#272 Cooperation and Competition

Fiscal Federalism Issues are Back in Action, Perils of Decentralisation with Chinese Characteristics, #SemiconIndia2024, and Reading Recommendations

India Policy Watch #1: Sharing Isn’t Caring

Insights on current policy issues in India
— RSJ

The familiar rumblings of the north-south divide in the country were revived this week by the Karnataka CM Siddaramaiah when he announced that he has written to Chief Ministers of eight states regarding the unfair devolution of taxes by the Union government. He has invited them to a proposed conclave in Bangalore (nice weather, best dosa, etc.) to deliberate on issues relating to federal fiscalism. The opposition-led states have jumped onto the bandwagon, and the familiar noise of states that contribute most to the GDP (or with higher GSDP) receiving a much lower share than their contribution from the central pool of taxes is back in discussion. I foresee more contentious debates on federalism over the next couple of years as we head into 2026. That’s the year when two decisions significantly impacting Union-state relations will be taken. The delimitation exercise of constituencies for the Lok Sabha and State Legislative Assemblies will be carried out using the population data from the latest census. Hopefully, the delayed 2021 census will be done by then. And then there will also be the 16th Finance Commission recommendations on the devolution of funds between the Union and the states that will apply for the five-year period starting 2026. If the multiple state elections in the interim see the opposition gain in strength or unseat the BJP in a few states, it will mean a fairly strong clamour for relooking at federal fiscalism.

This isn’t the first time CM Siddaramaiah has raised this issue. He had pitched his tent in Delhi earlier in February this year with a few ministers from Kerala and TN demanding their “fair share” of the central pool of taxes. As his government has rolled out a series of welfare schemes in the past two years, he finds his state’s finances worsening every year. He’s staying ahead of the curve by placing the blame on the Union rather than doing the difficult bit of managing the fiscal deficit through belt-tightening measures. As more state governments get into welfarism mode come election season (exhibit A, Maharshatra at this moment), they will struggle to balance their budgets. The demand for a fair share of revenues will only keep rising.

This is a dangerous slippery slope to go down. After all, the terms of the Finance Commission are to arrive at the tax devolution formula that is based on the principles of need (the backward states need greater support), equity (states with greater population will need more funds) and efficiency (states that have performed better on financial and social metrics should have the incentive to continue to do better).

Tax devolution refers to allocating a portion of Union taxes and duties to the states, enabling them to finance development, welfare projects, and other essential initiatives. As per the recommendations of the 15th Finance Commission, 41 per cent of the divisible pool of Union taxes is distributed among states in 14 instalments each year, covering the period from 2021 to 2026. The formula for the devolution of this 41 per cent is a difficult balance to achieve, and the Finance Commission uses data, consults experts and tries to build a consensus among states before arriving at a set of parameters that are representative of a state’s needs and performance and then assign them appropriate weights in line with the core principles. The current parameters include population, area, forest and ecology, income distance (how far from the highest GDP per capita state are you), tax efforts and demographic performance. Once the formula is set, there’s no role of the Union to meddle with the horizontal devolution of the divisible pool.

The 15th Finance Commission made a few important changes that the Karnataka CM and others are now questioning. The first change was the Union government directing the Commission to use the 2011 census as the metric for states' population rather than the 1971 census that has been in use since the 7th Finance Commission. Population is a simple and effective metric for devolution. After all, the higher the population of a state, the greater the financial need for it to provide for its citizens. It is only fair that the latest census data be taken to use this metric in the formula.

Unfortunately, till the current Finance Commission changed it, the population metric was used based on the 1971 census. But the population growth rates have diverged quite significantly since 1971 with several states, especially the more prosperous states of west and south, doing well in controlling birth rates. The northern and eastern states haven’t been as effective in implementing population control policies, and with a much larger share of the total population now than in 1971 will get a greater share of the funds. This is seen as penalising a good thing by the southern and western states. This same argument will be used with vehemence when the electoral delimitation exercise will be conducted in 2026. 

Now, this argument was expected and understood by the 15th Commission, which tried to balance this by introducing ‘demographic performance’, a stand-in for population control. The simplest measure of population control is the total fertility rate (TFR), which is the average number of children born to a woman through their child-bearing years. Lower the TFR, better the performance on this parameter. Or so, you’d have thought except that the Commission didn’t just take the TFR. Instead, they took the reciprocal (or inverse) of TFR and multiplied it by the 1971 population to arrive at the state-wise share under the ‘demographic performance’ parameter. This helped states that already had a large population back in 1971 still get a disproportionate share even if their TFR performance has been middling or worse. While those states with a smaller population then and a better TFR performance didn’t get the full advantage of their better handle on population control. Karnataka and Telangana are specific examples of losing out because of this. 

A similar issue was seen on the ‘tax effort’ parameter where the usual metric for this, which was Own Tax Revenues (OTR) to Gross State Domestic Product (GSDP) ratio, was slightly altered by the 15th Commission. The tax effort now was calculated by multiplying this ratio with the 2011 population of the state. So, once again, a population factor was included in a parameter that was supposed to represent efficiency. 

That apart there are other issues impacting the relationship between the Union government and the states on devolution and fiscal autonomy. The actual tax devolution to the states has been lower than the recommended levels in the past few years. The Union government has, arguably, limited the autonomy of the states by having a higher share of conditional grants vested with them, increasing cess and surcharges that go directly to the union kitty and a limit on state’s borrowings coupled with a stiff fiscal deficit target challenge. Also, the complete absence of fiscal discipline which had a weightage as high as 17.5 per cent in the 13th Commission, makes it difficult to reign in profligate state governments who propose welfare schemes with limited fiscal prudence. Politically, this is a difficult pill for opposition to swallow. Especially because the more prosperous opposition-ruled southern states who receive a much lower allocation for every Rs. 100 they contribute, see the less prosperous states often ruled by the BJP who receive a larger share, spend that money with little accountability. And, like always, being in opposition gives you the luxury to raise these issues because you aren’t doing the difficult job of arriving at the formula.

Like I mentioned before, these issues will become more fraught during the next two years. There’s more than adequate political incentive to present selective data cuts to paint your state as a victim and beat the BJP. The risk that’s obvious is that it makes the north-south divide a real deal. The truth about any devolution formula is that it will have to contend with the trilemma of need, equity and efficiency. Whichever way you allocate the weightages, you can always pick up a state and show one among the three principles being compromised for it. The same argument holds for the delimitation exercise. You can make a reasoned case against delimitation by arguing that it benefits states that have held India behind and now gives even more political heft to these states. But should that really matter? India is a union lest we should forget. The real test of the union is in managing and making peace with such trilemma and apparent contradictions. The political exigencies of the moment shouldn’t determine our support or opposition to these decisions. Those will change and the shoe will be on the other foot sometime in future. The opposition must remember that. The underlying principles that should guide our decisions should be sound and to the best of our ability, timeless. The ruling party has the onus to engage better with the states, demonstrate a true commitment to principles of cooperative federalism across all issues and not just when it comes to financial devolution and learn to share responsibility and power with opposition in the composition of such committees. Else, there’s enough angst for anyone to tap into such issues and widen the chasm between this emerging north-south divide. 

Talking of Union-state issues, Pratap Bhanu Mehta has a searing piece on the Manipur issue in his weekly column.

He calls out both the scale of our indifference and the puzzling failure of the Union government in even signalling who is in command in Manipur. I have picked out two relevant extracts here:

“The scale of our indifference to Manipur bears more calling out. Just think about all that has transpired in the last 17 months. You would have thought that the firing of drones and now the deployment of anti-drone technology, the use of rockets, deepening militia conflict, armed groups using terror against each other, brutal killings, journalists being fired at, internet and communication shutdowns, frequent confrontations between police and civilians, all in an area that is not just vital to India’s security but also central to its approach to the east would command the nation’s mind and attention. Students in Manipur have been protesting in large numbers, there have been torchlight processions, women’s marches and demands for the resignation of MLAs. It is as if an active civil society is banging its head against a brick wall.

But here is a deeper puzzle: Even in terms of the BJP’s own majoritarian politics, its behaviour over Manipur is shockingly bizarre. For one thing, let us look at the quotidian issue of chain of command.Who is actually in command in Manipur? There is something quite constitutionally astonishing about the fact that a sitting chief minister submits a representation to the governor of his own state demanding that the Unified Command be given back to the CM. At one level, it is amazing that the political and constitutional significance of this demand has not been noted. It is an indictment of the Centre, including the Union home minister.”

He concludes with a question on what’s at stake in keeping the fires burning in Manipur and with a strong note of caution that set me thinking:

“So back to the puzzle of the BJP’s stakes in keeping the conflict simmering. It certainly has a stake in majoritarianism. But the BJP has got to know that, in Manipur, its strategy will also engulf its own core constituency amongst the Meiteis. A successful government in Manipur would have consolidated the BJP’s own authority. Is the design more sinister then? Is it essentially to use disorder to buttress the argument of its ecosystem that all political conflicts in India are now products of a vast foreign conspiracy? It is the BJP that now needs instability to license more repression. Rather than admitting its failure, it will use the disorder to license more authoritarianism. Manipur will be used in national politics, but in the wrong way.” 

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Addendum

—Pranay Kotasthane

Earlier this week, the Finance Ministers of Kerala, Tamil Nadu, Karnataka, Telangana, and Punjab gathered to align their positions with respect to the 16th Finance Commission. This is a good move as long as the focus remains on vertical devolution. Focusing on vertical devolution will allow states to form a broader front with other states. This agenda will allow them to invite all state governments, putting those who ignore an invitation to raise their states’ own fiscal resources on the back foot.

In the previous edition, we proposed an algorithm that these states could consider presenting to the Union government to overcome the vertical imbalance.

Taking this work forward, Sarthak Pradhan and I analysed Karnataka’s position at the 16th Finance Commission. From the conclusion of our paper:

“we examined how Karnataka’s revenue position has been affected by the reduced devolution share during the 15th Finance Commission period. After analysing the 15th FC horizontal and vertical devolution formulas, we identified five potential changes that Karnataka should propose to the 16th Finance Commission. We based these recommendations on the principles of fiscal federalism and subsidiarity. We then estimated the fiscal implications of these recommendations by constructing various scenarios based on different proposals for horizontal and vertical devolution. We hope that the range of scenarios considered and the illustration of their corresponding fiscal implications will aid Karnataka in deciding its approach to the 16th Finance Commission. This approach can also be utilised by any state to present its case to the Finance Commission.”

Read the full paper here.

Currently, the 16th Finance Commission is visiting all state governments. Hence, each state government will propose modifications in the vertical and horizontal sharing formulae, keeping their own interests in mind. The framework suggested in our paper can be used by any state government to present its case to the Finance Commission.

Against this backdrop, a coalition of the finance departments of some state governments is a good move. Fiscal federalism is an ever-continuing negotiation; there is no end game. Hopefully, states will want to make a common cause with all states instead of reducing it to an imagined north-south contest, which is easy to dismiss and delegitimise.

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Global Policy Watch: The Perils of Decentralisation with Chinese Characteristics

Global policy issues relevant to India
— Pranay Kotasthane & Manoj Kewalramani

(An edited version of this article was published in The Hindu on 12th September)

In his Independence Day speech, the PM urged states to compete with each other to attract investors. In sharp contrast, extreme subnational economic competition seems to have run its course in China. Here’s why decentralisation—once celebrated as a reason for China’s economic miracle—has turned counter-productive. 

Unlike India, where city-level governments account for less than three per cent of total government spending, a staggering 51 per cent of government spending in China happens at sub-provincial levels. Local and provincial governments also have a much broader qualitative mandate. They are almost exclusively responsible for unemployment insurance and pensions, subjects we Indians generally associate with the national government.

Yet, China’s extreme decentralisation doesn’t make it a federal country. A key feature of a federal system is that higher-level governments cannot extinguish the powers given to lower-level governments, as the Constitution protects them. No such provision exists in China’s Party-state system. After Deng Xiaoping’s Southern Tour caused local governments to go on a spending spree, the central government severely and immediately restricted local governments’ ability to raise money through the Tax-Sharing Reform of 1994. 

Overcapacity is Structural

Local governments had to find a way out. Since economic growth was an important determinant of local leaders’ political prospects, they started prioritising industrial construction over the provision of public services. They offered industrial land at deep discounts compared to residential land in the hope that industrial outputs would increase regional economic growth and also become a source for future local tax revenues. Local governments attracted investors with attractive land rights. Firms accepted the offer, churned out goods at low rates because of cost advantages, and exported to the world. 

This investment-led model is structurally prone to overcapacity. This model of competitive sub-national growth is akin to a car having two accelerators and no brakes. The arrangement worked well from the Deng Xiaoping era to the Hu Jintao period. The central leadership set broad investment priorities and targets while local governments experimented and competed. The process of crossing the river while feeling the stones created tremendous wealth. However, it also generated structural overcapacity, wasteful investment, and loss-making entities. 

The overall trend remained net positive for two reasons. First, the directives were broad enough for local governments to try different ways to achieve growth or reform goals. For instance, provinces such as Guangdong interpreted the central leadership’s goal of pursuing economic opening by experimenting with Special Economic Zones. Other regions were free to follow alternate models. Likewise, the central leadership permitted local innovations in the housing sector rather than imposing a particular solution. This policy innovation process was locally determined and not micromanaged by the centre.

Second, a salubrious geopolitical climate was crucial. Foreign markets were willing and able to absorb China's ever-increasing capacity. China’s steel sector’s expansion since 2000 is a case in point. The sector was highly decentralised, with many small players producing the bulk of the capacity. Starting from the turn of the millennium, within six years, China went from being a net steel importer to the largest steel manufacturer and a net exporter. By the beginning of the 2010s, tackling overcapacity in the steel sector had become a prominent policy objective. While many Chinese companies failed along the way, many others rode this wave, generating tremendous value for employees and the government.

The Car Encounters a Slope

However, this model began to reach a tipping point around the time that Xi Jinping came to power. Researchers at the NDRC in 2014 estimated that half of all investment between 2009 and 2013 was “ineffective”, amounting to a waste of nearly $6.9 trillion. Xi’s solution to this predicament was to demand austerity, enhance supervision and strengthen central control over local decision-making. In addition, he sought to establish traffic lights to direct state and private capital in what the central leadership believes are desirable domains.

Consequently, over the past decade, central directives have become narrower. Seeking self-sufficiency, these directives are no longer broad directions but tend to translate into specific product lines. For example, the drive to localise the entire supply chain for semiconductors is divorced from market-based demand and the comparative advantages of the Chinese industry. This approach has tipped the scales unfavourably. The failures are way too many, and the successes are small and far fewer. For example, the “Big Fund” began in 2014 intending to build a self-sufficient semiconductor industry. Drawing from this fund, many local governments indiscriminately poured money into chip-making firms. Ten years later, China has not mastered the production of advanced chips. Nevertheless, many firms continue to milk local governments for funding. Firms producing chips used for electric vehicles are reported to be 30 per cent costlier, and the government is now imposing local sourcing mandates on Chinese EV makers to absorb this inefficient production. 

The solar equipment industry faces a similar predicament, with the China Photovoltaic Industry Association publicly calling for mergers and acquisitions and restrictions on domestic competition to control capacity. The Economist reports that 30 per cent of all industrial firms were making losses at the end of June 2024, beating the previous worst performance during the Asian financial crisis in 1998.

Another reason is that other governments now see China’s overcapacity as a national security threat. While governments were happy to import cheap consumer-grade products from China, they are taking a less-favourable view of tech-enabled Chinese products such as electric vehicles and telecom equipment. Moreover, China’s bad international conduct has exacerbated the negative perceptions of Chinese products and investments.

Xi planned to substitute Western markets with increasing domestic demand and find new international markets through BRI. Increasing domestic demand hasn’t worked out because this is unfamiliar territory for a structure obsessed with supply-side stimuli. In other words, the approach is fundamentally investment-based at the cost of household consumption. In any case, the COVID-19 shock further damaged the plan for increasing domestic demand. The BRI approach hasn’t worked because the participating countries aren't economically strong enough to generate huge demand either. 

In short, overcapacity and export orientation are baked into Chinese-style decentralisation. This model has now reached its limits due to China’s arrogant approach to international relations and its drive towards self-reliance. Though we might see a jump in exports for some sectors, China faces an economic decline if it doesn’t transform its political and economic relations with the world's major countries. 

(end)

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Addendum

—Pranay Kotasthane

Though we ended the article with a warning that China faces economic decline if it doesn’t alter its political and economic relations with the world, the nature of this ‘decline’ is a subject of intense debate.

Since overcapacity is structural, China’s party-state has long been aware of its ill effects. Long before the Belt and Road Initiative (BRI), in 2009, the State Council issued the “Opinions on Reducing Overcapacity and Duplicate Construction in Some Industries and Guiding Industrial Healthy Growth”. The recent waves of China’s external investment and dumping are both directed towards correcting the unique problems of its growth model. Astute observers of China’s geoeconomic strategy suggest that even an economic decline won’t prevent firms from exporting their structural problems; it’s not a short-term problem that can be swatted away with trade restrictions. Zongyuan Zoe Liu makes this point here:

“China’s GDP growth slowdown does not necessarily signal its full-scale retreat from the global market and international system. Quite the contrary, highly competitive Chinese firms – survivors of intense domestic competition that became industry leaders – will continue to compete for global market shares and challenge foreign firms. The influx of cheap Chinese manufacturing products will continue to challenge the industrial base and competitiveness of other countries. Despite the challenges to its economic growth, China’s global influence and its challenge to the U.S.-led global system will persist. The domestic and international challenges contributing to China’s economic growth slowdown will not remain within Chinese geographic borders but will also have political economic consequences worldwide. As Anne Stevenson-Yang argued, although China won’t be able to innovate its way out of its current economic challenges, the dead-end Chinese economy is bad news for everyone.” [Zongyuan Zoe Liu, China Leadership Monitor]

If we continue along this line of thinking, India’s economy could be impacted as follows.

As the West’s tariffs and controls on China’s products and investments rise, Chinese firms will have no option but to find alternate markets. India would be one such destination.

This could be a curse in terms of the trade deficit but a blessing in terms of investments. The direction of India-China trade is likely to be one-way for the foreseeable future. India’s attempts to resuscitate manufacturing will require cheap intermediate goods, which will largely come from a source where they are produced cheaply, i.e., China. For instance, there’s no way that India can step up electronics and chip assembly over the next decade without a sharp increase in imports of chips, wafers, and manufacturing equipment from China. In sectors such as these, where India doesn’t have existing capacity, allowing Chinese imports makes strategic sense while taking the necessary steps to build local capacity via sensible industrial policy. However, in sectors where competitive Indian players exist, Chinese overcapacity amplified by Western tariffs will cause some problems. Striking a balance that keeps India’s existing capabilities in mind will be crucial.

On the other hand, there is a case for being more open to Chinese investments. Some scholars argue that Chinese investments won’t help India as these firms don’t have an excess capital problem, just an excess capacity problem. Some even suggest that China will discourage outward investments to prevent a transfer of technology to a potential rival like India. However, these fears don’t seem to hold much water. A top EV firm such as BYD has already invested in countries such as Brazil, Hungary, Thailand, Turkey, and Indonesia. There’s no reason why it wouldn’t do so in India. Given the tough environment for China-made products, Chinese firms would be willing to diversify some of their production away from China, even if it means a limited transfer of technology. Don’t expect any R&D functions to come to India, but we can sure expect a transfer of manufacturing know-how. That itself would be an important gain for the Indian manufacturing ecosystem.

In edition #267, I proposed a framework that takes these considerations into account. Taking it further, it’s useful to think about India’s techno-strategic approach towards China. The stated approach of the US towards China in this regard is called “small yard, high fence”, meaning that in a narrow set of advanced technologies, Chinese firms will be resisted with the full force of the American State. In other areas, the approach will be business-as-usual. For example, American export controls on China’s semiconductor industry apply only to the most advanced semiconductors and not to trailing-edge chips. If the American approach is taken as a reference, three other options are possible, as this figure below suggests.

Currently, India’s strategy seems to be a mix of a [large yard, low fence] and [large yard, high fence] approaches. Essentially, we have closed ourselves to Chinese technology investments and products more than the US has. For instance, Chinese EVs, TikTok, and Huawei face more barriers in India than they do in the US.

Much of it is justified. It’s important that India avoids Chinese products that could impact our cognitive infrastructure. In that sense, a ban on TikTok and restrictions on Huawei in core telecom infrastructure are explainable. However, there’s no reason why India should be closed to investments by Chinese mobile phone firms, solar cell and wafer firms, or electric vehicle firms. Force them to have an Indian partner if you wish to, but get them onboard to improve the Indian ecosystem.

Perhaps there is a case for India to adopt a [small yard, high fence] approach, too. Of course, India’s “small yard” will differ from America’s. The domains that concern India might not be the same as the US. What do you think?

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India Policy Watch #2: When the Chips are Down…

Insights on current policy issues in India
— Pranay Kotasthane

The third edition of India’s premier semiconductor industry summit, Semicon India 2024, was held this week. I’ve been observing this event closely, and I think it’s gotten boring over time from a policy and geopolitics lens, and that’s great. Semicon India brand has transformed from an event where India was pitched to potential investors into an industry-led roadshow where companies pitch to each other. This is significant progress.

In case you missed the event, I have you covered. There were no major investment announcements confirmed during the event. The MeitY minister did mention that the next version of policies for the sector would be put in place in 3-4 months. These updates would perhaps try to shift the focus from chip assembly (since four such units have already been announced) to chip design and fabrication.

In the lead-up to the event, I had a ready-reckoner thread capturing all major developments since India’s current set of semiconductor schemes was announced in December 2021. Do check it out.

That apart, an underappreciated public policy-level change continues to be ignored. As exemplified by charts from sources like AT Kearney below, current industry data visualisations fail to accurately capture India's significant role in this crucial sector.

Source: AT Kearney Report - Europe's Urgent Need to Invest in a Leading-edge Semiconductor Ecosystem

As this chart shows, all value addition by chip design subsidiaries of foreign firms operating in India is credited to the country where the company is headquartered. While this approach may be justifiable for intellectual property ownership, it creates a skewed picture of actual value addition across different countries.

This misrepresentation is particularly detrimental for India, given its substantial presence in the global chip design landscape. One, India hosts design centres for nearly all the top 25 global fabless firms, many of which conduct high-end design work. Two, India boasts perhaps the world's largest outsourced chip-design services sector. And three, according to government data, India accounts for nearly 20% of the world's chip design workforce.

Despite this deep integration into the global semiconductor supply chain, India is conspicuously absent from value addition charts.

There are two reasons why accurately representing India's value addition in chip design is difficult:

1. Collaborative Nature of Chip Development: Chip design often involves close coordination across multiple company locations, making it difficult to attribute value addition to specific sites.

2. Data Gaps: Intra-company cross-border chip design exports are not captured with granularity in Indian government trade data, leading to an underrepresentation of India's contributions.

To address this issue, I propose that the Indian government take steps to publish data about India's value addition to the chip design segment. While direct estimation might be complex, developing a proxy for value addition is both possible and necessary.

Accurate representation of India's value addition in chip design can serve two crucial purposes. If the value addition is lower than expected, it will underscore the need for increased innovation in the sector. If the value addition is substantial, it will emphasise India's strategic importance in the global semiconductor ecosystem.

In an era where semiconductors play a pivotal role in technological advancement and geopolitical strategies, accurate industry data representation is crucial. By pursuing and publishing more precise data on its value addition in chip design, India can gain rightful recognition for its contributions and make informed decisions to further strengthen its position in this vital industry.

P.S.: The PM’s inauguration speech read, “When the chips are down, you can bet on India!”. Could our eponymously named book have inspired this phrase? Who knows?

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HomeWork

Reading and listening recommendations on public policy matters

1. [Article] Amid all the talk of the difference in GST rates of buns and cream buns, here’s the one article you must read. Dr Govinda Rao is India’s top-most public finance expert. He writes that the GST Council's complacency is worrying. Under the guise of seeking stability, it ignores its primary aim of reducing the three tax-related costs.

2. [Podcast] We recorded a fantastic episode on Indian Policing with Mr Javeed Ahmad, ex-DGP of Uttar Pradesh. It’s full of insights. Don’t miss.

   भारतीय पुलिस के हालचाल। The State of Policing ft. Javeed Ahmad

3. [Article] A long read on gene drives in the excellent Works in Progress magazine.

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