India Policy Watch #1: Winning The Long Game
Insights on current policy issues in India
— RSJ
Many moons ago I sat down for lunch with someone who is often referred to in the media as a ‘doyen of the industry’. Among other things, I asked him the single most important advice he would give to anyone who is at the start of their career. I didn’t have any burning desire to succeed in the corporate rat race. So, I wasn’t looking for a life-changing insight. I asked it because custom demanded you ask such questions of doyens like him over a meal. Also, even back then I was aware that I should fill my pitaara with such stories because sometime in future I could use them to make myself appear interesting. Anyway, he squinted at me and with something that appeared close to conviction told me, “always defer gratification”. I nodded and pronged a moody forkful of Aglio e Olio. Instant gratification.
Over the years I have come to appreciate that piece of advice. Running a successful business over the long term is all about how well you trade off short-term gains with doing what’s right for long-term sustainability. The odds are stacked against you because most of your shareholders, the analysts and the media are measuring you on quarterly performance. You can put out a convincing long-term story that will deliver a big, deferred outcome but how can anyone be sure you’re headed that way? Any short-term wobble can have people question you. It is tough to live a life of deferred gratification. I haven’t followed it to any meaningful extent in my life. Nor do I think even the doyen has done so since that meeting. But having understood how difficult deferring gratification could be, I appreciate how important it is for long-term success in any field of human endeavour. And, of course, that includes public policy in case you are wondering why am I channelling my inner Deepak Chopra and inflicting random truisms on you.
OPS versus NPS
This problem of grasping short-term gains while jeopardising the long-term has been running on my mind for the past few months as I see the spectre of the Old Pension Scheme (OPS) returning as a key election promise in the manifestos of Congress and AAP in state elections. There are two issues that I have been thinking about. First, what drives a political party to make a bonfire of the future for a questionable short-term electoral gain? And I’m picking on the OPS issue and these two parties only to illustrate this point. Every party in India has done this in the past. The abandoning of the farm laws was an instance of this. So, the question is what prompts a political party to do this and, importantly, why does the average voter get seduced by this? The other question is what can be done to change the incentives of the parties to do this? In other words, how can we make sure political parties learn to defer gratification?
But before I get into them, let me give you a short overview of what’s happening with the demand for OPS and the problem with states returning to it while abandoning the New pension Scheme (NPS). The Congress governments in Rajasthan and Chhattisgarh have already gone back to OPS and it has promised the same in its manifesto in Himachal and Gujarat. Not to be outdone, AAP plans to return to OPS in Punjab and might make it a plank in Gujarat. Nothing catches the imagination of our politicians like a bad economic idea, so we now have the Bharatiya Mazdoor Sangh, the RSS-affiliated trade union wing of the ruling BJP, demanding the same from the FM. As Business Standard reports:
“National General Secretary of BMS, Ravindra Himte told IANS that during the meeting with Sitharaman, the organisation has urged the Finance Minister to restore the old pension system, increase the amount of minimum pension from Rs 1,000 to Rs 5,000 and to provide better health facilities to retired people under the Ayushman Bharat scheme.
The BMS has also urged the Finance Minister to strengthen the social security scheme for workers and to take various other steps to protect the interests of the weaker section of the society.”
For context, there are nine state elections scheduled for 2023. Pension of state government workers is a state subject. They can claim they have the mandate of the people to change this if they win using this as one of their key poll planks.
Pension is a way to provide social security to workers following their retirement. A simple way to design a pension scheme is for an organisation to promise workers: upon retirement, we will continue paying, say 50 per cent, of your last drawn salary till you die.
This is simple and intuitive. The worker has served the organisation for long and you reciprocate that loyalty by taking care of them after retirement. A few years of this scheme and you will soon have a reasonable request from the retired workers. The pension provided isn’t keeping up with the inflation. The last drawn wage about a decade back is hardly worth anything now and a pension indexed to that is unfair to the worker. What do you do as a welfare-minded employer? You offer to index the wage to the revised pay scale that’s prevalent now. So, the pension drawn by a worker is no longer 50 per cent of their wage when they were last working in the organisation. It is now 50 per cent of the wage of anyone doing the same job now to keep up with inflation.
This is all good though a bit onerous. However, if you fast-forward this by a couple of decades, you will reach an uncomfortable scenario. The number of people who have retired from the organisation is now, say, equal to the number of people who are currently working. Those who have retired are drawing a pension that’s 50 per cent of the existing pay scale. Simply put, if the total wages paid to working employees is Rs. 100, the pension paid to retired employees is Rs. 50. A third of the total wage bill is allocated to pension. Another decade and you might have two-thirds of the wage bill being taken up by pension. This is a problem in many ways.
First, the working employee is continuing to take additional burden to pay for the ever-increasing number of retired employees. The incentive to be productive for the current employee keeps going down when they know the lion’s share of any productivity gain will go to the retired pool. The organization continues to be weighed down by the pension bill. It finds it difficult to attract new talent because it cannot match market wage rates offered by newer companies that don’t have such a pension bill. It also cannot invest in new products and innovations because the pension bill keeps rising. Unless the employer is the State, in which case, it can print money, increase its debt and keep paying for pension, there’s really only one end state to this. The organization will go bankrupt because of its pension burden. This is not a hypothetical scenario. A whole generation of great American companies went down this path including the giant automakers of Detroit. The OPS that is being revived in many states in India is exactly this scheme.
In 2004, the Union government introduced a New Pension Scheme (NPS) to avoid exactly this fate. The NPS model is quite simple. It is what is called a defined contribution model. The worker sets aside a small percentage of their salary every year towards a pension fund. The government matches that amount by making its own contribution from its coffers. This means there’s an additional wage burden for the government during that year. This amount goes into a pension fund which is managed by professional fund houses regulated by the PFRDA. The fund houses have fairly rigid investment rules that prohibit them from investing in speculative assets. This ‘accumulation phase’ continues till the employee retires. At the time of retirement, there’s a nice little corpus that’s built up. The employee can then take out, say 40 per cent of the corpus for their immediate need, the remaining amount moves into an annuity product where a fixed amount is paid out every year like a salary.
Over the years the NPS scheme has been taken up by all Union government employees and gradually all state governments adopted it too. The professional fund houses that manage the NPS funds report annualised returns that have always been better than the Provident Fund (managed by the government) returns or even the best of mutual fund managers. And the first generation of retirees who use the NPS can vouch that the annuity they get has kept pace with inflation without having to wage-index their pension to the revised pay scale. This a beautiful solution that frees up the government from having a pension burden on its balance sheet after the retirement of the worker. No longer are current employees paying for the pension of the previous generation. In fact, we have often quoted the transition to NPS as one of the more successful public policy examples in India.
Now, we want to undo it. There’s really never been a clamour for OPS. But if you go around telling retired or near-to-retirement employees that we will give you a higher-paying pension scheme by taking you back to OPS, you might find some traction. Even if the numbers don’t bear you out. Few voters will ask you how will you foot the bill. If the current and future employees don’t see that eventually, they will be paying for this largesse, you might be able to convince every working employee that this will work better for them. I don’t think we are there yet but I never bet against the popularity of a bad economic policy. They have tremendous seductive appeal.
The Difficulty In Choosing Deferred Gratification
This is just another example where there are short-term pains in implementing a policy that will yield outsized long-term benefits. We could do that by implementing the NPS in 2004. Now, we are on the reverse. We want to implement a policy that might have short-term gains for a few but huge long-term costs for everyone. There are other similar policy questions in a democracy. How should we think about climate change? Should we take costly actions now by punishing polluting industries and impacting job creation while waiting for the benefits of these actions to pan out over decades? Or, how about increasing taxes today to rebuild roads and public infrastructure that will benefit society thirty years later? How should a political party think about these issues when their incentive is to win elections that happen every four or five years? Are democracies doomed to pick policies that are good in the short run but damaging in the long term because of this flaw?
This intertemporal trade-off between maximizing societal welfare now and investing for the future is a vexing issue for political parties in a democracy. What I want to do is to understand the reasons for this trade-off being skewed in favour of short-term value maximisation and see if there’s a way to engineer a choice architecture for the public that redresses it. I can think of four reasons why the skew exists.
Firstly, there’s the commitment problem among political parties. People are never convinced that a political party will stay the course on a particular policy. This is borne out of experience. Parties are less guided by economic ideology these days. The same set of politicians who might advocate a higher tax today and ask you to tighten your belts may change their tune tomorrow when they sense a change in the air. Also, politicians aren’t permanent. There is turnover among them within a party itself. And the newer set might renege on previous commitments. So, for the citizens, paying short-term costs because you believe in the political commitment of a party now is fraught with risks.
Secondly, forecasting is difficult. There’s the fog of uncertainty and lack of adequate information to accurately predict these benefits. It is easier for a voter to use past performance as a guide to the future than predict it based on the impact of a new policy. The average voter anyway has only limited cognitive mind space for public policy. They might be able to think only about present outcomes with some clarity. This encourages politicians to think of policies that are typically myopic. Further, this information challenge means even if voters and the government say they care about the future, their actions will continue to be shortsighted. Separately, even those who are trained in public policy to think about the intertemporal trade-off can struggle to make accurate assumptions about the future. We live in a world that’s more volatile and ambiguous than before. To predict the future and the societal context that will emerge then is a risky proposition. For the policymaker, it is optimal to maximise a more certain near-term than go out on a limb for the distant future.
Thirdly, we have the old problem of concentrated benefits and diffused costs. It is natural for a smaller group for whom the benefits of a policy are concentrated to organise themselves and demand its implementation. The converse of this is also true. Any policy action where the short-term costs are to be borne by a small but organised group while the benefits will emerge over time for the wider society will get scuttled by this group. The repeal of the farm laws was an example of this. Even if the short-term pain and the long-term gains both accrue to this small group, they will oppose it. Because a better alternative for them is to redistribute the short-term pain to everyone while securing the long-term benefits for themselves. Or, to continue with the status quo.
Finally, we have the problem of political parties that have either run out of ideas or who want to make a dent in new electoral terrain. To them getting a foothold through the aid of a myopic policy is worth the price. After all, they have many other policies that are better for society, which they might rationalise. Or, it is a question of survival and how does long-term matter if you will cease to exist then. This is what explains the actions of AAP and Congress on OPS.
Is There A Way Out?
So how does a policymaker counter these? I have a few suggestions, some of which might seem Machiavellian.
First, there are ways to take the sting out of short-term costs. A deft policymaker can obfuscate some of the costs by making their calculations more complex (say, in the design of an auction or a tax) that is difficult for the voter to understand. The idea is to reduce the overt display of the cost to be paid in the short-term. The other option is to impose the short-term costs in a phased manner or in specific cohorts (‘grandfathering’ certain beneficiaries for some time). There is a whole field of behavioural economics that can be used to nudge the voter towards a certain action like loss avoidance. The other way to do this is to diffuse the responsibility of who is imposing the short-term costs among many agents of the state including the government, independent regulators, corporates, local bodies or international treaties. This fragmentation of power and diffusion of the blame can make it easier to take difficult calls. They can take the sting out of the costs to be paid for future benefits.
Second, there are ways in which the long-term gains can be crystallised into something more tangible in the present. There are ways in which some of the future payoffs can be advanced through well-choreographed pilots. This is particularly true for infrastructure investments where the example of a few recent successes can be talked up and few well-timed benefits early on in the investment process can convince the citizens of the long-term benefits. The other way to think about it is to play up the huge long-term consequences of not acting now with any small evidence in the present being used to project a terrible future. This is how climate change activists are playing the game today where any minor aberration in weather patterns anywhere in the world is used to proclaim ‘climate change is real’. You might disagree with them on principle but their approach to building public support is right.
Third, we come to making political commitments sticky for the future so that voters are more willing to support taking short-term pain. The way to go about is to make any reversal of course difficult by making a policy difficult to dismantle. This can be achieved by placing exit barriers while implementing a policy that could include multiple players and steps whose consent would be needed to roll back a policy. They could have veto powers to stop such rollbacks. The more the institutional fragmentation, the higher the barrier to exit. Other means could be adopted too like making an amendment to the law or constitution or setting up a new independent authority to institutionalise a policy. By having such players whose incentives are aligned with long-term benefits promised in the policy, one can create a significant hurdle. The costs of reneging on a commitment go up significantly.
Lastly, how do we counter the small but organised interests that might scuttle a policy because they don’t want to take the short-term pain? In most cases, the problem here is how do we mobilise the larger group for whom the benefits are diffused and in the long-term to counter the smaller but highly motivated group? One of the ways to think about this is to choose a smaller subset from the larger group whose benefits (or costs in case the policy isn’t chosen) might have greater salience for the group. For instance, talking about children and the future of our planet makes it easier to focus on the costs of not making climate change investments today. The ability to show with clarity that the redistribution of benefits of a policy that imposes costs on current beneficiaries and favours a future group is crucial in winning the battle of minds. The benefits are often spoken in abstract terms over a larger group than making it very specific for a focused smaller group. If that’s done well, you get a countervailing force against the small, organised group that wants to retain the status quo.
The intertemporal policy choice is crucial to ensure democracies don’t lapse into the most shortsighted policy recommendations because that’s what gets instant mass approval. The wise man who told me to ‘always defer gratification’ gave me the best career advice. Unfortunately, he didn’t tell me how to do it. I suspect he didn’t know it too.
Because it is tough.
For more on the Pension issue, check these editions:
A Framework a Week: Understanding Cognitive Maps in edition #62
Thanks for reading Anticipating the Unintended! Subscribe for free to receive new posts and support our work.
India Policy Watch #2: The Cats See Through the Monkey’s Trick
Insights on domestic policy issues
— Pranay Kotasthane
In edition #131, I wrote that India’s fiscal federalism resembles the monkey and the two cats fable. While states fight amongst each other to corner a higher share of the total money devolved to them, the Union government can go scot-free even as it appropriates nearly 60 per cent of the divisible pool resources, raises new cesses, and uses a part of these funds to run its own centrally sponsored schemes. This focus on horizontal devolution (the formula used for sharing resources between states) masks the far more serious problems of vertical devolution (how money is split between the Union government and all states as a whole).
Given this starting point, one news item from the past week caught my attention. State Finance Ministers (FMs) in the pre-budget consultation meeting with the Union FM highlighted the problems with the vertical devolution regime. Their criticisms and suggestions can be summarised as follows:
Increase states’ share in goods and services tax (GST) to 60 per cent from 50 per cent at present.
Merge cesses and surcharges with the existing taxes so that states are not deprived of their share, and
Rationalise the expenditure under centrally sponsored schemes. The Tamil Nadu FM said that "All states, irrespective of political parties, expressed a common theme -- states' fiscal autonomy is greatly constrained by the extent of centrally sponsored schemes, by the extent of changing ratios of funding of such schemes”.
Let’s focus on the first suggestion, which seems to be a reform pathway for India’s fiscal federalism. What should we make of it?
First up, a clarification. The 50 per cent share that the state FMs highlighted refers to the rate of taxation and not the share of total GST collections. If you check any bill, the GST is split equally into two halves — SGST (which remains with the states) and IGST (which goes into the total divisible pool to be split between Union and state governments). Since 42 per cent of IGST is again devolved to states using the Finance Commission formula for vertical devolution, states already get about 70 per cent of the total GST collections. If the proposed change were to be made, the states’ share in GST will further rise to 76.8 per cent, according to former J&K Finance Minister Haseeb Drabu.
Keeping this important clarification aside, the suggestion to increase the share of SGST by 10 per cent is excellent. As I have argued earlier, any fiscal reform that increases general purpose transfers to states increases their autonomy and allows them to decide their own priorities. In a country where the GSDP per capita of the richest state (Goa) is nearly ten times that of the poorest (Bihar), one-size-fits-all schemes run from Delhi can hardly be expected to be effective.
However, the proposed reform in its current form will be dead on arrival. There’s nothing in it that would motivate the Union government to change its stance, and nor are states promising anything at their end in return. With some conditionalities, this reform can be made to work in the overall interest of citizens.
One, states should commit to sharing a fixed percentage of their increased SGST share with local governments. State governments cannot always play victims. They are simultaneously culpable in strangling the finances of local governments. An increase in the SGST share can act as a useful incentive mechanism to fix this crucial flaw in our fiscal federalism.
Two, states should commit to a fixed increase in capital expenditure. The increased fiscal space can easily be frittered away by states. Three states switching back to the costly Old Pension System that burdens future generations is a case in point. Hence, an increase in the states’ GST share should be made conditional on improving the quality of expenditure.
Three, the increased SGST share should be accompanied by a sunsetting of centrally sponsored schemes. This will create fiscal space for the Union government to focus on higher-level functions: defence, trade, manufacturing competitiveness, higher education, and R&D. Admittedly, this change would be the toughest part of the bargain. The Union government runs so many centrally sponsored schemes precisely because it is politically beneficial for parties to portray that our day-to-day requirements are solved directly only by the largesse of the occupant of the 7, Lok Kalyan Marg. A move away from this low-level equilibrium would need immense political capital.
To make this idea palatable, a move to the 60:40 sharing can be made optional. Only states that agree to the above three conditions can transition to the new regime. The rest can continue to be stuck with the older compromise. In sum, the proposed reform merits serious discussion.
Advertisement: Here’s an awesome opportunity for mid-career professionals who missed out on learning the liberal arts.
Global Policy Watch: Myth-busting Reservations About Global Supply Chains
Insights on global issues relevant to India
— Pranay Kotasthane
Geopolitics is trumping geoeconomics the world over. The good old days when international trade was unapologetically perceived as a positive-sum game are past us. Countries are pursuing expensive industrial policies across sectors, by labelling everything from the display screen of your phone to the apps on it as “strategic”. In this worldview, one constant villain is Global Supply Chains (GSCs). The dominant narrative seems to be that shorter and more domestic GSCs are more reliable, and hence government intervention to snip these GSCs is desirable.
But what does the evidence suggest? A few recent papers inject some sense into the ongoing debate. In this section, I will summarise key insights from them, and link out to more readings on GSCs.
The one economist to read on GSCs is Richard Baldwin. His 2012 paper Global supply chains: why they emerged, why they matter, and where they are going covers the foundational concepts lucidly. It delivers one insight after another, busting many myths in the process. Sample this:
“Globalisation is often viewed as driven by the gradual lowering of natural and man-made trade costs. This is a serious misunderstanding.
Globalisation has been driven by advances in two very different types of ‘connective’ technologies: transportation and transmission.” …
In Baldwin’s view, the first unbundling of globalisation was made possible by steam and made profitable by scale economies and comparative-advantage-led separation. The second unbundling was made possible by information communication technologies and made profitable by wage differences.
There’s a lot more in the paper that I’m still processing. Do give it a read.
Meanwhile, his latest paper with Rebecca Freeman investigates if the current structure of GSCs is too “risky”. They acknowledge that the recent challenges—COVID-19, climate change and geopolitical tussles—are of a global scale and will likely reshape GSCs.
They add that all firms make a risk-reward trade-off. Recent events have already driven firms to invest more in building resilience. Thus, there are just two cases where a government intervention makes sense. First, when the social evaluation of this trade-off puts greater stress on the “risk” compared to the firm’s evaluation of this trade-off, there’s a case for market failure. The higher the gap between these two perceptions, the higher the likelihood of government intervention. From an Indian perspective, China’s recent actions have widened this gap.
Second, the complexity of GSCs might make firms (especially the smaller ones) underestimate the true risks involved. This lack of information can be another justification for government action in the form of mapping and making this information public.
On the issue of which interventions might actually reshape GSCs, they suggest:
Locational equilibriums are unlikely to shift unless firms perceive a permanent shock and governments commit to substantial, long-term production subsidies (as with agriculture), massive regulation (as in banking), or massive state-lead interventions (as in defense).
Policies on essential medical supplies and semiconductors may well prove to be more durable and effective given their critical nature. Arguments that these sectors are part of today’s national defense, broadly defined, are more credible, and thus more likely to endure long enough to reshape production structures.
Going beyond government interventions, they identify a trend that’s of importance to us in India. Given the improvements in industrial automation and AI, future manufacturing GVCs might become shorter. At the same time, future services GVCs might become longer and more widespread, given the multilateral agreements on services trade, which are far less protectionist than those in manufacturing trade.
From an Indian perspective, these propositions mean that India (or any other country) is not likely to displace China in the manufacturing of goods which are not considered “strategic”. Instead, it is automation that’s more likely to reduce other countries’ dependence on China. On the other hand, India’s opportunity lies in the services trade. Policies such as data localisation or restrictions on human capital movements will only dampen India’s chances.
Perhaps, the far more important lesson from the US export controls on China is not that the US might do something similar to India, but how difficult it is to displace a country of China’s size once it’s embedded itself in GVCs. India’s strategy should therefore be to embed itself in services GVCs.
HomeWork
Reading and listening recommendations on public policy matters
[Podcast] DO NOT MISS this Puliyabaazi with Ajay Shah in Hindi/English on state capacity and public policy. While you are there, subscribe to our channel :).
[Report] The State of State Finances report by Saket Surya and Tushar Chakrabarty of PRS is useful reference material for anyone interested in contemporary Indian public policy.
[Twitter Thread] For a simple explanation of the central issue in India’s fiscal federalism, read Pranay’s thread.
[Explainer] This Trade Deficit-101 is worth your time. It asks: What is a trade deficit and how does it affect the economy?
#193 No Country For Young Men?