Although India is one of the fastest growing economies in the world, its growth potential has been compromised by resource misallocation, especially when it comes to land. India is one of the most land-scarce countries in the world, and demand for land has accelerated with the increase in the pace of industrialization and urbanization. But huge distortions in land markets have slowed the pace of growth. If these resources could be used more efficiently, India has the potential to achieve double-digit growth.

Indian firms differ enormously in productivity growth compared to the US. The productivity of a US firm in the top decile is twice as high as that of a firm in the bottom decile in manufacturing industry. This is five times greater in India.

The differences in productivity growth across firms reflect factor market distortions that enable less efficient firms to access more resources. It is estimated that productivity growth could increase by more than 50% in India if factor market misallocation in India could be brought down to US levels.

Firms use three factors of production—labour, land and capital—to produce output. Which factor market is most distorted?

Conventional wisdom has focused on the labour market as being the most distorted in India. But there are even bigger distortions in the other factor markets.

Distortions in land markets are much bigger than those in labour markets. A comparison of factor misallocation indices at the district level has shown that an increase in the misallocation of all factors is associated with a huge decrease in output per worker in the manufacturing sector. Most of this decline originates from the misallocation of land and buildings. This appears to be at the root of much of the misallocation of output, and it accounts for a large share of the differences in productivity.

If land is so highly misallocated, does this have repercussions on capital allocation through financial markets?

The two are interconnected. Most bank loans require some form of collateral to guarantee the loan. Land is simply the best form of collateral due to its immobility (i.e. the debtor can’t run off with land). While borrowers can often pledge 80% of the land value against loans, for most other forms of fixed investment, the loan-to-collateral value ratio is substantially lower.

Misallocation in labour market inputs had no adverse impact on the allocative efficiency of financial loans. When it comes to land misallocation, however, the consequent degree of financial misallocation has only worsened over time as large manufacturing firms have moved out from cities and into rural areas in search of more land. Financial misallocation is far greater in the organized manufacturing sector than in the unorganized.

Land appears to be a minor concern in services. We compared the role of factor market distortions in services with the manufacturing sector (see A Detailed Anatomy Of Factor Misallocation In India by Gilles Duranton, Ejaz Ghani and Arti Goswami, a World Bank paper). Land misallocation affects output in services in essentially the same way as it does in manufacturing.

However, most services tend to be less land intensive compared to manufacturing industry. So land distortions have not constrained productivity growth in services. This explains India’s success in services relative to manufacturing. India has many more service tech start-up companies than anywhere else in the world, except the UK and the US. The rapid globalization of service, and the fourth industrial revolution, provide new opportunities for India to scale up and achieve explosive growth.

This does not mean, however, that policy makers can ignore land market distortions in India. The country’s land scarcity is reflected in its land density (people per square kilometre of land areas), which is 450 in India, compared to 148 in China, 36 in the US, and an average of 58 globally.

Distorted land markets are a breeding ground for crony capitalism and political subsidies. While the policy focus on improving land administration and regulation is well placed, there are bigger growth benefits that can be derived from shifting the policy focus from reducing land “regulatory tax" to increasing land revenue tax. This will enable more efficient firms to grow faster and increase the budgetary revenue to maximize finance for development, and additional revenues needed for investments in infrastructure, urbanization, housing, and social programmes.

Property taxes share some of the characteristics of land taxes, but generate small revenue. In most municipal corporations in India, property tax contributes less than 20% of municipal revenue. In most major cities, nearly 50% of the properties do not pay any tax.

It is estimated that non-linear and progressive property and land taxes could almost quadruple revenue to 1% of gross domestic product (GDP) from currently 0.15–0.2%. As land and property are visible, land taxes are in principle more difficult to evade than taxes on consumption, income or goods.

Broadening the tax base will not only enable India to improve efficiency in resource use and accelerate growth, but it will also make growth more inclusive. India is one of most unequal countries in the world. The richest 1% in India own 53% of wealth compared to the richest 1% in the the US who own 37.3% of wealth. Reducing land market distortions is a key step towards making growth more inclusive and achieving double digit growth.

Ejaz Ghani is lead economist at the World Bank.

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