India is easing its regulatory burden on businesses, but the battle against its inspector raj will be hard fought

The government has notified its four new labour codes covering wages, industrial relations, social security and working conditions nearly six years after they were cleared by Parliament.

Meanwhile, Niti Aayog has reportedly finalized a report that suggests radical changes in the way government agencies oversee the operations of companies, ranging from registrations to inspection, based on a culture of trust rather than suspicion.

Several Indian states have been changing their rule books on everything from building bye-laws and working hours for women to regulations on land use.

And the Reserve Bank of India has repealed 9,446 circulars to replace them with 244 master directions to the lenders it regulates.

The 1991 reforms dismantled the licence raj, but largely left the inspector raj untouched— the rule of the factory inspector, labour inspector, pollution inspector, tax inspector and so on. Many have draconian powers. In that context, the recent policy changes should be seen more as an overdue start towards deregulation, rather than the completion of the very difficult task of simplifying a tangled mess of rules across levels of government, departments and regulatory agencies—an opening note rather than a crescendo.

The underlying culture has long been one of suspicion rather than trust. When Jaswant Singh took over as finance minister in 2002, he had summoned senior tax officials to tell them that no civilized country conducts tax raids on its own citizens. Not a single tax raid was conducted during his two years as finance minister. There is a lesson there for how the Indian state deals with its entrepreneurs over a wide spectrum of regulations.

Why does deregulation matter? One good place to start is by taking a look at the Enterprise Surveys of the World Bank.

These surveys are one of the most comprehensive firm-level data-sets on the business environment across countries. They gather information directly from business owners and top managers, covering a wide range of topics including access to finance, corruption, infrastructure challenges, workforce skills, regulatory burdens and competition.

Take a look at two simple metrics reported in the World Bank’s Enterprise Surveys: the average time spent by senior management in dealing with government regulations and the proportion of firms identifying business licensing and permits as a major or very severe constraint.

A comparison with some developing Asian economies such as China, Vietnam and Indonesia shows the extent of the excess regulatory burden on Indian companies.

Interestingly, this pattern remains unchanged even if one digs one level deeper. The numbers are broadly the same for small enterprises (5-19 employees), medium enterprises (20-99 employees) and large enterprises (over 100 employees).

However, larger firms have the ability to hire professionals to deal with various foot-soldiers of the inspector raj. Small firms are less likely to have the resources to do so.

Easing most of this excess regulatory burden should hopefully help in dealing with one of the less appreciated issues in India—the problem of ‘the missing middle.’ Between large established enterprises at one end and tiny suboptimal enterprises at the other, India does not have enough firms in the middle of the distribution. They are the key to robust job creation.

The sixth economic census conducted more than a decade ago showed that the average Indian enterprise employed just 2.24 workers. Indian enterprise has a problem of scale and hence of productivity.

A recent report by the International Monetary Fund says that nearly 75% of manufacturing establishments in India employ fewer than five paid workers, compared to 38% of manufacturing establishments in the US. Other research shows that firms that survive in a competitive market tend to grow rapidly in the US, but they stagnate in India.

The productivity gap between small firms and large firms in India is more than twice that in the US. Also, small firms are usually young firms in the US, while they are not necessarily so in India. There are a host of reasons why this is so, including lack of access to formal finance. But there is no doubt that regulatory and compliance burdens and the time spent by small entrepreneurs on dealing with it are a big part of the answer as well.

At the core of the deregulation argument is the issue of economic freedom, as Bhuvana Anand of think-tank Prosperiti, which works with several state governments on land market and process reforms, wrote in an article in Business Standard last week.

The national discourse often implicitly assumes that economic growth falls from the skies. It is enterprises—from the smallest workshop to the largest company—that invest, innovate, trade and employ. The current deregulation initiatives, and perhaps more in the coming months, will hopefully give them more space to breathe.

The author is executive director at Artha India Research Advisors.