Thou Shall Enforce The Contract

My coming across a paper*, co-authored by Shruti Rajagopalan an Associate Prof of Economics at State University of New York, on Indian state capacity, coincided with a news reports that the income tax department has rejected Tiger Capital’s application for exemption from tax on capital gains it made from its stake sale in Flipkart. The department has reasoned that Tiger has used the India-Mauritius tax treaty by routing its investments through Mauritius, even as ‘head and brain’ of the investment was based in US. The paper and news report brought forward a failing that is not talked about enough and which in the opinion of this writer needs urgent attention- the enforce-ability of contracts in India.

Any exchange, economic or social, is fundamentally execution of a contract. One party offers a good or a service and receives a consideration in exchange. These contracts are either enforced by social moors or by legal statues. You are reading this post because I am offering an insight and your time is the consideration I seek. I have an employment contract with my employer, we enter a contract with our governments, we elect them to offices- good governance in exchange of a consideration called taxes. Our success as individuals, societies and as an economy or a country is a function of how effectively we can execute these contracts.

Enforce-ability of a legal contract is a function of state capacity. The confidence parties have in their ability to enforce contracts define their propensity to enter the contract and assign the risk premium to the considerations of the said contracts. Where does India stand in its ability to enforce contracts? How do some of the citizen facing departments of government fare in enforcing contracts?

The prime minister has made improvement in ease of doing business in India a visible marker of his economic vision. What is India’s global rank in the ability to enforce a contract: 163 (Out of 190 countries that the World Bank ranked for the study in 2019).

Shruti Rajgopalan’s paper gives us the following data points on some aspects of India’s state capacity:

· Number of Police per 100000: 135. (The global median is 318 per 100000).

· Number of Judges per million: 12. (The corresponding number is the US is 108).

· Backlog of cases in Indian courts: 32 million.

Deloitte in February 2020 published a paper on reducing income tax disputes in India, the paper estimates it takes 12–14 years of litigation, if all legal avenues are to be exhausted, to resolve a case. The Deloitte report also mentions a study conducted by OECD on tax appeals in OECD and other advanced countries. In India, the 11.5% cases were settled in favour tax administration, the average for countries in the study was 65%.

The aforesaid facts do not make for a pleasant reading. The capacity constraint that afflicts the state is accentuated by multiple layers of regulation that businesses must face and the ever-expanding quasi-judicial system. If the tax department and labour commissioner spare you, well there is a National Green Tribunal to get you. The encroachment of legislative domain by the courts is another variable that a business must account for.

All law making by the government is defining the terms of the contract. The efficacy of the contract is dependent on the faith the parties to the contract have in the clarity and transparency with which those rules are laid out and their confidence in impartial and prompt adjudication if those terms are violated.

The talk today is focused on simplifying the terms of the contracts across factors of production in the economy- reforms of agricultural, labour and land laws that are being brought in by various states and strengthening of the capacity the state capacity needs to deliver on its side of the contract- Aadhar.

The redrafting and simplification of these terms are much needed but our ability to leverage on these reforms will be dependent on our ability to demonstrate that rules are followed and participants have recourse if one of the sides to the contract defaults.

The lack of enforce-ability of the contract leads to a vicious cycle, participants seek reasons to avoid delivering on their side of the contract- this is a version of game theory at play, since they don’t have the confidence in their ability to make the other side keep its side of the bargain, they try and pre-empt and so forth, that leads to sub-optimal outcomes.

An aggregate of all such sub-optimal outcomes results in a trust deficit society and economy, increasing the cost of doing business and adding to the risk premiums.

If the reader wants to get a sense of how confident they are of enforce-ability of contracts in India and how it influences their decisions making, here is a simple test. If you are an Indian and reading this, you are part of a privileged minority- you own a smart phone and are well verse with a foreign language.

Despite the privileges that you enjoy, how confident are you of approaching the police and courts if you meet with an accident on road, end up with a legal dispute with your landlord/tenant or confident of successfully taking on a government department in the court of law.

Perhaps the love for a government job in India comes from the challenges of enforcing a commercial contract.

As the government tries to change the rules that run the Indian economy, what its also needs to do is augment the capacity of our courts and regulatory tribunals. The ICBC 2016, lays down the number of days in which a case needs to be settled- 330. Perhaps that is the template the needs to be replicated for all civil litigation. Let us have a National Disputes Resolutions Service, on lines of the venerable IAS and allied state services, that takes our courts and regulatory tribunals to every nook and corner of this country.

It is not just the rules of the game and ease with which it can be played that drive its popularity, it is also the fact that participants and viewers know that they will be followed and infringements punished that makes sports such a popular and commercially successful activity. We get rule following right and perhaps the magic of markets will kick in, in the meanwhile one can look forward to a group of exasperated fund managers sitting out of New York trying to take on Bharat Sarkar’s tax department.

*Premature Imitation and India’s Flailing State- Shruti Rajagoplan and Alexander Tabarrok.