Does politics drive economics or vice versa? In an insightful analysis, Mohan argues that politics does drive economics in India, especially as elections approach. Mohan shows how two important economic policy initiatives of the current coalitional government, involving tax reform and privatization, have stalled because of the political need to satisfy powerful interest groups.

Dr. Vinay Bharat-Ram, one of India’s leading industrialists, recently stated that although the economy drives the political agenda in the United States, the opposite is true for emerging economies such as India. Instead, in India politics drives the economy.[i] As India’s current coalitional government led by the Bharatiya Janata Party (BJP) comes to the close of its five-year term, India’s prospects for economic liberalization can be analyzed through a political lens.

At a time when elections for nine state governments are scheduled for 2003,[ii] followed by a national election in 2004, politics has already begun to cast a shadow on the BJP government’s agenda for economic reforms. The compulsions of the election cycle dictate the need to satisfy various interest groups that support the BJP-led government. The reform agenda is often the casualty, especially if it is perceived to harm these interest groups and adversely affect the electoral fortunes of the ruling party.

This article focuses on the fate of two important reforms that exemplify the dynamics of politics driving economics in India today. The first of these concerns the failed efforts to implement tax reforms scripted by the economic advisor to the Union finance minister, Dr. Vijay Kelkar, in the Union budget for 2003-04.[iii] Second is the BJP government’s faltering privatization agenda, which again illustrates how powerful interest groups – both within and outside the government – have succeeded in stalling important reforms.

Regarding tax reforms, BJP politicians worried about the impact on the party’s primary support base, the urban middle class. Kelkar's proposals called for the removal of tax exemptions for salary earners to build houses and invest in small savings schemes. In addition, tax reforms were proposed to tap the agricultural sector, which raised concerns among BJP’s allies in the coalition government who represent agrarian interests. One of them is Ajit Singh, the Union agricultural minister, whose support base is the prosperous farming belt in the western region of the state of Uttar Pradesh. Clearly pandering to his supporters, he stated that this was the “most impractical and ill-thought out proposal.” According to Singh, farming was not remunerative enough to be taxed, especially after the monsoon rains last year.[iv]

Politics is also dictating the fate of privatization. Prior to 1991, socialist-inspired economic development in India meant that vast swathes of industries were under government control. After 1991, however, there was a paradigm shift, which opened the economy to market forces and to the influence of the private sector as an engine of growth. This process entailed the gradual withdrawal of the government from the commanding heights of the economy. Efforts were begun to privatize state-owned public sector undertakings (PSUs), a legacy of government-sponsored industrialization since the 1950s.

Privatization is now most likely to be slow as the process enters a contested political terrain. A case in point involves two oil sector PSU majors, Hindustan Petroleum Corporation Limited (HPCL) and Bharat Petroleum Corporation Ltd. (BPCL), whose privatization plans face stiff opposition from interest groups. For example, unions vociferously oppose these sell-offs fearing widespread job losses. This type of political pressure signaled the end of a push for strategic sales of the PSUs, evident in a hiatus regarding HPCL and BPCL. The fate of these two companies exemplifies the challenges of big-ticket privatization.

Prime Minister Atal Behari Vajpayee himself indicated in an informal lunch with journalists that reforms which hurt the electoral prospects of the BJP will not be implemented: “Well, if political effects are there, we will not reform. We’ll not reform if there [is] a political cost to pay.”[v] This provides an indication of the mood at the highest levels of the BJP-led government, indicating that politics will lead the way in determining the reform agenda of the BJP-led coalition government.

One Step Forward, Two Steps Back

What were the origins of this “one step forward, two steps back” reform phenomenon? The defining moment came in April 2002, when the ruling party faced electoral reverses in the state assembly elections in Punjab, Uttar Pradesh and Uttaranchal, as well as municipal elections in Delhi.

The BJP was crestfallen after its electoral defeats. Uttar Pradesh is significant because it represents the Hindi-speaking heartland with the highest Parliamentary constituencies. Delhi is the BJP's traditional bastion of support, especially among people uprooted by the Partition of India in 1947 who streamed in from Pakistan. Losing in the municipal elections provided a clear sign that the ruling party was becoming steadily alienated from its traditional support base.

These electoral defeats provided the impetus for the BJP to reexamine its economic reform policies through an electoral lens. After witnessing electoral setbacks and the BJP’s response to them, social scientists may have had a sense of deja vu.

Going back in time, a similar fate clouded former Prime Minister Rajiv Gandhi’s half-hearted efforts to liberalize the economy after losing the Haryana elections in 1987.[vi] Rajiv had an overwhelming electoral mandate that swept him to power, but his halting and modest efforts at reform were impeded by resistance from powerful vested interests. Rajiv sought to liberalize imports of capital goods and machinery to improve the efficiency of Indian industry, but this was resisted by domestic manufacturers and organized labor, forcing Rajiv to retreat.

Economic reforms initiated by former Prime Minister Narasimha Rao also suffered after the Congress Party lost important assembly elections in Andhra Pradesh and Karnataka in 1994. Rao’s technocratic reforms had been driven by an IMF stabilization package, which recommended massive spending cuts by the government, besides a devaluation of the Indian rupee among other measures. The immediate crisis was an external one involving the building up of foreign exchange reserves through faster export growth. After 1994, Narasimha Rao took the middle path by drifting away from his earlier technocratic reforms.

Electoral setbacks weakened Rao’s effectiveness in implementing economic policy, although one might argue that communalism was more to blame than economics. The early 1990s was a formative time for Hindu fundamentalism at Ayodhya, and communal carnage along with the dramatic Mumbai bomb-blasts diverted the government’s attention away from economic issues. Moreover, Rao faced internal challenges to his leadership. Despite all this, electoral setbacks were perceived as a repudiation of reforms. While Rao remained publicly committed to reform, he could no longer provide political support to the process in practice.

These episodes underscore the electoral politics of liberalization. Party leadership both then and now blamed economic reform agendas for alienating their supporters during the elections. At the BJP national executive committee meeting held shortly after the electoral upsets in April 2002, leaders held the Union budget responsible for the alienation of middle class voters. The party’s mood has remained anti-reform since that time. Like in 1987 and 1994, the ruling party's stance on reform is best described as “one step forward, two steps back.” Bearing in mind this characterization, this article discusses below the two reform initiatives, Kelkar’s tax proposals and the BJP’s privatization efforts.

Momentary Autonomy

Why have economic reforms become politically problematic? I discuss this question elsewhere in a paper co-authored with Professor Ronald Herring entitled, “Economic Crisis, Momentary Autonomy and Policy Reform.”[vii] One reason is clear: in a democracy, state autonomy is always difficult to come by.

Perhaps the most striking period in which the BJP-led government enjoyed momentary autonomy to push through reforms occurred after the Pokhran nuclear blasts and the imposition of sanctions in 1998. But the government’s efforts in this direction, like opening up the insurance sector, faced intense opposition, including within the party itself. It is paradoxical indeed that when the BJP was most keen to reform, its efforts attracted tremendous opposition from its grassroots supporters and its trade union wing.

Given conflicting pressures, external sector reform – like lowering tariffs, facilitating convertibility, and encouraging foreign direct investment – has made considerable progress, while the domestic agenda remains subject to problems of implementation and intra-party opposition. On the question of labor reform, hire-and-fire policies are highly contentious, and the ruling party’s own trade union wing has taken to the streets protesting the move.[viii] The fate of the privatization and the Kelkar tax proposal further illustrates this problem, and these issues will be discussed below.

Did the BJP gain a momentary autonomy in December 2002 with its decisive triumph in the state elections in Gujarat? To a large extent, this victory was the result of polarizing the electorate on the divisive issue of religion. The significance of the Gujarat election for the BJP’s campaign strategy cannot be overemphasized. The election followed an outbreak of statewide violence by the majority Hindu population against the minority Muslim community after a group of Muslims was held responsible for burning a train compartment full of Hindus on the Sabarmati Express on February 27, 2002. In this context of highly charged communal sentiments among voters, the BJP swept the elections. At the time, party leaders speculated that a similar polarization in other states would pay similar electoral dividends.

The top leadership believes that its fundamentalist agenda must be kept alive in order to win various state elections this year and the national elections in 2004.[ix] Not surprisingly, fundamentalist issues, rather than economic ones, increasingly dominate the BJP’s agenda. The building of a Ram temple at Ayodhya (on the site where the BJP’s supporters razed a Muslim mosque in 1992) continues to be a strategy for maintaining the support of the Vishwa Hindu Parishad and other Hindu groups. Another example of this fundamentalist agenda is the current discussion in the national legislature concerning the slaughter of cows. With so many popular fundamentalist issues on the agenda, little room exists for less-provocative but more pressing reform issues.

Circumstances have shown that the BJP's autonomy after Gujarat was indeed momentary, if it occurred at all. The BJP’s strategy for replicating the Gujarat model of polarization received a setback in Himachal Pradesh in February 2003. The BJP lost the election despite a high-profile campaign in which Prime Minister Vajpayee along with the chief minister of Gujarat, Narendra Modi, appeared on behalf of its candidates. When the news of defeat arrived, the BJP leadership blamed in-fighting within the state’s party unit rather than its polarizing strategy.

A Scapegoat and a Scion

After initial electoral setbacks in April 2002, the BJP’s national executive committee found a scapegoat in the Union budget presented by the then-finance minister Yashwant Sinha. Policies intended to improve India's fiscal situation were believed to have alienated the middle class, which serves as an important political base for the BJP. The adverse impact of a lower interest rate regime on retired persons and the pruning of tax rebates on contractual savings were particularly blamed. A series of financial scams compounded the problem and engulfed mutual fund institutions like the Unit Trust of India.

The BJP leaders believed that Yashwant Sinha’s budget cost them the elections, and he was thus replaced by Jaswant Singh, the scion of a royal family in Rajasthan. Clearly indicating that he planned to improve the electoral fortunes of the ruling party, Singh pointed out that “food should reach the stomachs of the poor” and that there should be more money in the pockets of citizens and the purses of housewives in the country.[x] These welfarist objectives were reiterated in his recent Union budget for 2003-04.

Although the middle class represents an important electorate in urban India, no elections can be won without addressing the needs of the rural poor. Indeed, Singh's first budgetary announcement was a scheme to provide heavily subsidized food grains to an additional five million families living in poverty in villages. Rajasthan and Madhya Pradesh experienced severe drought conditions last year, and reports surfaced of starvation and hunger-related deaths in these locations even though the government had ample stocks of food grains. Because elections are due to be held in these states later this year, followed by a national election, the government is keen to ensure that deprivation-related issues will not damage its electoral prospects.

Clearly, politics drives the economics of Singh’s budget. In simple terms, his mandate is to see the party through to the five state elections remaining this year and the national elections in 2004. Under these circumstances, he will only do the bidding of the Prime Minister. If the latter is averse to implementing politically difficult reforms, so too is Singh. In fact, what he unveiled in his maiden budget for 2003-04 is a populist proposal whose thrust is largely pro-middle class in orientation, a move encouraged by Prime Minister Vajpayee.

In contrast to previous budgets, the one proposed by Singh assures the middle class that its interests are foremost on his party’s agenda. The budget reduces excise duties on a wide range of industrial goods to boost their demand, and the middle class is expected to benefit from cheaper cars, air-conditioners, bicycles, and imported liquor. In the new budget, Singh also provides tax rebates for the education of children along with pension schemes for the retired.

The finance minister’s budgetary strategy imparts a feel-good factor to the middle class and provides incentives for it to spend more. In terms of savings, Singh’s measures are designed to divert the middle class away from contractual savings to equity investments in the stock market. Accordingly, he exempts dividends and mutual funds having equity-oriented schemes from taxation, and capital gains tax has also been abolished.[xi]

With these electoral compulsions, the impetus to rein in the combined fiscal deficit of the central and state governments, which constitutes approximately 10 percent of the gross domestic product (GDP) and is crowding out resources for private investment, has petered out. This is especially unfortunate because the government’s borrowing requirements are enormous. Expenditures on interest payments, defense, subsidies, and salaries of its employees consistently outpace the government’s tax revenues. Interest payments alone account for 50 percent of the total government revenues.

Given his efforts to woo the middle class, Singh is constrained from pruning subsidies and wasteful expenditure. His effort to modestly trim fertilizer subsidies provoked an outcry from the BJP’s allies, which had less to do with the merits of the policy and more with pandering to the party’s electoral base. Meanwhile, there were strong protests in the Parliament with the Congress Party demanding a rollback. The opposition’s question is: why is Singh asking the farmers to pay more for fertilizers, when he has made available cheaper cars and other items of middle class consumption? Though Singh initially argued that the matter was non-negotiable, political pressure has forced him to back down on this budgetary move.

An alternative means to rectify the fiscal situation would be to raise revenues by broadening the tax base, but this is also problematic for political reasons. The agricultural sector which accounts for 25 percent of India’s GDP contributes next to nothing by way of revenues, because of the widespread opposition to any effort to tax it. Services represent the most important sector in the economy, accounting for 50 percent of the GDP, but contribute not more than 0.2 percent of the GDP in direct taxes. The fiscal situation cannot be set in order when sectors accounting for 75 percent of the nation’s GDP provide negligible direct tax revenues.

The imperatives of politics cast a long shadow over Singh’s maiden budget, which is replete with populist giveaways and welfarism. Singh’s objective is to ensure that food grains reach the needy and the middle class has more to spend.[xii] With a packed election schedule this year and in the next, the BJP simply cannot take the risk of alienating its traditional bastions of support. Nowhere have these compulsions been more evident than in the dilution of Kelkar’s tax proposals.

Kelkar Taskforce on Taxes

The far-reaching proposals of the Kelkar taskforce sought to simplify the existing tax structure and address longstanding oversights within it in order to mobilize additional tax revenues. Agriculture had never been sufficiently taxed due to state governments’ dependence on wealthy farmers for political support. Services likewise remained a largely untapped source, because the sector had not been significant enough to warrant attention when India became independent. The two most controversial aspects of the recommendations that emerged from the Kelkar taskforce involved the taxation of agriculture and the removal of all middle class tax exemptions.

Kelkar’s proposal advocated a system of tax rates according to income bracket.[xiii] This system exempted those with annual incomes up to Rs 100,000, which (at the rate of Rs 50 to a US dollar) is equivalent to approximately $2,000 and reflects a lower middle class standard of living in India. However, according to the proposal, those earning between Rs 100,000 and Rs 400,000 would pay taxes at a rate of 20 percent and those with Rs 400,000 plus incomes would pay 30 percent. In conjunction with simplified tax rates, the proposal entailed the removal of all exemptions, including tax breaks on housing and savings.

When these proposals were submitted to the government, they triggered a storm of protest from the BJP itself. With more state elections this year and national elections in the next, the party feared that Kelkar's proposals would constitute a political minefield among middle class voters. After the election losses in April 2002, the BJP was in no mood to take chances by implementing Kelkar’s report during the rest of its five-year term.

The budget of Finance Minister Jaswant Singh discarded many of Kelkar’s proposals that negatively impacted the middle class. In particular, Singh rejected the proposal to scrap all exemptions and retained most tax breaks, including those on housing and savings by senior citizens. Singh's budget is also silent on the most radical proposal, namely, to tax agricultural income. Given the intense opposition from the BJP allies, this idea has also been abandoned.

Politics thus has sealed the fate of Kelkar’s proposals on direct taxes. The government has cherry-picked only those suggestions which are uncontroversial, such as the simplification of the tax regime through the establishment of a fully computerized Tax Information Network. Given the need to satisfy its support base ahead of the elections, a valuable reform prospect has been wasted.

Stalled Drive to Privatize PSUs

Privatization of PSUs is another area in which political imperatives continue to bedevil a reform that potentially could have been the biggest achievement of the BJP-led government. As liberalization gained momentum in the early 1990s, successive governments offloaded small quantities of government-held shares in PSUs to bridge fiscal deficits. This action was termed disinvestment and was largely uncontroversial in nature, as control still remained very much in the hands of the government.

The BJP government, however, went much further and boldly embarked on privatization through strategic sales of the government’s stake in selected PSUs. In sharp contrast to the earlier sell-offs, strategic sales entail a transfer of management control. Not surprisingly, they attracted political lightning as no other reform did – especially from the Congress Party and the Left, which considered them to be comparable to selling the family silver and a reversal of the post-Independence strategy of state-sponsored industrialization.

Total central government holdings in PSUs have been pegged at Rs 785 billion, and the strategic sales since 1999 have offloaded only 1 percent of that total. Although the amount realized was only Rs 113 billion or 37 percent of the revenues raised through sell-offs since 1991,[xiv] the exercise has nevertheless ground to a halt. Due to vested interests getting in the way, only a diluted agenda can now be expected during the remaining term of the BJP-led government. To be sure, there will be some sale of minor PSUs, but the drive for big-ticket strategic sales has clearly stalled.

The credit for this bold reform, which awakened the moribund bourses, should be accorded to the dynamic Arun Shourie.[xv] The former crusading journalist turned technocrat-politician did what few others dared to do – he sold the government’s stake in the country’s passenger car giant Maruti Udyog Ltd. and the long-distance telecommunications monopoly, Videsh Sanchar Nigam Ltd., among numerous other PSUs. These were all sales in which management control passed on to the private buyer.

As noted earlier, the sale of the government’s stake in Hindustan Petroleum Corporation Ltd. (HPCL) and Bharat Petroleum Corporation Ltd. (BPCL) reached a perpetual gridlock on September 7, 2002, when the government decided to defer any decision over their privatization. Since that time, complications remain despite the meetings of the Cabinet Committee on Disinvestment (CCD), which is the official body empowered to take decisions on this matter. The privatization of HPCL has finally been approved, but matters will likely be delayed considerably due to the political interests at stake.

The Union cabinet still remains deeply divided over the move, especially when electoral considerations loom large. Both the finance minister Jaswant Singh and the defense minister George Fernandes remain hostile to Reliance Industries, India’s largest private sector company bidding for HPCL or BPCL. Their argument is that a public monopoly should not become a private monopoly.

Interestingly, even the Swadeshi Jagran Manch (SJM) supports this position. However, the SJM cannot really keep Reliance out of the bidding process.[xvi] Even if that could be done, given the organization’s antipathy for multinational corporations, it is unlikely that Royal Dutch Shell would be an appropriate substitute. At the other end of the spectrum are cabinet members, such as Petroleum Minister Ram Naik, who are loath to lose administrative control of PSUs. They oppose strategic sales, as these erode rent-seeking possibilities and patronage-client relationships with PSUs. This attitude is also seen in the Union civil aviation ministry, which has stalled the sale of the national flagship carriers, Air India and Indian Airlines.

The bureaucracy is a big source of opposition but attracts less attention. Approximately 90 percent of state-level PSUs are headed by civil servants belonging to the Indian Administrative Service, who are unenthusiastic about handing over control. State governments, too, are opposed to selling off profitable PSUs in their region, and this opposition will only intensify when elections loom on the horizon. The last but not the least important factor is organized labor. The trade unions are the biggest and most vocal sources of opposition to privatization, because they fear the loss of jobs.

None of these vested interests has so far relented on this issue, with the exception that the Union cabinet cleared the privatization of HPCL on January 26, 2003. With politics hijacking the BJP’s privatization agenda, doubts have surfaced over the time frame for the sale of HPCL and over the issue of whether or not public sector oil PSUs such as the Oil and Natural Gas Corporation and GAIL can participate. Arun Shourie does not favor their participation, but Ram Naik evidently does. The Union cabinet will thus have to deliberate on this issue on a case-by-case basis, factoring in political consequences as state and national elections draw nearer.

With two more years left in its term, the BJP-led government is under pressure to be politically pragmatic rather than reformist. Rather than promoting policies that might inflict short-term austerity yet garner long-term benefits, the government has adopted this “one step forward, two steps back” stance on liberalization, which panders to traditional support bases like the urban middle class through welfarism. Singh’s maiden budget clearly reflects these electoral imperatives.

Despite the setback in the Himachal Pradesh elections, fundamentalist issues continue to dominate the BJP's agenda for the remaining state elections this year and the national elections in 2004. Economic reform is bound to be a casualty of this strategy. The BJP is finally learning what Rajiv Gandhi did in 1987 and Narasimha Rao after 1994 with regard to the electoral compulsions of liberalization. A reform agenda remains in the shadow of politics.

Endnotes

[i] “Interdependence of Macro and Micro Economics in the Global Environment,” Public Lecture No. 1, Centre for Policy Research, New Delhi, November 11, 2002.

[ii] These states are Himachal Pradesh, Meghalaya, Mizoram, Nagaland, Tripura, Delhi, Chattisgarh, Madhya Pradesh and Rajasthan.

[iii] India is a federal polity comprised of various states. Union refers to the central government.

[iv] The Hindu, December 29, 2002.

[v] This lunch with editors on the occasion of National Press Day took place on November 16, 2002, and this quote was in response to a question posed by Ms. Aditi Phadnis, senior editor of The Business Standard.

[vi] See Atul Kohli, “Politics of Economic Liberalization in India,” World Development 17(3), 1989.

[vii] Amita Shastri and Jeyaratnam Wilson (eds.), Post-Colonial States of South Asia (Curzon Press, 2001).

[viii] Hire-and-fire policies did not exist prior to privatization thanks to the socialist ethos, but that will no doubt change when PSUs are turned over to private owners.

[ix] Four of these nine state elections have already been held in the states of Himachal Pradesh, Manipur, Meghalaya and Nagaland at the end of February 2003.

[x] The Hindu, July 4, 2002.

[xi] These are from budget documents available on the official website (www.finmin.nic.in).

[xii] Singh was candid enough to admit in the following way in response to a question as to whether politics or economics dictated his budget: “There is no year in India that is entirely free of elections. Can the job of a finance minister be solely dictated by economics? Is that possible? No, never. The finance minister has to arrive at a synthesis of the competing demands of politics and economics.” India Today, March 10, 2003.

[xiii] Towards this end, the taskforce adopted a variant of an idea proposed in the 1960s by the late eminent jurist Nani Palkhivala that pertained to giving a flat income of Rs 100,000 to parliamentarians or politicians. This was to be followed by removing all exemptions and perquisites that they enjoyed. This reform was designed to give parliamentarians and politicians a sense of the hardships in paying taxes at the highest marginal rates prevalent in that socialistic era.

[xiv] Privatization overview, www.divest.nic.in, which is the official website of the Ministry for Disinvestment.

[xv] Arun Shourie – the Union Minister for Disinvestment, Information Technology and Communications – is at the helm of this privatization effort but faces intense opposition from vested interests in government, including trade unions.

[xvi] The SJM is a member of a family of political organizations that support the BJP. It generally adopts a highly nationalistic stance on economic policies and favors keeping out foreign multinationals.