There is now growing evidence that the quality of the business environment is the determining factor that pulls investment into a country rather than fiscal incentives. Considering that all state governments are today seeking rapid inflows of private investment, both foreign and domestic, to generate and stimulate growth, they need to take a close look at what determines location preferences of investors. All evidence suggests a move away from fiscal incentives towards designing a public expenditure policy to improve the business climate.
For a long time since independence, our planners focused on motivating industry to locate in backward areas by granting tax concessions. This was thought to be the best way for industrialising backward areas, generate new jobs and reduce regional inequalities. We all know that this policy has been a dismal failure. Tax incentives failed to produce any serious industrialisation and backward areas such as in the northern and eastern parts of the country continue to lag behind western and southern parts of the country.
Likewise, the tendency of state governments in the recent past to compete with each other in offering tax incentives at the cost of revenue have also failed to motivate investors to move to areas where infrastructure and the supporting facilities needed by business have been found wanting. A recent survey of what motivates foreign investors to choose a country as a business destination by McKinsey & Company provides useful evidence in this context. The McKinsey study finds that government policies that seek to attract foreign investment by offering tax and import duty concessions and subsidies on factors such as land and power have failed to achieve their desired objective.
In contrast, what have successfully motivated investors to choose one country over another are the quality of manpower, infrastructure facilities, accessibility and the size of the domestic market. Similarly, other studies have pointed to quality of life indices such as the quality of cities, schooling and recreational facilities etc.
An example relevant for India and all state governments is the set of reasons that made Ford Motor Co chose Tamilnadu and not other states in India as a location for its manufacturing operations. Though the state government did offer financial incentives and land subsidy to lure the company, these came low down on the company?s list of priorities. The three factors that clinched the issue were availability of quality infrastructure including linkages to a port, a supplier base and skilled manpower. One can safely guess that the company must have also assessed the suitability of Chennai as a city for its executives while making their choice. Not surprisingly, most foreign company executives interviewed by McKinsey say that they would be happier if governments invested the money offered to them as incentives into infrastructure.
This finding is critical for state governments as what they do now would play a critical role in sustaining India?s growth trajectory. Secondly, reforms that pull in private investment to all sectors including agriculture would determine the pace of growth of the local economies. Here, a substantial step-up in public investment in infrastructure such as roads, water supply, links with ports and airports, and urban facilities would be required. This is precisely the reason why a vigorous urban reform agenda has become the need of the hour, as poor quality of cities remains one of the major weaknesses of India?s investment environment.
In addition, states must re-examine their HRD policies. They would have to invest not just in primary and secondary education but also in vocational education to improve the quality of human resources that can attract private investors. Indeed, quality of manpower is proving to be India?s greatest strength, and investments in this area would have the highest spin-off.
In all these areas, even while states increase their allocation of public funds, they would have to redefine laws to create a suitable environment for public-private partnerships. Put differently, while in some areas like education, highways, urban facilities, private investment would supplement public effort, in others such as ports, airports and power, it would be the other way round as private investment can take the lead. Radical fiscal reform to remove revenue deficits and increase public investment, together with creation of an enabling environment for public-private partnerships, would provide the mix for sustaining a surge in investment and growth.
The author is an advisor to Ficci. Views expressed herein are personal