India’s economic pivot from rules-based reform to deals-based tinkering

This article, coauthored with

Shreyas’s Substack

was published in the latest issue of East Asian Forum Quarterly (Vol 16. No. 3, July - September 2024). We argue that over the last decade Indian policymakers are moving away from a rules based approach towards the long pending economic reforms, and instead have a deals based approach favoring a few sectors and firms. Ungated version reproduced below.

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India’s economic pivot from rules-based reform to deals-based tinkering

Prime Minister Narendra Modi’s first term saw India climb the Ease of Doing Business rankings. The country placed 63rd in 2019 and 2020, up 79 positions from 142nd when he took office in 2014. Government reports often cite these rankings as evidence of a pro-growth, pro-business and anti-corruption agenda.

Yet, The Economist’s 2023 Crony Capitalism Index tells a different story, estimating that wealth from crony capitalist sectors rose from about five per cent to eight per cent of GDP during the first two terms of the Modi-led National Democratic Alliance’s (NDA) government. This index ranks India 10th out of 43 countries, with Russia at the top spot and China at 23rd.

Has India embraced rules that ease business or rules that encourage cronyism and corruption?

India’s political economy in transition defies simple explanations based on rankings or anecdotes about corruption. The regulatory legacy of socialist times combined with reform challenges in a federal system complicates matters. Add to this an economic model of picking national champions in a system with high entry barriers and protectionism—cronyism inevitably follows.

These factors have led India to adopt, what Lant Pritchett, Kunal Sen and Eric Werker call, a deals-based economic approach rather than a rules-based one. While this has improved the business environment for some crucial sectors and firms, it has entrenched cronyism further.

The goods and services tax (GST), introduced in 2017, exemplifies this shift from a rules-based to deals-based approach. It was designed as a value-added tax that aimed to unify India’s fragmented tax landscape, replacing hundreds of state taxes and eliminating endemic corruption at state borders. This major reform required broad-based consensus and an amended constitutional compact between central and state governments working towards a single unified market. It suggested a commitment to market-oriented policies and economic liberalisation, continuing the reform trajectory initiated in 1991.

Initially designed with three rates and a plan to consolidate to a single rate, its implementation has strayed far from the promised ideal of a ‘good and simple tax’. The current GST system imposes seven non-zero rates, ranging from 0.25 per cent to 28 per cent. There are also 21 cesses ranging from one per cent to 204 per cent, as well as numerous exemptions. Rate disparities across sectors are stark and often regressive and arbitrary. Gold is taxed at three per cent, gemstones at 0.25 per cent while low-cost biscuits, a cheap calorie source for daily wage earners, carry an 18 per cent tax.

This complexity is exacerbated by frequent revisions—the GST Council altered rates for over 550 goods and services between 2017 and 2022. The frequent rate changes and sector-specific treatment have intensified lobbying, with industry groups pushing for favourable rates or complete exclusion from the system. This chaotic cronyism, characteristic of the government’s deals-based approach, subjects businesses to uncertainty over tax rates and production costs. The frequent tinkering with what should have been a broad-based consumption taxation system imposes high compliance costs and disproportionately burdens smaller businesses. With GST failing to deliver on both simplicity and revenue generation, even one of its architects, Arvind Subramanian, has buyer’s remorse.

But cronyism for large conglomerates goes beyond rates and cesses. When one of the NDA government’s national champions, the Adani Group, took over operations of the Jaipur, Ahmedabad and Lucknow airports from the Airports Authority of India in 2019–20, these transfers were GST-exempt, justified as transfers of ongoing businesses rather than new transactions.

Tinkering with the tax system is not just about raising revenues or favouring some firms and sectors—it also leaves more power in the hands of the bureaucratic and political class. India’s Supreme Court has upheld interpretations of the GST enforcement mechanism that allow tax and investigative agencies to make arrests based on a tax official’s ‘reason to believe’ tax evasion has occurred, without completing assessments. These offences carry prison sentences for executives. Businesses, especially those without political favour, operate under the ever-present threat of arrest and prosecution, not only for wilful evasion but for disputes arising from good faith interpretations of ambiguous and ever-changing GST regulations.

The 2023 inclusion of the Goods and Services Tax Network under The Prevention of Money Laundering Act’s (PMLA) information-sharing framework has escalated the potential for harassing businesses. Enacted in 2005, PMLA originally focused on combating the laundering of money aiding terrorism and drug trafficking. The law has undergone significant changes, particularly since 2014 under the NDA government. PMLA imposes harsher penalties and permits asset freezing and confiscation of suspected crime proceeds, with the potential to paralyse business operations pre-conviction in a judicial system that takes decades to conclude cases.

The 2023 inclusion doesn’t directly bring GST offences under PMLA but enables information exchange between the Goods and Services Tax Network and agencies like the Enforcement Directorate, which could transform routine tax matters into subjects of money laundering investigations. And given the gravity of charges under money laundering provisions, the threat of PMLA can easily be weaponised against businesses, especially those not currying favour with or those critical of the government.

This has given rise to a quid–pro–quo through the electoral bond scheme, introduced in 2018, which allowed anonymous political contributions through state-owned bank-issued bonds. Major companies have channelled billions through these bonds, effectively purchasing influence, securing regulatory and contractual favours and avoiding disfavour. The entire scheme, connecting business and political interests, remained a black box for six years as the Supreme Court delayed hearing the case and became complicit in institutionalising corruption and enabling undisclosed corporate influence over government decisions. In 2024, the Supreme Court belatedly found the scheme to be unconstitutional.

The subsequent mandated disclosure of political donations revealed the intricate connections between corporate largesse and governmental favour. Tracking the electoral bonds donated to political parties across all states suggests that such donations influence criminal investigations and government bids. Future Gaming, while under investigation by central agencies, saw some allegations dissipate after purchasing electoral bonds worth 13.68 billion rupees (US$163 million) between 2019 and 2024. Megha Engineering, facing scrutiny over the Kaleshwaram Lift Irrigation Scheme, secured the Thane–Borivali tunnel contract after purchasing 1.4 billion rupees (US$16.7 million) in electoral bonds in April 2023, a fraction of the 12 billion rupees (US$143 million) it spent on bond purchases between 2019 and 2023.

Others, outside the top three contributors, also benefited shortly after contributing through this scheme. The Vedanta Group received environmental clearances for oil drilling projects in Rajasthan. The Aditya Birla Group set up its alumina refinery in Odisha, while the RP-Sanjiv Goenka Group secured lucrative government contracts in the energy and infrastructure sectors.

The Adani Group’s rise typifies this system of preferential treatment. The group now controls 15 ports and terminals, representing 27 per cent of India’s total port capacity. In 2018, it secured contracts for all six major airports privatised by the government, as the government waived airport operations experience requirements and the cap on airports per bidder. While facing new money laundering and corruption charges over Mumbai airport operations, GVK Industries swiftly transferred the asset to the Adani Group, fuelling speculation about weaponising anti-money laundering laws to influence corporate transfers to national champions. Public sector banks settled 620 billion rupees (US$7.47 billion) in claims from ten distressed companies for 160 billion rupees (US$1.93 billion)—a 74 percent reduction in recoverable debt—when Adani acquired the companies.

Reliance Industries has similarly succeeded in securing favourable treatment, though with less public scrutiny than Adani, given the Ambani family’s rise in the public imagination since the 1970s. Reliance’s entry into the telecom sector through Jio in 2016 was marked by regulatory decisions, like the 2018 amendment that allowed Jio to maintain low prices while preventing competitors from matching them.

The ease of diversification for these conglomerates is notable. The defence sector, traditionally dominated by public sector undertakings, has seen rapid private sector inroads. Tata Advanced Systems secured a US$3 billion deal to manufacture military transport aircraft, while Adani Defence & Aerospace and Larsen & Toubro have rapidly accumulated defence contracts worth millions.

Some argue that this is the Indian version of the Asian growth model of choosing national champions. While parts of this playbook are reminiscent of the Asian model, East Asian countries also maintained low tariffs and embraced global trade. In those economies, winners and losers were picked through the feedback provided by global markets. But in India’s regulatory regime, with rising protectionism and regulatory favouritism, victors often ascend via political connections, instead of global competition.

Since 2016, the NDA government has embraced a more inward-looking stance, aligning with its ‘Make in India’ initiative. This encompassed reversing the trade liberalisation trend that began in 1991, through newproduction subsidies, tariff increases, and a reluctance to join multilateral trade agreements. Since 2014, around 3200 tariff increases have elevated the average rate from 13 to 18 per cent, placing India among the world’s highest tariff regimes.

Arvind Panagariya, Chairman of the 16th Finance Commission, has cautioned that increasing tariffs and frequently using anti-dumping measures risks isolating India from global supply chains and hindering its broader economic aspirations.

Rejecting the Regional Comprehensive Economic Partnership, the largest Asian trade treaty which could have integrated India into regional supply chains, has not been offset by effectively using other trade agreements. Pravin Krishna finds that India’s current bilateral trade agreements commonly include only modest tariff reductions implemented slowly over many years and impose complex rules about product origins, discouraging trade altogether.

The government has used these measures to shield domestic industries from ‘unfair competition’ favouring specific business interests over broader economic benefits. This high tariff regime has created inward-looking industries, with exports remaining a small fraction of total output, contrasting with more globally integrated economies like China and Mexico.

India aims to compete with China as a major electronics manufacturer. But in 2018, India raised mobile phone import duties from 15 to 20 per cent to encourage firms to ‘Make in India’. When this failed to attract investment, import duties for certain mobile phone components or inputs were reduced in January 2024. Soon after, India’s Finance Minister Nirmala Sitharaman announced plans to revert the duty on mobile phones to 15 per cent. This approach has increased consumer costs without making Indian mobile phones domestically or globally competitive. Similarly, in 2023, the government abruptly banned laptops and IT hardware imports to boost domestic production. It eased these restrictions soon after. However, with all the policy flip-flops, local manufacturing has not expanded sufficiently to replace imports.

The perennial protection for the auto industry, with tariffs of 125 per cent for cars and 100 per cent for motorcycles, insulates domestic manufacturers from global competition. The government’s ‘infant industry’ justification rings hollow for this 80-year-old sector. Despite, or likely because of the high protection, Indian cars are not competitive in the global market.

The ‘Make in India’ model—subsidies and protectionism without the disciplining mechanism of global competition—has enabled a form of cronyism that, in turn, demands greater protectionism. And attracting foreign investment and capital from global leaders to ‘Make in India’ results in making exceptions for specific firms, leading to policy uncertainty.

The electric vehicle sector is the most recent casualty. It started with the NDA government wooing Elon Musk to set up a Tesla Gigafactory in India. Musk demanded lower import duties as a precondition, challenging the government’s protectionist stance. The government announced a reduction in duties contingent on local manufacturing commitments, but only offered it to a few firms with conditionalities. Allegedly, the latest point of contention is over the government’s favouring of Gujarat, Modi’s home state, over Tesla’s preference for established automotive manufacturing bases in states like Tamil Nadu. The Tesla deal seems to have run out of charge.

The Production Linked Incentive (PLI) scheme, introduced in 2020, offers subsidies of three to five per cent on incremental sales for five years to large firms meeting scale-related qualifications in select sectors. However, the focus on capital-intensive sectors overlooks labour-intensive industries like apparel and footwear, and its emphasis on largescale production may disadvantage smaller domestic firms. Despite some successes like Apple’s investments, the overall private investment rate has barely budged.

These efforts have led to a decline in net foreign direct investment as a percentage of GDP from 1.2 per cent to 0.8 per cent during the first two terms of the NDA government. Policy uncertainty has also led to low levels of domestic private investment, which shows no signs of real recovery since its decline in 2012. A deals-based approach only gives confidence to a few investors, whereas a rules-based approach would have attracted the non-politically connected majority.

This system of crony capitalism creates an uneven playing field where political connections often trump market forces and innovation. Small and medium enterprises, lacking the resources for substantial political donations, find themselves at a significant disadvantage. Bureaucrats and politicians often weaponise laws, further chilling private investment. The system stifles long-term economic growth by misallocating resources to politically connected firms rather than those that are most efficient or innovative. It also raises concerns about the integrity of India’s regulatory environment and the independence of its institutions—an important consideration for the foreign capital India hopes to attract.

There was a time when Narendra Modi railed against India’s oligarchic capitalism and corruption. In his 2014 election campaign, he pledged to create a rules-based system to tackle cronyism and encourage genuine market competition through this plan for ‘minimum government, maximum governance’. In the first term, the NDA government investigated previously sheltered oligarchs like Vijay Mallya and Nitin Sandesara and also Nirav Modi, caught under its watch.

In 2014, the NDA government initially continued India’s rules-based economic reforms. Building on previous governments’ reforms, it passed the Insolvency and Bankruptcy Code, 2016, to streamline exits and unlock resources shackled in failed firms. A new inflation targeting regime followed, with an independent Monetary Policy Committee comprising central bank and government appointees to set inflation targets and tolerance bands aimed at price stability and economic growth. It implemented the GST, unifying states under a single value-added tax system and eliminating corruption at state borders.

Next on the list were streamlining factor markets like land and labour—knottier problems that previous governments had not successfully solved due to coalition pressures and state holdouts. Many believed that factor-market reforms needed a single-party majority in parliament, a strong leader with economic vision and an understanding of the pressures on state governments. While Modi checked all these boxes, his leadership failed to build consensus beyond his party. Policy announcements were followed by protests, paralysing any further economic reforms.

Abandoning broad-based land and labour reforms was a turning point for the government. One view was that if broad-based reforms were not implementable, the government still needed to ‘do something’ to encourage private enterprise and stimulate growth. This gave rise to golden handshakes and sweetheart deals to large conglomerates. Progress towards a rules-based approach was abandoned for a deals-based system, entrenching cronyism, with the government favouring specific sectors and firms instead of broad reforms to ease entry, competition and innovation.

The government’s economic evangelists claim that it champions private enterprise, historically demonised under socialism. While both rules-based and deals-based approaches support private businesses, their impact differs significantly.

A rules-based approach benefits both incumbents and future firms, fostering innovation and incubating ideas. But the deals-based system rewards the status quo. Rules-based economics treats all equally, while deals-based tinkering allows the state to pick winners and losers. And this shift explains the unhealthy relationship between government and business—one which is sometimes beneficial to both sides but is also weaponised when convenient for the political class. Most importantly, the policy uncertainty and absence of rule of law hurt investment, innovation and economic growth.

In its third term, the Modi-led NDA government places the Indian economy at a critical juncture. It must choose whether it wants India to grow through a rules-based market order, or transition from crony socialism to crony capitalism.