India’s constitution and the economy


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THE Indian Constitution, admittedly the longest and most comprehensive document of its kind in the world, was the result of years of work by a full time Constituent Assembly. It was the culmination of a long-drawn freedom struggle against the colonial occupants of the country and was drafted in the immediate aftermath of a disturbing communal carnage. Integrity of the country, preservation of political freedom, democracy, rule of law and an independent judiciary, therefore, find pride of place in the Constitution and are manifestly important elements of the new order that India established for itself. Given the low level of economic development of the country and mass poverty that characterized the bulk of its people, an equally important aspect of governance ought to have been the economic system that the country adopted for eliminating mass poverty and securing economic prosperity of the nation. It is believed by many scholars that the strong ‘state’ that was considered necessary and desirable for preserving the integrity of India got written into the Constitution in the economic sphere too.

This note will examine this interesting question, namely, did the Indian Constitution facilitate and enable the task of building a modern economy by encouraging the adoption of rational and pragmatic economic policies or did it make this difficult by an overt or covert economic ideology woven into the Constitution? The answer is unlikely to be a clear cut yes or no and perhaps needs to be more nuanced and detailed than what this note can attempt. This note will, therefore, focus only on key aspects of this question and hopefully stimulate more in-depth examination of the question by other scholars.

Evident from the summary statistics presented (Table 1) is that Indian economic growth and development on the one hand, and poverty alleviation on the other, was quite dismal in the 40 years pre-1990 and picked up considerably in the latter two decades. It is also well documented that the pre-1990s Indian economy was characterized by barriers to trade and external capital, strict licensing and regulation of local capital, and policies/laws that sought to limit the role of markets and increased both the direct role of the ‘state’ and ‘state’ directed use of resources.


Growth and Economic Development in India



Average annual GDP growth 1950-1990(fitted exponential trend)


Average annual GDP growth 1991-2012(fitted exponential trend)


Real per capita income in 1990 (2004-05 prices)

Rs 13947

Real per capita income in 2012 (2004-05 prices)

Rs 37851

Percentage of population below poverty line 1993-94


Percentage of population below poverty line 2009-10

29.8% *

* Estimated using the Tendulkar method.

On the other hand, the post-1990s economic policy was characterized by removal of trade and capital account barriers, doing away with domestic industrial licensing, and creation and expansion of many markets.

The data in Table 2 brings out an obvious consequence namely, the greater role that the private sector, and by proxy ‘markets’, began to play and continue to play in the post-’90s Indian economy.


Growth of Private Sector in the Indian Economy


Private sector share of GDP at market price at 2004-05 constant prices

Private gross capital formation to total










Though a three percentage point increase in twenty years does not look major, it should be remembered that this was during a period when the GDP increased 3.9 times at constant prices. In other words, there is a significant increase in the importance of the private sector in the economy and, hence, that of markets. The same aspect is evident in another important measure of the economy’s productive capacity, namely gross capital formation. Here again, the private sector is clearly far more important today than it was previously.

In recent years the rates of growth have begun to slow down and there is demand for further reforms and liberalization to accelerate economic growth and poverty reduction. There is also the opposite argument, namely the need to arrest these ‘neo-liberal’ policies and go back to the earlier ‘state’ dominated economy. The Indian polity will resolve this contentious debate and decide the way forward. Given that both the dismal growth of the pre-1990s and the relatively better performance of the post-1990s were achieved broadly under the same Indian Constitution, it can be argued that prima facie, the Constitution itself did not come in the way of choosing an appropriate economic system or set of policies being adopted by the government of the day. However, a deeper examination would show that perhaps this is not the case.

The view being advanced in this note is that the Constitution as interpreted by the judiciary clearly favoured the adoption of the policies that were proposed immediately after independence. Whether it is the Constitution per se or the particular judicial interpretations which led to this is a difficult debate, but not entirely relevant for our analysis and we will treat this as a composite whole for our present discussion. When these policies and the overall approach demonstrably failed by the late 1980s and we had a crisis on our hands, the government and the Parliament moved away from the earlier approach. A pragmatic judiciary did not impede this change of direction and facilitated it by its various pronouncements. However, this movement was neither complete nor smooth and has perhaps run its course now. Further progress in this direction will require constitutional changes, thereby demonstrating that the Constitution as adopted did not fully support a market oriented economy.


Modern economies require large, seamless markets. The last century has many examples of countries voluntarily breaking down barriers to create large common markets. India, which acquired the advantage of a large continental size economy on account of the merger of British India with princely states after independence, could have capitalized on this and enabled the creation of world class industries by the sheer size of its domestic market demand. It is submitted that the prevailing ideology of the day, as reflected in the Constitution, effectively discouraged this. Let me demonstrate this with some illustrations.

The first illustration relates to the allocation of legislative and executive competence between the central and state governments. The allocation scheme envisaged in Schedule VII of the Constitution for distribution of powers clearly militates against, or at least seem to not be informed by, the basic principles of economics. Instead, the allocation of subjects in Schedule VII of the Constitution, driven by political considerations of state autonomy etc., led to a situation where each state has become a closed and fragmented market for many commodities rather than working towards the creation of a national market. This is evidenced by the following instances.


As a result of entry 14 of List II of Schedule VII of the Constitution, which relates to agriculture, state governments in India have succeeded in banning and controlling the movement of agricultural produce outside the state borders. Hence, the creation of a national market in rice, wheat, cotton, sugarcane etc., is now a Herculean task. Typically, these are also the commodities where state governments have imposed tight controls on all aspects of their production, processing, trade and so on, justified and supported by other provisions of the Constitution, on the production, pricing and sale of agriculture and agro-based commodities.

Sugarcane and all the products of this sector are a good example of this phenomenon. Though sugarcane has been notified by the Government of India as an essential commodity under the Essential Commodities Act 1955, state specific legislations regulating sugarcane have been held to be constitutionally valid by the Supreme Court. The combined effect of the various legislations have been that the cultivation of sugarcane, its sale, and the price at which the sugarcane will be sold is regulated, with the result that the state government decides/ approves the areas where sugarcane can be grown, to whom the cane can be sold, and at what price. Likewise, it also decides which sugar factory can purchase cane from which farmer, at what price and in what manner/time frame the price will be paid.


The industry is further controlled in terms of the most valuable by-product of sugarcane crushing, namely molasses. Most state governments have banned inter-state movement of molasses while some allow it with permits. The end use of molasses produced in the state is determined by the state governments and allocated across competing uses, thereby effectively determining the price of this input as well as the prices and economic fortunes of the downstream products and producers. Even if it is conceded that the production and consumption of alcohol has been a regulated activity in most countries, it is difficult to justify the fragmentation of this market, half of which is used as an input in the chemical industry. A complete distortion of locational decisions against all other logistics and economic considerations is taking place because molasses and alcohol cannot freely move across state boundaries within India.

The above is an illustration of a product market distortion on account of the distribution of economic regulatory powers as envisaged in the Constitution. In the case of factor markets, particularly in the critical factor, capital, which is of great significance in a capital scarce country like ours, the situation is even worse. Micro-finance institutions typically lend small amounts of money without collateral to the relatively poorer sections of the population. Thanks to the opportunities provided by a growing Indian demand for credit from this segment of the population and the inability of the formal financial sector to meet it, there was an explosive growth in the number of MFIs and the borrowers served by them. This is evident from Table 3.


Growth of Micro-Finance Institutions


Number of MFIs

Number of active borrowers

Gross loan portfolio




Rs 0.009 billion




Rs 5.0 billion

In the state of Andhra Pradesh, which saw among the highest rates of growth of this kind of lending, some micro-finance institutions were accused of lending practices that adversely affected the lives of the poor borrower, to the extent that some committed suicide. This led to state government intervention with an ordinance that effectively stopped collection of micro-debt and prohibited any new micro-loans in the state. The more systemic outcome from this was the lending freeze by the banks to the micro-finance sector, not just in the state but all across India. Notwithstanding the aberrations and misdemeanours of some MFIs, the sector as a whole was serving a good social purpose and MFIs with the required scale economies were just about emerging in India. But thanks to the constitutional ambiguity, taking recourse to the entry relating to moneylenders and moneylending, and relief of agricultural indebtedness, the state legislated on the subject, effectively preventing the creation of a national market.

Theoretically speaking, moneylending and banking are not fundamentally different. From a public policy and regulatory point of view, they call for more or less similar regulatory responses. While banking is in List I of the VIIth Schedule of the Constitution, money lending and cooperatives are in List II. This clearly creates a regulatory arbitrage, with cooperative banks taking advantage of the lacunae and indulging in practices that are not possible in banking which is more tightly regulated by a central legislation. Ideally, the long-term policy should lead to a regulator for the distribution of all financial services. Such a regulator would be difficult to create in this fragmented distribution of similar subjects to different layers of governments.


We can also consider the case of NBFCs and state governments. Non-banking finance companies are covered in entry 43 of List I of the Constitution and accordingly are regulated as per provisions of the RBI Act. However, many states have legislated against usurious rates of interest in pursuance to the powers vested in them as per the entry relating to money lending and relief from agricultural indebtedness. The Karnataka Prohibition of Charging Exorbitant Interest Act of 2004 is one such legislation. While implementing the act, the Government of Karnataka took the view that NBFCs are also covered under this act and RBI registered NBFCs should apply to the competent authority under the act to seek exemption from its application. Clearly this would fragment the regulation of NBFCs and become a new and additional obstacle in the creation of a national market for non-banking financial services. Gujarat had earlier attempted similar regulation which had been struck down by the judiciary, but the Government of Karnataka nevertheless has made a similar effort. The matter is still pending though no coercive actions have been taken by the state.

Dematerialization and an electronic market for securities provide further food for thought. Though shares and debentures are clearly enumerated in the relevant entry, namely entry 46 in List I, and stamp duty on them is mentioned in entry 91 of List I, since ‘bonds’ are not explicitly mentioned in these entries, the creation of a national electronic market and depositories for all financial instruments in the mid-1990s got considerably delayed because it required an amendment to the Constitution ratified by a number of legislative assemblies. This single-most important reform in the financial markets, namely dematerialization of financial instruments that allowed screen based trading and the transition to a complete electronic market with all the attendant advantages of integration and creation of a national market was made possible only after an amendment to the Constitution.

India could not have developed a large equity market with a market capitalization of close to 100% of GDP and thereby reduce the cost of capital for firms without this pan-Indian market. With national participation and hence very liquid markets, costs have been driven down, thus enabling the raising of a large amount of risk capital for the newly emerged firms in India. The same stamp duty problem continues to hold up the development of a fully liquid and deep corporate bond market in the country, in turn causing difficulty in financing infrastructure. This has led to banks, which are ill-suited to finance this activity, to actually hold a lot of this kind of funding in their books, potentially leading to systemic risks.


The second illustration relates to a major institutional requirement of modern market economies. This is the institution of an independent and autonomous regulator, which combines legislative, economic and judicial functions in one entity. Natural monopoly arguments and information asymmetry considerations have led to this development. Across OECD countries, regulators have become important institutions to ensure consumer protection, prudential conduct of firms and stability etc. India is also embracing this development and creating many regulatory agencies. However, the separation of powers has been held by the Supreme Court to be a ‘basic feature’ of the Indian Constitution and potentially regulatory agency design can run counter to this. Likewise, accountability of regulators in a parliamentary system where the executive is answerable to Parliament is a problematic issue. Given the proliferation of regulatory agencies, these issues will perhaps need to be addressed by an amendment to the Indian Constitution.


The third illustration relates to the difficulty in reforming the taxation of goods and services by introducing a Goods and Services Tax (GST) to replace the separate taxes on commodities imposed by the GOI (on production) and the state governments (on sale and purchase) and on services imposed by the GOI. The foremost benefit of GST is that it will eliminate the cascading of taxation in indirect taxes on supplies of goods and services, which at present exists on account of multi-level and multi-stage taxation, particularly on the supply of goods, without set-off of input stage tax. This will ensure a common national market for goods and service, and enhance trade competitiveness. The tax administration too will benefit as tax leakages would decline due to inbuilt checks. It would also facilitate incorporation of international best practices in our tax administration.

Within the basic framework of the Constitution, a GST cannot be imposed without an amendment to the Constitution. This is essentially because if GST has to be levied by both Centre and states, an appropriate entry would be necessary in the concurrent list, i.e., List III of the Seventh Schedule of the Constitution. At present tax entries are contained only in List I and List II of the Seventh Schedule. As such a tax entry in the concurrent list is not barred, making an entry in List III relating to GST is entirely feasible. However, this may give rise to another constitutional problem in as much as the Union gets precedence in the matter contained in List III, which is perhaps necessary to bring about uniformity and advance the idea of a common market and, therefore, the jurisdiction and independence of the states to levy GST may get compromised. In the event, given the political reality and narrative on federalism, there is a need to find a solution which reconciles these two conflicting objectives. The idea of a GST Council may not resolve the conflict as the doctrine of repugnancy as contemplated in Article 254 gives Parliament overriding power. As such, carving a distinct and separate jurisdiction for the Union and states poses serious challenge.


This note examines the impediments that the Constitution potentially places on the adoption of policies that will allow the emergence of a market based economy in India. Though apparently the Constitution does not mandate or prescribe a particular economic philosophy, there are many provisions in the Constitution that limit the emergence of a pan-Indian national market for goods and services. To the extent that this is a requirement for a modern economy, the Indian Constitution will need to be amended where required to pave the way for an economy organized on the basis of modern market principles.