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Another Year, Another Development Formula from the World Bank

Arvind Panagariya

 Entitled "Equity and Development," the World Development Report (WDR)2006 of the World Bank is a great leap backward in development thinking. Ignoring the lessons of 50 years of experience, it advocates bringing equity to the centre stage of development-policy making.

The report is not oblivious to the fact that virtually all agree that the central goal of development policy should be to tackle poverty, not inequity.

That would be impossible since the slogan “Our dream is a world free of poverty” is prominently displayed on virtually all walls of the opulent World Bank building. But the report contends that the pursuit of equity speeds up the elimination of poverty. “Equity enhances the power of growth to reduce poverty,” says the press release launching the report.

It is an elementary point that greater equity does not guarantee less poverty even holding the total national income constant. Take one billion dollars away from Narayana Murthy and distribute it equally among 1,000 existing millionaires. You will get greater equity but not less poverty.
 Indeed, given the prospect that as a billionaire Murthy is likely to engage in greater philanthropy than the 1,000 millionaires, the redistribution may reduce the potential for future poverty reduction.

But let me concede that for a given national income, a more equitable distribution would yield greater poverty reduction. The critical question then is whether once you adopt equity as an objective or an active instrument of poverty reduction, the policies that sustain high rates of growth of national income would themselves be sustained. In asking this question, we must distinguish between policies targeting poverty directly that were the subject matter of the WDR 2000/2001 and those targeting income distribution on which WDR 2006 focuses.

Anyone well versed in the history of policy making in India would get chills at the thought of targeting income distribution. Virtually all anti-growth and anti-poor policies India has been dismantling for the last two decades have their origins in the pursuit of equity.

Thus, the desire to establish a socialistic pattern of society was at the heart of the dominant role the Indian policy makers gave to the public sector in the industry. The same desire also contributed to the control of private sector through industrial licensing.
 And when the liberal foreign investment policy and relatively relaxed investment and import licensing regime in the 1950s led to rapid growth of private industry and the emergence of several large industrial houses, it was once again the concern for equity, viewed as an instrument of poverty eradication (remember the slogan garibi hatao?), that led Indira Gandhi to erect the massive regulatory structure that even 20 years of reforms have not been able to entirely demolish.

To cap the concentration of economic power in the industry, Gandhi confined all future investments of undertakings with more than Rs 20 crore ($27 milion) invested in land, building and machinery to a narrow list of 19 “core” industries. At the other extreme, she reserved many labour-intensive products for the exclusive production by small-scale units — entities with investment in machinery and plant not exceeding Rs 750,000 ($100,000).

Considerations that large banks did not adequately lend to the smaller enterprises or open rural branches led Gandhi to nationalise them. She also restricted foreign equity in an enterprise to 40%. Undertakings with 100 or more workers were denied the right to fire the latter. The acquisition of vacant land in the great cities by households and firms was limited to just 500 square metres. Marginal income-tax rates at even modest incomes were set at 95%.
 The WDR makes no serious attempt to underline the hazards of the preoccupation with equity to which the Indian experience points. Instead, it notes in passing that the ‘history of the twentieth century is littered with examples of ill-designed policies pursued in the name of equity that seriously harmed — rather than spurred — growth,’ and proceeds to sing the song of complementarity among equity, growth and poverty reduction.

It makes no attempt to confront the question whether politics would allow the government to selectively choose those equity-oriented policies that promote growth and reduce poverty or force its hand in the opposite direction. There may be a good reason why history is what it is.
 The WDR also comes short on analytic sharpness. In support of the view that equity and efficiency go together, in chapter 5, it argues that the relaxation of credit constraints faced by small entrepreneurs may result in the realisation of huge returns. As an example, it cites a study by distinguished economists Abhijit Banerjee and Esther Duflo. In 1998, India changed the investment limit defining small-scale units from Rs 65 lakh to Rs 3 crore. This change qualified the firms with investments between Rs 65 lakh and Rs 3 crore to access the priority-sector lending available to small-scale units.
 Banerjee and Duflo estimate that the resulting increment in the availability of working capital allowed these firms to reap a rate of return of 94%! While interesting in itself, the finding raises at least two questions. First, at rates of returns of 94%, why do the banks not lend to these firms even absent priority sector lending requirement?

And why do large firms not invest their retained earnings and households their savings in them either? Are all agents in the economy credit constrained? If yes, this points to a fundamental problem with financial intermediation. If not, how can we be sure that returns in other activities are not even higher?

Second, if the extension of priority sector lending leads these enterprises to receive extra credit at the cost of even smaller enterprises, the impact of the change is to increase, not reduce equity. Recall the objective behind the original restriction on priority sector lending to units below Rs 65 lakh in investment was precisely to promote equity. The WDR does not even raise these questions, let alone grapple with them.

Economic Times October 19, 2005