If you have no credibility, try tax sops

Updated: Sep 30 2006, 05:30am hrs
It is difficult to fault the Prime Minister's exhortation to the chief ministers of the northern states to focus on better administration, top class infrastructure and human capital to foster growth rather than tax sops and MoUs to attract industry. The question is why our chief ministers continue to take the sop route and what could they do otherwise.

One answer lies in our history of the Licence Raj when development was handing largesse to a select group, who were given the opportunity to participate in Indias industrialisation, much like a sharecropper is chosen by a landlord. Only today, the shoe is on the other foot. Landlords have much land for tilling but few sharecroppers willing to till. Hence the MoUs, which still preserve the illusion of largesse. Focusing on administration, infrastructure and people be akin to fertilising the soil and waiting for the seeds to sprout spontaneously, not a skill learnt by our leaders in those days.

Another answer can be found in the Prime Minister's closing statements on governance. A key characteristics of well-governed states is credibility, Sadly, a commodity in short supply. If an entrepreneur is promised better infrastructure, well-trained workers and freedom from inspector-raj, she is likely to look askance, given that the track record of delivering on these promises is dismal. In contrast, states have not usually gone back on their pledges of tax concessions, even after changes in government. Tax-sops are among the few credible instruments left.

Credible yes, but fatal; for this is indeed a vicious spiral to the bottom, as tax concessions prevent resources from being raised that can be invested in running a race to the topin providing physical and human infrastructure and administration that is more efficient.

The only redeeming feature is that tax concessions can only go so far. Take for example a garment factory. Of every hundred rupees of value, two-thirds is raw material, a fifth is spent on items like wages and infrastructure services and the rest is split between the profit and other overheads. If a state manages to reduce the cost of power to its industry, it can provide much more benefit than if it waives taxes. If states can show that they can turn the power sector around, as some southern states, and even Delhi, have done, they will be much more attractive to investors than by offering tax sops.

What else could the states do to begin this virtuous spiral For a start, they could focus more on maintenance of their existing infrastructure. If all state power plants were maintained like NTPC plants, power shortages would be much less. The same holds true for their water and sewerage treatment plants, electricity distribution networks, and potholed roads. All of these can benefit from performance based operation and maintenance contracts. They could use 'PPP', not for raising moneythat comes from user fees or taxesbut for making the private sector more answerable, by combining construction and maintenance contracts and linking payment to performance. This will stop shoddy works contracts from being executed in collusion with corrupt officials.

It is possible to reverse this vicious spiral, with a big effort by states to embrace migration and engender credibility in their governance, and a big leap of faith on part of industry
They could begin by opening up their education systems such that the private sector can provide meaningful vocational training and supporting initiatives in these areas. Punjab has recently brought private participation into some ITIs and this is an experiment well worth trying out in other states.

However, states can only do so much. It is time too that the Centre looked at itself. A single tax is indeed an ideal situation, but with multiple responsibilities for implementation, it becomes necessary to evolve rules for allocation, which is the role of the Finance Commission. Yet, the past trend in central transfers to the states has been to reduce the transfers through the Finance Commission and increase the share of ad-hoc transfers through centrally sponsored schemes.

Similarly, as the importance of urban areas increase, they must emerge as independent polities with the financial capability to take their own decisions. In this it is even more important that the state finance commissions emerge as established authorities, which they have yet to do. It is fallacious to think that urban growth can be managed at the state or national level, especially for large states. And yet, in the Centre's approach to urban development, the JNNURM, another centrally sponsored scheme, is rapidly emerging as a scheme for funding projects in cities, without much impact on the nature of urban governance or sustainability of the urban fisc.

Finally, it is important for us as a nation to recognise that growth is not a rising tide that will lift all regional boats. As in developed countries, some regions will become growth centres and others will barely industrialise. But, for such development to reach more people, we must learn to live with much more migration than has been seen in the past. Over our last census period, only 20 million people moved from urban to rural areas. The corresponding figure in China was a 140 million, a staggering seven times more. This is an inevitable part of development and can be managed, as China and even Tamil Nadu have shown.

Moving away from tax sops requires states to embrace migration and engender more credibility in their governance. The lack of credibility that the northern states have built up over the years, today condemns them to sink deeper in the same morass. It is possible to reverse this, but it will take a big effort on the part of the states and a equally big leap of faith on the part of industry for this spiral to be broken.

The writer is senior fellow, Centre for Policy Research. He was formerly with IDFC. These are his personal views