Economic freedom is the bedrock of modern capitalist societies. It is based on personal rights, voluntary exchange, and open markets. The link between economic freedom and prosperity has never been clearer. The chart below shows the results of a study of more than 150 countries over a twenty year period conducted by the US-based Heritage Foundation.
The 1st and 2nd quartiles represent countries that are rated “free” or “mostly free,” and quartiles 3rd and 4th are countries that are “mostly unfree” and “ repressed”. Countries with free economies generate incomes that are more than double the average levels in other countries and six times higher than the incomes of people living in countries with “repressed” economies. GDP growth rates in countries with economic freedom are twice that of economically repressed economies.
The evidence is clear: economic freedom leads to economic prosperity and reduced poverty. It also leads to higher overall well-being, taking into account such factors as health, education, environment, innovation, societal progress, and democratic governance. And as the data clearly shows countries with greater economic freedom have a more equitable distribution of wealth. Countries which are economically unfree have a small class of wealthy elite and a very large number of poor people.
In the Heritage Foundation/Wall Street Journal 2017 Index of Economic freedom, India ranks 143rd out of 180 countries. This puts it in the category of “mostly-unfree” countries behind countries like Pakistan, Nicaragua, China, Nepal, Bangladesh. The top-ranked countries with the highest levels of economic freedom are Hong Kong, Singapore, New Zealand, Switzerland and Australia.
Why does India rank so low on economic freedom?
India scores very poorly on investment freedom and financial freedom because state-owned institutions dominate the banking sector and capital markets. It also scores below average on its antiquated labor laws which restrict labor freedom ( hiring and firing of workers), and the burdensome regulatory and legal framework which discourages entrepreneurship and private-sector growth. And, finally, it scores poorly on freedom in the goods market because the state maintains an extensive presence in many critical areas of the economy through public-sector enterprises.
With the recent slowdown in the Indian economy, policymakers and economists are grappling with the question “What can the government do to spur growth?” The data provide an obvious answer: “Adopt policies that advance economic freedom.”
What policies will improve India’s economic freedom?
Firstly, as Mr. Modi himself said in 2014: “ The government has no business of being in business.” The government currently owns and runs about 300 companies in critical areas like energy, shipping, transportation, mining, telecom, steel, coal, gas, paper and is even involved in making condoms and film. The current market value of these holdings is a staggering Rs. 13 lakh crores. This money belongs to the people of India. The government should appoint a group of leading investment banks to systematically liquidate these holdings with the proceeds invested in a Bharat Sovereign Fund managed by investment professionals from the private sector (not bureaucrats). Its mandate should be to co-invest with private companies in PPP projects related to infrastructure, education, and health, and in startups, small enterprises, and businesses in the informal sector to incentivize their movement into the formal sector.
Secondly, India urgently needs a capital-friendly tax policy. The country’s arcane and opaque tax policy is a huge deterrent for businesses to invest capital. Abolishing the corporate and capital gains taxes will invigorate investment in capacity building and generate employment, and increase wages and consumption. A consumption-based tax to replace the repealed taxes will generate higher tax revenue without hurting economic activity.
Thirdly, all barriers and regulatory constraints to foreign direct investment should be removed, and the rupee made fully and freely convertible. Currently, the rupee is only partially convertible with capital account convertibility not permitted. This prevents foreign companies from investing in India knowing that repatriation of profits back into their home currency would be subject to restrictions. Along with the elimination of the capital gains tax, a freely convertible rupee will encourage the free flow of capital that is vital for economic growth.
Fourthly, all ministries should be required to cut in half, paperwork, and regulations relating to business activity. If this is done in conjunction with reducing the number of ministries in half, it will bring greater consistency and transparency to India’s stifling regulatory environment. The more barriers that government creates, the tougher it becomes for aspiring entrepreneurs to pursue productive ventures, and for workers to find the jobs those ventures create. A few simple and stable rules promote economic growth and social harmony far better than volumes of obscure and conflicting regulations that succeed only in introducing unnecessary confusion, chaos, and conflict into society.
Finally, an overhaul of India’s capital markets is urgently required. The role of capital markets is to route capital from households to the industry. Very little of the capital that flows into the markets is channeled into funding Indian industry. Instead, it simply fuels trading. The Indian stock market is largely a trading market and not a provider of industry capital. Also, the corporate bond market at only 4% of GDP is minuscule compared to the size of the Indian economy. As a result, almost 80% of the private sector’s capital needs come from the banking sector and only about 20% from capital markets. These numbers need to be reversed to provide much-needed capital for private investment.
It is remarkable that Estonia, a country that got its independence from the Soviet Union in 1991, is ranked 6th in the 2017 Economic Freedom Rankings. How did it get there so quickly? Its reforms included wholesale privatization of state enterprises, removal of all tariffs to free trade, a simplified tax system with flat rates and low indirect taxation, an independent judiciary, a competitive banking sector that operates with minimal state intervention, and above all a revitalized effort to move toward limited government and greater economic freedom.
India could take a page from Estonia’s book. The most significant factor holding India’s economy is the extent of government intervention in the capital, labor, and goods markets. Prosperity for the masses will be achieved only with limited government, and a rapid move to replace politics-based economic activity with market-based economic activity.