingly ahead of Bolsonaro. That’s been enough for Bolsonaro to again take a leaf out of Trump’s playbook and raise doubts about the integrity of the electoral process. Venezuela has a Hugo Chavez bhakt running against a populist ‘outsider’ who wants to upend the system and start fresh. Turkey has an autocrat who turns macroeconomic theory on its head in running its economy. South Africa is muddling through, and Russia is mostly an international pariah at the moment. Indonesia and smaller economies like Vietnam and Laos are possibly the only emerging markets that can claim to be in a similar zone as India. There’s no competition, really.

On the other hand, I have called out India’s remarkable ability to lose its way because of either overconfidence or distracting itself with a ‘zero return’ nationalist agenda of aatmanirbharta or some random ‘One Country - One X’ ideology. Like I wrote in edition #182:

“…not overdoing aatmanirbhar Bharat beyond the rhetoric and remaining an open and liberal democracy that convinces others that it will have sufficient checks and balances to not lose its way. These are the basic block and tackle moves to capitalise on the opportunity.
Because the only lesson to learn from a possible China misstep is that overdetermined leadership and top-down economic thinking eventually fail.”

It becomes challenging to plan for India's long-term prospects because of this dichotomy of being bullish on its economy while being worried about social harmony. I mean, one day, you applaud the entrepreneurial spirit taking root in small-town India and the other day, you hear another state enacting some love jihad law.

It is like that E. B. White quote:

“I arise in the morning torn between a desire to improve the world and a desire to savour the world. This makes it hard to plan the day.”

Anyway, for the sceptics on either side, I will try to go beyond the evidence that people are good at avoiding. There are structural reasons why both these arguments about India hold.

Let’s tackle the issue of why India is in this sweet spot.

Firstly, in the past few years, there’s been a retreat from globalisation, or hyper globalisation , as Dani Rodrik would put it. This was somewhat inevitable if you go by Rodrik’s trilemma: it is impossible to enjoy the fruits of integrating with a hyper-globalised economy, national sovereignty and being a democracy simultaneously, because only two of these things can be achieved at any one time. Rodrik believes that eventually, most large economies will choose national sovereignty and democracy and retreat from globalisation. This has come to a pass all over the world now. India, which has always been somewhat ambivalent about globalisation, now finds it doesn’t stick out because of this stance. This retreat has meant that any economy with a large domestic market is at a relative advantage. Through a fortuitous mix of demographic dividend and periodic fiscal stimulation, domestic demand in India is going strong. This will attract capital flow into the economy.

Secondly, the widespread adoption of digital means for production and distribution has meant the traditional constraints of infrastructure and labour laws aren’t as binding as before. The national digital infrastructure in India (JAM, FASTag, UPI, etc.) is among the best in the world, and there’s evidence now that they are improving domestic efficiencies across multiple sectors. Even surface transport, railways and ports have improved substantially in the last few years. These are nowhere near world-class, but the improvement is sufficient to reduce service costs across industries. Also, while ‘retail’ corruption remains an issue in India, even the most prominent critic of the current government will admit that large-scale institutional corruption is a thing of the past. There are allegations of crony capitalism which might come back to bite in future, but for now, India provides as good a level playing field as any other emerging market.

Thirdly, the aftermath of the pandemic has been surprisingly benign for India. The extended credit scheme for small businesses, free food distributed through PDS for BPL families and the restrain shown in keeping the fiscal deficit in check appear to have paid off. The national-level vaccination drive has all but erased the memory of those traumatic days of the second wave. Contrast that with China’s botched vaccination policy that is still hurting its economy.

I will confess I didn’t see this scenario unfolding. Even the Ukraine war and the rise in oil price has been managed well. In continuing to buy oil from Russia (now in INR) and allying with the US on Quad, India seems to have manoeuvred the geopolitical storm well. Despite strong misgivings in some quarters (with good reasons), the key institutions (central bank, market regulators) have stayed objective and independent in their policy thinking. The bar on strong and independent institutions in emerging markets is set really low, and India seems to be scaling it easily.

Finally, the freedom to raise or issue debt in its own currency, the inflating away of debt that’s happening now and the flexibility of the labour market, all mean India isn’t in any near-term danger of stagflation that’s spooking the west.

Many of the above factors can be credited to the sound policy measures taken over the past two decades. And, there’s, of course, the good fortune of being in the right time at the right place.

All good.

So, why do I harp on the risks of social harmony and overdetermined leadership? Well, the history of many emerging countries is replete with such moments of opportunity in their history. Barring a few exceptions, most have failed to capitalise on them. They didn’t get their economics wrong. Most often, they failed on political and social fronts.

It turns out that being a functional, liberal democracy does improve your odds of getting this right. However, in most cases of failure, countries turned more illiberal, assuming it won’t hurt them. Curbing freedom of expression, compromising judicial integrity, restricting voting rights of minorities and abusing coercive power of the State are classic moves here. This is abetted by creating an ‘us’ versus ‘them’ construct that takes over everything. The blame for any shortcoming can be laid at the doors of ‘them’, who typically include the old elites, intellectuals and some hapless minorities. Once this template is set, the divisiveness in the society between ‘them’ and ‘us’ is played up at every opportunity. The pitch is queered further by the revisionist history project to redress past wrongs, the mindless glorification of the nation, a continuous search for enemies among the ‘them’ and escalating levels of punishment for any deviation from the norm. The middle continues to shrink, and debates and compromises become rare. Everything is maximal. Many people think these moves won’t hurt the economy because in markets, as the Indian aphorism goes, ‘paisa bolta hai (money talks)’. This is both a flawed understanding of economics and a complete disregard for history. A society that loses its middle ground makes terrible choices. And that shows up in the economy.

We have a tremendous economic opportunity because of the way cards have fallen in our favour. And we are making the classic mistakes in potentially fomenting social trouble and losing the opportunity again. I don’t understand why it is difficult to hold these two ideas together in our brains and find a way forward.

There’s a possibility that this dichotomy could be solved if there were public discussions on these issues together. But it is rare to find that kind of a platform where a dispassionate and constructive discussion about India’s future is possible. Those who believe in the ‘sweet spot’ thesis have very little inclination or a sense of historical perspective to appreciate the existential risks of social disharmony. They are happy nodding off to ‘this is India’s time’ lullaby. While the others who bemoan the loss of what’s often called the idea of India cannot believe India could be, by design or happenstance, sitting on a golden opportunity under this regime. There must be a catch somewhere and they spend inordinate amount of time looking for it.

It reflects the barren intellectual landscape prevalent in India that we cannot acknowledge and debate these in good faith. You can only be monotheistic. There can only be one truth. Those who reject it are enemies.

It’s a pity really.

India Policy Watch #3: The Nature of Competitive Federalism in India

Insights on topical policy issues in India

— Pranay Kotasthane

It’s rare for semiconductors, federalism, and favouritism to appear in the same story. But the last week did blow up a political storm that combined the three. Vedanta-Foxconn signed a much-publicised Memorandum of Understanding (MoU) for a display and semiconductor fab with the Government of Gujarat. All was good. but then came the news that the consortium turned down the Maharashtra government’s reportedly superior offer, leading to accusations of the Union government having a hand in favouring Gujarat.

Keeping regional and partisan politics aside, how should we parse this news? Are there frameworks to help us appreciate such events?

At first, it appears encouraging that states are vying to kick off advanced manufacturing. It seems to be a perfect illustration of the merits of what is known as Competitive Federalism. States compete for investments, woo investors, and the best one “wins” the prize. Didn’t the Prime Minister say in his independence day speech that "it is the need of the hour that besides cooperative federalism, we need cooperative competitive federalism. We need competition in development”?

To answer these questions, it is worthwhile to understand the “competitive federalism” rubric. This term gained prominence in public finance literature after a 1987 paper by Albert Breton titled Towards a Theory of Competitive Federalism. Crucially, he identified two preconditions for competitive federalism to be efficient.

The first condition is competitive equality. This condition is similar to the logic behind affirmative action for individuals from disadvantaged communities. Healthy competition between states requires not just good umpiring but also progressive rule-making, one that does not put some states at a permanent disadvantage. In Breton’s words:

“horizontal competition does not require that all competing units be of equal size any more than efficient competition in markets requires that firms be of equal size. But it must be that the large units are not in a position to continually dominate, coerce, and in other ways prevent the smaller units from making independent autonomous decisions; nor are they in a position to inflict "disproportionate" damage on them. The smaller units must be able to compete with the strong on an equal footing.
… A capacity to compete is more than a capacity to talk; it is also, and radically, a capacity to exert a real influence on decisions. That is the real meaning underlying the notion of "monitored" competition.”

Breton identified that the responsibility for ensuring competitive equality lies squarely with the union government. In his view, two monitoring mechanisms available with the central governments are: intergovernmental grants that offset the disadvantages of certain states, and a “Council of States” that can genuinely give “salience to the provincial dimensions of public policies”.

The second condition is cost-benefit appropriability. As Breton puts it:

“In competing to attract businesses to its jurisdiction, either by supplying particularly attractive local public goods, such as theatre, concerts, or dance, by offering tax advantages, or by buying part of the output of the sought-after enterprises, the government of a province should not be able to shift the burden of the offered amenities to the citizens of other jurisdictions.”

In other words, states should be regulated by a hard budget constraint, i.e. the consequences of breaching spending limits should be significant. A moral hazard develops if states assess that the central government will bail them out in case of fiscal failure. When the budget constraints on states are of a “soft” nature, they will continue to borrow or widen their deficits, confident that other state and union governments will come to the rescue. Competitive federalism under such conditions would not be efficient.

A third precondition, proposed by M Govinda Rao, is that there should be no impediments to the unrestricted mobility of factors and products across the country.

This discussion of competitive federalism suggests that not all competitive federalism is good. It needs guardrails to deliver results. And the Indian experience with competitive federalism has been suboptimal as governments have violated all three preconditions to varying degrees.

As a result, we are stuck in a low-level equilibrium. States compete, but on issues such as wasteful subsidies on private goods, welfare schemes, and salary structures for government employees. And when they do compete to attract investments, they do so based on spectacular tax and non-tax waivers rather than on promises of better business and law and order environments.

To make India’s competitive federalism deliver, we need reforms along three dimensions:

Reforms to ensure that states face a hard budget constraint. An independent fiscal council that ex-ante evaluates the costs of government proposals can help. Consider the fact that both Maharashtra and Gujarat allegedly promised subsidies worth Rs 40000 crores and Rs 28000 crores, respectively, without public scrutiny of the costs and benefits of the project. An independent fiscal council would come of use here by conducting an independent financial evaluation of such policies before they receive the final approval. A stricter Fiscal Responsibility and Budget Management Act can also help here.
Reforms to improve competitive equality. Designing intergovernmental transfers that actually help bridge the gap between states will create a level playing field. Moreover, an institution that allows states and union governments to bargain and negotiate, like the one proposed by the 14th Finance Commission, might also contain unhealthy competition.
And most importantly, a union government that acts as an unbiased umpire is crucial for competitive federalism to succeed.

Without some reforms along these lines, we will continue to see competitive federalism of the more harmful kind.

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HomeWork

Reading and listening recommendations on public policy matters

[Article] Raghuram Rajan’s note questioning the underlying assumptions of Production Linked Incentives.
[Paper] Fiscal Decentralisation in Indian Federalism by M Govinda Rao explains India’s experience with fiscal devolution.
[Report] The USAID Democratic Decentralisation Programming Handbook is a fantastic starting point for understanding decentralisation.

* From Alexis De Tocqueville’s magisterial Democracy in America, in which he writes: “the federal system was created with the intention of combining the different advantages which result from the magnitude and the littleness of nations; and a glance at the United States of America discovers the advantages which they have derived from its adoption”.