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Inequality or interest-group politics?

Arvind Panagariya

Professor Pranab Bardhan of the University of California at Berkeley has  recently resurrected inequality as the key explanation for the impasse on  the reforms (Financial Times, August 8, 2006). He rightly argues that the recent claims of greater equality in India are in  error since they compare the consumption inequality in India with income  inequality in other countries. Because the rich save proportionately more  than the poor, measures of consumption inequality are lower than of income  inequality, biasing the comparisons in favour of India.

For consistency, Prof Bardhan compares wealth inequality for which  comparable cross-country data are available. For the year 2002, the Gini  indices of wealth inequality in rural and urban India at 0.63 and 0.66  respectively turn out to be dramatically higher than the corresponding  figures of 0.39 and 0.47 in China.

The closer this index to 1, the greater is inequality. He goes on to link  this higher inequality in India to the current impasse in the reforms: "Does  it [inequality] matter for economic reform? I believe it does, because  social heterogeneity and economic inequality make it difficult to build  consensus and organise collective action towards long-term reform and  co-operative problem-solving."

Taking the evidence on inequality at face value, is this claim right? At  least as a general proposition, the link between inequality and the ability  to implement reforms is highly tenuous. Thus, in 1991, India launched a  process of wholesale reforms that sustained for 15 years.

If inequality was a key factor obstructing the reforms in the prior years,  we should have seen a precipitous decline in it in 1991. Likewise, the  current impasse should have been preceded by a significant increase in  inequality. Yet, there is no evidence that such changes in inequality  happened.

Indeed, given how slowly inequality evolves, it will be astonishing if such  evidence were found. Furthermore, with its inequality so much higher than of  China, how did India manage to undertake such massive reforms during the  last 15 years?

After all, India has gone from near autarky in industrial goods to near free  trade; massively opened to foreign investment; put a complete end to the  draconian licensing regime; undertaken ambitious domestic tax reform;  achieved very substantial financial sector liberalisation; accomplished  dramatic changes in the telecommunications policy; and even made modest  progress towards privatisation.

Therefore, a link between inequality and reforms at the general level is  untenable. A more limited claim may be that some reforms are feasible even  in highly unequal societies but not others. Specifically, the reforms  already completed by India were feasible in the face of high inequality but  not the ones currently on the agenda.

To be sure, none of the past reforms ranging from trade liberalisation to  the end to the state monopoly in telecommunications was a cakewalk. In each  case, the government had to persuade the groups that feared losing from the  reform that their interests would be protected.

Gradualism in the reform was partly intended to give these groups time to  adjust to the new opportunities but also to demonstrate to them that their  interests would indeed be protected. Sustained growth and poverty reduction  that accompanied the reforms helped lay to rest the fears of the groups  newly exposed to competition and make the change irreversible.

This said, based on the struggle we witness today, it is perhaps true that  the current reforms are more contentious than the past ones. The critical  question, however, is whether inequality is at the heart of it. If yes,  given the known inability of democratic governments to change inequality in  a short time, the future of the Indian reforms would seem to be bleak.

Luckily, as I argue immediately below, it is the collective action theory,  pioneered by the late Professor Mancur Olson, rather than inequality that  explains better the past reforms and current impasse. The vast majority of  the past reforms including trade liberalisation, de-licensing and opening to  foreign investment involved changes that cut across many sectors.

This produced winners and losers that were spread over many sectors. In  turn, this made it difficult for the losers to organise against the change.  Moreover, the incremental nature of the change made the cost of mounting  opposition higher than the potential benefit from it. Most importantly, once  these groups found out that the incremental policy change had not been  detrimental to their interests, the next instalment of the reforms became  that much easier.

But reform is politically much harder when it applies to a specific sector.  In such cases, the likely losers are concentrated and can rally behind a  common cause. This was the case, for example, when the telecom reform posed  a threat to the monopoly of the Department of Telecommunications (DoT).

DoT employees quickly railed against the proposed change. Had the government  been less determined, the reform would have been shelved. Instead, the  government persisted, chose to address the concerns of DoT workers, and  eventually carried the day. Ex post, the reform produced few losers.

Privatisation faces an even more uphill battle since it must proceed  enterprise by enterprise. Privatisation of each enterprise brings the  opposition from its existing employees. If the government is determined and  skilful, it finds ways to compensate them and bring them on board as was  done, for example, in the case of Balco. If not, it shelves the reform as  happened recently in the case of Nalco and Neyveli Lignite Corporation.

Interest group politics can readily derail reforms that promise to promote  equality. Take the labour market reform. Most reasonable policy analysts  agree that greater labour-market flexibility in the organised sector would  lead to much needed expansion of the large-scale, unskilled-labour-intensive  industry.

In turn, this would bring a larger proportion of the labour force into  high-wage organised-sector, reducing both poverty and inequality. Yet, the  inability of the government to negotiate an acceptable package with the  existing organised-sector labour holds back the reform..

Economic Times August 23 2006

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