San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley


The Economic System of India

Before the last decade, the 1990's, India was probably on the short list of almost every economist outside of India of the countries with the worst economic systems. India had and probably still has a parasitical class of politicians and bureaucrats that micromanage the economy in the interests of their class. They hypocritically aver that they are doing what they are doing in the interest of the people of India. There has been some official allegiance to socialism with a goal of achieving it through Stalinist central planning. The fact that the result has been some horrible mixture of state capitalism and moribund corporatism is usually attributed to incompetence and ineptitude on the part of the bureaucracy. The Indian American economist Jagdish Baghwati of Columbia University remarked that he agreed with the view that "India's misfortune was to have brilliant economists: an affliction that the Far Eastern super-performers were spared." The policies implemented by the Government of India before the last decade were brilliant only in maintaining the power and influence of the bureaucrats. Judged with respect to an promoting the welfare of the Indian people those policies were ridiculously bad, to the point of stupidity.

The bureaucracy has been rather competent in generating excuses for the failure of their policies. One of those exceuses has been that there is a Hindu rate of growth that is significantly lower than the rate of growth that other countries could achieve. What the bureacrats dare not say is that in maintaining a pool of economic rents the bureaucrats' policies were an outstanding success.

The disappointing economic progress in India up to 1990 cannot be attributed to any shortcoming in talent among the Indian people or the impediments resulting from Indian cultures. Indians out from under the oppression of the bureaucracy of the Indian Government have succeeded spectacularly in professions and business.

Probably the misguidance of India development can be attributed to India's first prime minister, Jawarharlal Nehru. Nehru chose the goal of economic self-sufficiency with economic development to be achieved by central planning modeled on that of the Soviet Union. By cutting off imports India gave a protected market to domestic producers. India got domestic production but it was production of low quality, obsolete products. The policies stifled economic growth and India, with its high level of population and poverty, could ill afford low rates of economic growth.

The two makes of automobiles produced in India, copied from models of the British Austin and Hillman of the 1950's, remained unchanged for more than forty years.

The planning and adminstration of the economic did not emerge full blown. The first five year plan (1951-55) called for the planned development of only a few industries, the ones that private industry had not developed for one reason or another. In the first five year plan the other industries were left to the market.

The second five year plan (1956-1961), the product of P.C. Mahalanobis' work, was more inteventionist. It tried to implement the elements of British socialism and combine them with the tenets of Mahatma Gandhi. It sought to eliminate the importation of consumer goods, particularly luxuries, by means of high tariffs and low quotas or banning some items altogether. The large enterprises in seventeen industries were nationalized. License were required for starting new companies, for producing new products or expanding production capacities. This is when India got its License Raj, the bureaucratic control over the economy. Not only did the Indian Government require businesses get bureaucratic approval for expanding productive capacity, busineeses had to have bureaucratic approval for laying off workers and for shutting down. When a business was losing money the Government would prevent them from shutting down and to keep the business going would provide assistance and subsidies. When a business was hopeless an owner might take away, illegally, all the equipment that could be moved and disappear themselves. In such cases the Government would try to keep the business functioning by means of subsidies to the employees. One can imagine how chaotic and unproductive a business would be under such conditions.

Government planning also involved requiring businesses to produce in particular areas, usually economically backward areas. It also might require the production of certain goods such as cheap cloth for the poor.

The Indian Economic Plans had to be financed and this often meant taking resources away from agriculture and giving them to pet industries that were not viable on there own. Ultimately this meant starving agriculture to feed inefficient industries the Government favored. Such a program was not likely to alleviate poverty and so in 1971, under Nehru's daughter, Indira Gandhi, the Government tried to eliminate poverty by promoting small, labor intensive enterprises.

The net effect of the Government programs was to take away resources from agriculture in the countryside to give it to favored businesses in the cities. When the effects on agriculture and the countryside became significant the plan added programs to help the countryside (labor intensive small businesses) and programs to aid agriculture such as a fertilizer subsidy. These programs to help agriculture and the countryside generally came from resources which the Government took away from agriculture and the countryside. The fertilizer subsidy may have been of greater benefit to the wealthier farmers than to the poorer farmers.

India's output did grow but not as much as did that of other countries in the region. The Government of India generally takes credit for growth, but when India's performance is compared to that of other countries one sees that the Government's contribution to growth was negative. The followi shows the magnitude of the shortfall in growth that India's oppressive system is responsible for.

Comparative Growth Rates
of Developing Economies
Average Annual Rates 1960-88
South Korea15.212.68.810.1
Hong Kong10.
Sri Lanka5.
* - 1970-1980
Source: The Economist May 4, 1991, Survey page 7

With the top performers achieving a growth rate of industrial production of about ten percent while India achieved a growth rate of only at most about five percent the cost of the License Raj to India's growth rate was about five percent, or half the rate of growth.

One of the most wonderful things to happen to the world was the genetic development of high-yielding grain varieties, the Green Revolution. This development probably put an end to famine from natural causes. Between 1970 and 1989 agricultural production in India did grow but the rate of increase was only 2.1 percent per year whereas over the same per period the annual rates of growth of farm output in Indonesia, Malaysia, the Philippines and Thailand were 3.7%, 4.7%, 3.6% and 4.5%, respectively. Again the cost of the License Raj to growth in India was about half the rate of growth. The cost of the License Raj more importantly is in the slower pace of alleviating poverty.

The License Raj in Action

The success pattern of development in Taiwan and other nations of Asia has involved cultivating export industries. In the case of Taiwan the first export industries were associated with agriculture, such as processing sugar cane into sugar. Later light manufacturing emerged as economically viable. Generally the labor force for manufacturing came from the surplus labor force in agriculture, often this was young women from the countryside who moved to the cities to work in the factories. Economically this was a transfer of labor from agriculture where labor productivity was to low to higher productivity occupations in manufacturing.

The products that could be successfully produced by the emerging manufacturing sector in Asian countries was often not technologically sophisticated or prestigous. For example, one of the early successful export products of South Korea was wigs made from human hair. But the successes in the low tech products led to successes in more tehnically sophisticated products. One thing that emerged out of the experiences of Japan, South Korea, Taiwan, Hong Kong and Singapore is that it is difficult to develop successful export industries without also importing products.

In contrast, India virtually shut off imports with high tariffs, low quotas and outright banning. The structure of India's wall against trade is shown below:

Consumer Goods
Consumer Goods
Essential (Medicines)
Capital Goods
PermittedCertification of Being Essential
Indigenous Angle Clearance
Capital Goods
Open General License
PermittedNo License Required
Intermediate Goods
Intermediate Goods
License Required
Intermediate Goods
Limited Permissible
License Required
Intermediate Goods
Open General License
No License Required

In addition to rules concerning the imported goods there are rules based upon the nature of the importer. Imports are to be brought in only by the actual user where is subject to bureaucratic definition. The Economist cites the case in which vehicle tires cannot be imported by bus or trucking companies because only vehicle manufacturers are deemed actual users. Some products whose importation is scheduled for reduction can only be imported by certain government agencies called canalizing agencies. In 1988 40 percent of India's imports were of this canalized variety. Another 12 percent were in the category of restricted, 32 percent were limited permissible and only 16 percent fell into the category of Open General License.

Completely separate from the matter of the regulations on imports is the matter of tariffs. That is to say, even if the importation of a product is approved the tariff might be prohibitive. India in 1985 had the highest level of tariffs in the world, as is shown in the following table.

Nominal Tariff Rates of Various Countries
As Percentage of Value, 1985
Source: World Bank, cited in The Economist May 4, 1991, Survey page 9

The end result is that India in 1988 had the lowest ratio of imports to GDP of any country in the Asia and consequently also had a comparably low ratio of exports to GDP. It is not impossible to expand exports without having a corresponding expansion in imports but it is as a practical matter difficult to do so. India's government, however, decided in the late 1980's to try to promote exports without loosening its restrictions on imports. The system is a typical Indian bureaucratic monstrosity. Exporters in India are given Import Replenishment Licenses which can be used to buy imports. Profits on exports were made exempt from the corporate profit tax. Because the loopholes created for export industries could be used to avoid the taxes and restrictions on other parts of the economy there are numerous rules and regulation to prevent the specieal rules for exporters from being abused.

The Effect of Protection on Enterprises and Industries

There are some very interesting comparisons to be made between the protected industries and the ones that are not protected. The following table compiles the comparisons.

Comparison of High Protection and Low Protection
Manufacturing Industries in India, 1986
 High ProtectionLow Protection
Number of Sectors2130
Share of Labor Employed18.5%77.7%
Share of Value Added39.0%54.9%
Share of Capital Employed53.243.1
Capital per Worker92,500 rupees17,800 rupees
Average Wage15830 rupees9360 rupees
Energy Consumption1.93 MWHr1.13 MWHr

The notable differences between the high protection and low protection industries is that the average wage rate is almost 70 percent (69%) higher under high protection. One consequence of the higher wage rates is greater capital intensity in the high protection industries and that did occur. The capital/labor ratio in the high protection industries is 5.2 times that in the low protection industries. As a result the high tech industries, which produce 39 percent of the value-added only employ 18.5 percent of the labor force. The protection system promoted the substitution capital for labor in a country which has an abundant surplus of labor.

Public-Sector Enterprises

In addition to over-regulating the private sector the Government of India has created socialist enterprises directly. The Government nationalized heavy industry (the commanding heights of the economy) and built new state-owned enterprises, SOE's. The evidence that SOE's were inefficient was abundantly clear before the bureaucracy created their new ones. These SOE's are generally more costly to build than privately built plants. In the case of steel plants the SOE's cost 30 to 40 percent more. The excess capital cost should be met out of the return on the capital for the plant but that is not likely to occur since, according to a study by the Bureau of Industrial Costs and Prices, the average rate of return on capital in SOE's is just 1.5 percent. The management problems that afflict most SOE's are:

Sometimes the management problems of SOE's are the fault of the operating managers but often supervising authorities impose unreasonable policies on the SOE's. For example, the Government authorities require electrical generating plants supply power to farmers at a price of zero and to households at a price insufficient for the coverage of costs. The operating deficit for the electrical utilities has to covered by a government subsidy, which is funded by a tax on economically viable enterprises.

India which has woefully inadequate production for its population set up a system in which any action to expand production, beit opening a new plant, moving existing operations to a new location or even expanding production in an old plant, required a license. In the early 1980's the License Raj rejected 50 to 60 percent of the application, most commonly on the basis that there was adequate existing capacity. What this really means is the existing producers did not want to face additional competition and give up their monopolistic control of their markets. The existing producers also discovered the strategy of applying for such licenses to thwart potential competitors from getting licenses. So of the 40 to 50 percent of the license applications that were approved some portion represented spurious application so, in effect, the rejection rate of legitimate applications was higher than 50 to 60 percent. There was a tendency for the License Raj to restrict successful firms from growing. Perhaps this is out of fear that small firms will grow to be large firms. There is a definite ideological opposition to large firms within the Indian planning establishment.

Large firms in certain industries, called core industries, have to abide by the Monopolies and Restrictive Trade Practices Act, (MRTP). Despite the name the effect of the MRTP tends to restrict competition and protect the monopoly of the firms which are already in an industry. The worst monopolies are state monopolies and the MRTP does not apply to them and nothing restricts their practices.

The Government of India has a policy of reserving certain products for "small" companies. In the late 1970's there were 800 products reserved for such companies. A small company was defined as one having plant and equipment of value less than a specified figure. Although such companies were small compared to the giants of industries the amount of wealth involved in the ownership of such companies was large compared to the average wealth of the general population of India. The Lincense Raj provided protection for a class of quite well-to-do Indians, a class ideally suited to dealing with and sharing rents with the members of the License Raj.

The Economist characterized the overall system as follows:

In combination with the industrial-licensing regime [the small company policy] has given India the worst of both worlds: too many small and inefficient companies at the bottom, too many large and monopolistic ones at the top.

The Government of India also has a policy of encouraging firms to locate in economically backward areas. These areas with high unemployed and underemployed labor are not lower cost sites for businesses because the union rules on wages prohibit these areas from competing with the prosperous areas on the basis of labor costs. Thus in these backward areas the wage costs are the same and the transportation costs are higher.

On top of all the other detrimental eeconmic policies India has price controls for many goods. Generally the control prices are set by a formula of cost plus a markup. The cost plus formulation means that firms in the affected industries not only have no incentive to keep costs down they have an incentive to increase costs.

Firms cannot in the matter of labor costs reduce their costs by laying off workers. To do so requires government permission and financial hardship of the firm is not a proper justification. As would be expected, India with this multitude of wrong-headed economic policies has a problem of failed firms. When a firm becomes bankrupt it cannot without permission legally go out of business. The Government tries to keep such failed firms running, sometimes giving subsidies and requiring the state bank to grant loans. The owners of such failed firms may illegally take those assets of the firm which are movable and disappear. But even the disappearance of a company owner may not result in the shutdown of the firm. The Government tries to keep such zombie firms operating under the management of the employees.

Since the net effect of Indian Government policies are negative and upwards of two thirds of the economy is in agriculture the policies are a terrible tax on the poor. Rather than abandon the policies the government and bureaucracy added another layer of policies to try to ameliorate the impact of the other policies. The Government created irrigation projects and fertilizer subsidies for agriculture. In addition there is a roadbuilding program for the rural areas. The bureaucracy also created a system of transfer payments for the rural poor which in its typically obfuscating fashinon called rural development.

In the support of the Indian Government for education the class interest of the government and bureaucracy can be clearly seen. The level of education which is most generously supported is higher education rather than elementary education. But it is generally the children of the well-to-do who attend colleges and universities. Thus the support of higher education is, in effect, a subsidy for the well-to-do families. It is a transfer of income from the poor to the middle and upper classes, the classes which dominate the governement and bureaucracy.

Economic Reforms of Rajiv Gandhi

Rajiv Gandhi was the oldest son of Indira Gandhi, but he did not enter politics until after his younger brother Sanjay was killed in an airplane accident. Sanjay had entered politics as an advisor to his mother, Indira Gandhi. After his mother's assassination in 1984 Rajiv inherited the political mantle of his grandfather Jawarharlal Nehru and the leadership of the Congress Party.

Rajiv came into power as the Prime Minister of India in 1984. He was somewhat of an outsider, his first interests had been in engineering and aeronautics. He was not impressed with the excuses of the bureaucratic establishment. He said,

A poor country cannot afford to carry on billing the poorest people for its inefficiency and call itself socialist.

Rajiv called for a tax reform which cut the income and corporate tax rates. As a result of the lower tax rates tax evasion was reduced and the lower tax rates brought in 40 percent more revenue.

He reduced the restrictions on the economy. He modified definitions so that the limitation imposed by "small company" policy were lessened. Some industries were removed from coverage by the MRTP Act. He created broadbanding in the matter of licensing. Broadbanding meant that a license for version of a product would serve to allow production of a closely related version of the same product rather than requiring a new license for the new version.

Rajiv Gandhi's reforms were considered outside of India as mild and timid adjustments but to the License Raj they were a threat to their hegemony and considered audaciously radical. Mild and timid though they were they brought results. India began to experience some semblance of a surge in production. Unfortunately Rajiv Gandhi was assassinated in 1991 by a suicide bomber representing Tamil extremism.

Infrastructure Policy of India

The rural areas of India need many things but what they get is ill designed programs that they themselves have to finance.

The biggest program is irrigation. The program is beneficial but the management of the irrigation programs is rife with corruption. Successful candidates for administrative positions in the irrigation programs spend many times the amount of the salaries they receive to get these positions. This make sense only because of the opportunities to obtain bribes. Yet the irrigation systems often operate at a loss because the charges are too low. The picture that emerges is inefficient, subsidized operations in which users can be assured of getting the product only if they bribe the administrators.

Many areas need more roads or better roads. Under self-sufficiency communication and transportation to other regions is not essential. But self-sufficiency usually means a primitive, Dark Ages life. Economic improvement requires trade and specialization and this means roads.

The Government maintains a fertilizer subsidy for the rural areas but this is again another program where the result is far different from the purpose. The purpose was to aid the poor but the allocation of the subsidized fertilizer is subject to the discretion of administrators. This presents opportunities to divert the fertilizer into unintended uses, such as to the farms of more well-to-do.

A similar program is the one to sell food to the rural poor at subsidized prices. Again this can lead to theft or diversion and hence the benefit accrues to people other than the poor.

The Economist notes that the spending of India for education is disdirected. More emphasis is placed on secondary and higher educaion than on primary (elementary) education. Thus India is subsidizing the wealthier families who are more able to finance their own educational need. This seems a case of the bureaucratic class taking care of their own interests.

Economic Reform in India As Of 1995

Regional Economies of India

Although the states of central India; Madhya Pradesh, Rajasthan, and Maharashtra; have the largest land area it is the states of eastern India, Uttar Pradesh and Bihar, that have the largest populations. It is also these eastern states that have the lowest literacy rates, the highest birth rates and the highest death rates. Five states that were poor in 1961; Manipur, Bihar, Orissa, Tripura and Uttar Pradesh; remained poor in 1991. Madhya Pradesh, poor in 1961, moved up significantly in relative income by 1991. Dehli is the richest state, having a percapita income more than double the average of the rest. Five above-average-income states in 1961; Maharashtra, Punjab, Gujarat, Tamil Nadu and Haryana; remained above average in 1991. West Bengal, above average in 1961, fell below the average. Some of the above-average-income states are industrial; i.e., Delhi, Gujarat, Maharashtra and Tamil Nadu; but two, Haryana and Punjab, are primarily agricultural.

There is a weak indication that the poorer states are growing faster than the richer states and thus there will be a convergence of incomes levels. The evidence is not overwhelming that this is true, but if so the rate of convergence is quite slow. The estimate is that it takes about a half century for a state to make up half the difference between its income and the national average. This convergence, if it occurs, comes from such mechanisms as the diffusion of capital from states where there is a lower marginal productivity of capital to ones where it is higher. Some convergence may come from net capital transfers by the central government from the richer states to the poorer. Convergence could also come from migration, but this may not occur if it is the more prosperous in the poorer states who move to the richer states. Generally; the states to the east in India and the city of Calcutta are poorer. The states to the west and the city of Bombay are wealthier. Bombay is the industrial and commercial power house of India. Delhi is a special case. Its economic prosperity stems from being the seat of national government and its bureaucracy. Businesses locate near Delhi because there is a definite advantage being close to the agencies that set regulation, issue licenses and disperse government contracts.

Madras is an important economy in the south and Bangalore, once primarily a resort, has become the center of India's high tech, computer-oriented information technology industry.

Reference: Paul Cashin and Ratna Sahay, "Regional Economic Growth and Convergence in India," Finance and Development, March, 1996, pp. 49 -52.

The GDP of India

For the economic histories of other countries click here.

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