Subir Gokarn: European lessons

A unifying and centralising constitution does not guarantee economic integration

The rejection of the European Constitution by French voters in last week's referendum may well be a fatal blow to the prospects for European integration to be taken to the next stage.

Over 40 years, notwithstanding the occasional bursts of nationalist sentiments, there was remarkably steady and substantive progress towards economic integration.

A process that began with co-ordination on the production and distribution of coal and steel built up into a free movement of goods and co-ordination on exchange rates and, eventually, free movement of labour.

Simultaneously, on the macroeconomic front, exchange rate co-ordination evolved into a single currency and the establishment of stringent fiscal policy rules, effectively centralising macroeconomic management and taking it out of the hands of individual members.

In economic terms, the transformation of Europe from a widely differentiated set of countries into a single integrated entity is virtually complete. However, going by the French outcome and the impact it is expected to have on the decisions of citizens of other countries, a limit to integration appears to have been reached.

India's development and nation-building process present a striking contrast to the European experience. The concept of a single nation, a relatively centralised power structure and a united front to the rest of the world, preceded the emergence of a systematic approach to economic policy.

The re-drawing of state boundaries in 1956, predominantly on linguistic criteria, created a very Europe-like scenario within our national boundaries. Many potential nation-states came to co-exist under this broader national umbrella.

There have been occasional expressions of secessionist sentiments, but few would argue that the basic integrity of the structure has been seriously questioned. In some very important ways, what Europe seeks to achieve with the enactment of its new constitution, India achieved way back in 1950.

Economics was another matter altogether. Even as the nation and its institutional framework evolved, a variety of policy measures contributed to increasing degrees of fragmentation of economic activity.

The power to restrict the movement of commodities, which had its roots in wartime compulsions, gave state governments an instrument to deny producers access to the wider national markets. Industrial licensing and reservation for small-scale production put constraints on investment decisions, which went against the basic logic of a large domestic market and the comparative advantage of different parts of the country to exploit it.

Notwithstanding the good intentions about balanced sectoral and regional development, the end result was a single nation under a unifying constitution with more than 20 economic jurisdictions within it. To be fair, many of the incentives for fragmentation have been eliminated or at least diluted in the course of economic reform.

But, despite this, some people have observed that transporting goods across state boundaries is more difficult than bringing goods from other countries into India. Even today, the objective of an Indian common market is one that industry associations pursue with great vigour, suggesting that we are still some distance from it.

At one level, we could pass this off as a transitional phase, in which the structure of the economy is moving to recognise and exploit the opportunities provided by the constitutional framework within which the nation exists and functions.

At another, however, it is rather intriguing that the European experience, which started off at a point diametrically opposite that of India's, appears to have hit something of a brick wall when it comes to taking it to its logical conclusion.

I think that are some key lessons to be learnt from the European experience""both the movement towards economic integration and the limits that appear to be built into it. The European, or at least the French, emphasis on protecting "sovereignty" may not have direct relevance to the Indian context, but there are some important parallels. Speaking from a strictly economic perspective, the relatively weak powers of the states to levy taxes is one example of where the nation-building objective has come into conflict with autonomy.

To cut a long story short, more tax revenues are collected from the economically better-performing states than they get by way of transfers from the Centre. This "success tax" has at least two significant adverse effects. First, it weakens the incentives that state governments have to engage in growth-inducing activities.

Second, it takes resources away from states in which the returns from re-investing these would be relatively high (as indicated by current economic performance) and gives them to states in which these returns are likely to be relatively low (at least in the short term).

Nobody would deny that a federation of states has an important redistributive function to play. The question is whether the power to do this should be constitutionally frozen or should vary to accommodate changing needs and circumstances.

If states were indeed to have greater power to tax activities within their boundaries, there clearly is a risk that the compulsion to discriminate between "insiders" and "outsiders" may grow. But, sooner rather than later, economic rationality will prevail and the superiority of a co-operative and coordinated solution, which allows all states to take advantage of the huge domestic market, will assert itself.

Voluntary compliance is the principle underlying the eventual acceptance of VAT. From a long-term perspective, there is no doubt that the process by which VAT came to be will provide a model for inter-state co-ordination on economic as well as other policy issues.

The search for a more productive balance between national objectives and regional compulsions would also mean a re-examination of the roles of the state and central legislatures. Going back to the classic separation of powers between the two, defence, foreign affairs, international trade and the oversight of domestic market integration are clearly in the domain of the latter.

Broadly speaking, the European governance structure, comprising the commission and the parliament, takes care of the economic functions on that list. The role of our parliament, however, goes far beyond this. Worse, it appears constrained in its ability to deliver on objectives related to domestic market integration. The Centre can, clearly, play a facilitating role as far as inter-state co-operation is concerned, which it has on occasion, but the solutions are not in its hands.

The bottom line is that, while economic integration does not make sovereignty and autonomy any less desirable, a unifying and centralising constitution does not guarantee economic integration. Both Europe and India need to either accept the limits that their prevailing models have reached or work towards finding a different equilibrium between the two. In India's case, it is imperative to use the opportunities provided by the constitutional framework to build a fully integrated domestic market.

The author is chief economist, Crisil. The views here are personal