Reforms work best when there’s trust

After coming to power in 2014, the BJP government has launched a slew of reforms. Notably, the GST subsumed 17 different indirect taxes and held promise of converting the entire country into a single free trade zone with no barriers to free movement of goods and services. The Insolvency and Bankruptcy Code was enacted to find quick resolution to the chronic NPA problem of public sector banks.

The government has brought corporate tax rates down to 15 per cent for new domestic manufacturing companies; and has further liberalised the rules for foreign direct investment. Much more recently, it has enacted new laws for freeing farmers from cartels operating in mandis functioning under the AMPC (Agricultural Produce Market Committee) Act. It has also consolidated a plethora of labour laws into four codes; and, more controversially, the nation has progressed from a rank of 142 to 63 in the World Bank’s Ease of Doing Business rankings.

Will these measures translate into a higher growth and standards of living? Our recent economic history provides some answers.

The year 1991 taught the government that reckless borrowing could not finance India’s economic growth without the country risking bankruptcy. So even as its very limited gold reserves were airlifted to the vaults of Bank of England, it hesitantly abolished industrial licensing; stabilised its fiscal deficit; encouraged the entry of non- debt creating foreign capital (basically FDI) into the country; and later in the decade, reduced import tariffs, and relaxed international trade restrictions.

By the end of the 1980s, the ten year annual average rate of economic growth — in GDP terms — had already climbed to 5.8 per cent. After the reforms carried out in the 1990s, this figure improved slightly to about 6.1 per cent by the close FY 02.

Throughout the 1990s the critics of the reforms had a field day, pointing out the futility of the exercise. In the next five years, however, the situation changed quite dramatically — the rate of growth rose to 8.1 per cent; and India emerged as one of the two fastest growing economies in the world.

One important lesson we learn from this episode is that when a country launches reforms, it must stay the course to get results. Economic reforms, it appears, do help in accelerating growth. A rising tide, observed John F Kennedy, lifts all boats. Between FY 06 and FY 16, 271 million people were lifted above the poverty line, explains a UNDP report of 2019.

No immediate benefits

But the benefits may not accrue immediately. In the short run, growth may be disrupted by ephemeral causes that may outweigh the effect of the reforms: bad monsoons (in FY 15 and FY 16), flawed implementation of a reform scheme (introduction of GST in 2016), a public health emergency (Covid-19 in FY 20), etc. The benefits of these reforms kick in only in the medium to long term.

There is one way, however, a nation can better realise higher growth potential from each reform more quickly; and that is by creating trust. Reforms will yield much better outcomes if a society runs on the basis of trust. This may be because trust in society tends to reduce opposition to, and suspicion of, reforms.

It also creates conditions necessary for social and economic institutions to blossom, writes the Japanese intellectual Francis Fukiyama. It is impossible, he writes, to separate a country’s economic life from its cultural and social life. The roots of economic success or failure often lie in the latter. And so it is with economic reforms.

In India, transaction costs are very high because of lack of trust or social capital. How many times do we think before we give a loan. This lack of social capital permeates relationships between citizens, government and its officials, officials themselves, the Central and State governments, and indeed between the government and the citizenry.

Lack of trust breeds suspicions and generates complex laws; the latter result in poor implementation of policies, corruption, low levels of compliance with legal and social obligations, and ultimately, lower growth.

The underlying structure of a successful reform consists of two parts: there is a technical component — finding out what is required? Most governments get this right. The income-tax department has successfully harnessed technology for mass processing of returns and issue of refunds. More recently, it has modified processes to usher in faceless assessments and appeals. But this is really the easier part of any reform. The more difficult part is creating trust in society.

Fortunately, there is a solution here as well, albeit a long-term one. Our fiscal history appears to suggest that the government has only gained when it trusts citizens. Till the end of the 1960s, the I-T department would scrutinise every return of income filed with it; currently it does not even scrutinise 1 per cent of the returns.

All available evidence, however, appears to indicate that, over the decades, tax collections, both in absolute terms and as a percentage of GDP, have soared. But the huge backlog of cases pending before various appellate forums and the courts appears to indicate that a huge trust deficit still exists.

In 2014, the government allowed citizens to attest their personal documents instead of finding gazetted officials to do this; there has been no increase in frauds, as consequence, of this reform. The secret is: trust, but verify, if only at random.

The writer was Chief Commissioner of Income-tax