Tamil Nadu

Improving Investment Climate

October, 2004

Team: Lili Liu, Simon C. Bell and Abha Joshi-Ghani (co-task mangers), Taye Alemu Mengistae on investment climate survey and analysis, Andrew Singer on regulatory constraints, Nagavalli Annamalai on labor market reform, Michael Engelschalk and Tuan Minh Le on tax policy and administration, David Dowall on urban land market, Rajesh Sinha and Rohit Mittal on power, Arnab Bandyopadhyay and Piers Vickers on roads, Abha Joshi-Ghani on water, and Ted Liang on ports.

Sector Manager: Ijaz Nabi, SASPR

TABLE OF CONTENTS

EXECUTIVE SUMMARY...............................................................................................................................IIIII CHAPTER 1: TAMIL NADU’S ECONOMIC GROWTH ACHIEVEMENTS AND CHALLENGES ............................. 1

ECONOMIC GROWTH ........................................................................................................................... 1 FOREIGN DIRECT INVESTMENT............................................................................................................ 3 EXPORTS.............................................................................................................................................. 4 KEY POVERTY OUTCOME..................................................................................................................... 6 INVESTMENT CLIMATE ........................................................................................................................ 8

CHAPTER 2: REGULATORY BURDENS ......................................................................................................... 12 OVERVIEW......................................................................................................................................... 12 LABOR MARKET RIGIDITY ................................................................................................................. 13 CONSTRAINTS IN FINANCING ............................................................................................................ 17 URBAN LAND MARKET CONSTRAINTS............................................................................................... 19 INEFFICIENT TAX SYSTEM ................................................................................................................. 23 REGULATION OF ENTRY AND EXIT .................................................................................................... 25

CHAPTER 3: INFRASTRUCTURE BOTTLENECKS........................................................................................... 28 OVERVIEW......................................................................................................................................... 28 POWER............................................................................................................................................... 28 ROAD TRANSPORT ............................................................................................................................. 31 MARITIME TRANSPORT...................................................................................................................... 33 WATER SUPPLY ................................................................................................................................. 36 PUBLIC PRIVATE PARTNERSHIP IN INFRASTRUCTURE SERVICE DELIVERY........................................ 38

CHAPTER 4: REFORM AGENDA FOR IMPROVING INVESTMENT CLIMATE ................................................... 43 INSTITUTIONALIZING THE REFORM PROCESS ............................................................................... 43

AN AGENDA OF REFORM OPTIONS FOR TAMIL NADU...................................................................... 44 Labor market flexibility ................................................................................................. 44 Urban land market reform.............................................................................................. 45 Tax policy and administration ....................................................................................... 45 Streamlining regulations of entry and operation............................................................ 46 Power sector reform....................................................................................................... 46 Scaling up private sector involvement in infrastructure service delivery...................... 47

ANNEX 2.1: ACTS AND RULES ENFORCED BY THE LABOUR DEPARTMENT................................................ 49 ANNEX 2.2: BUSINESS REGULATIONS IN TAMIL NADU .............................................................................. 50 ANNEX 2.3: REGISTERS AND RETURNS AT A GLANCE ............................................................................... 54 ANNEX 3.1: PUBLIC PRIVATE PARTNERSHIP IN INFRASTRUCTURE SERVICE DELIVERY ............................ 57 REFERENCES ............................................................................................................................................... 61

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TAMIL NADU IMPROVING INVESTMENT CLIMATE

EXECUTIVE SUMMARY

1. Tamil Nadu has emerged as the fifth largest economy in India (its population of 62 million is the seventh largest). Its GSDP is about US$37 billion at official exchange rate or over US$100 billion based on purchasing power parity. With the fourth largest industry in the country, higher than Indian average growth rate in the 1990s, solid agriculture performance in the past, a rapidly growing IT service sector, an educated, hard working and disciplined workforce, good law and order, and ongoing reforms, Tamil Nadu can accelerate its economic growth and quicken the pace of poverty reduction. Economic Growth and Investment Climate 2. The liberalization in the 1990s accelerated economic growth in Tamil Nadu, increasing average GSDP growth rates to 6.4% from 5.4% in the 1980s. Tamil Nadu’s per capita income growth ranked the third highest among Indian states in the 1990s. The faster growth of industry and services relative to agriculture has changed the shares of these sectors in the GSDP: with the service and industry sectors accounting for 54% and 31% of GSDP in 2001/02 respectively, and the agriculture sector accounting for 15%. Tamil Nadu has been one of the most favored foreign and domestic investment destinations in India; but India as a whole has significantly lagged behind countries such as China. Tamil Nadu accounts for 60% of merchandise exports of four southern states, 15% of all-India merchandise exports and 17% of all-India IT exports; in 2001/02, it exported US$6.5 billion worth of merchandise and US$1.2 billion worth of IT services. IT has been Tamil Nadu’s strongest growth sector since 1997/98, growing by nearly 40% on average per annum. Traditional exports, such as textiles, garments and leather goods, have grown by only 3-6% on average per annum over the same period.

3. Economic growth has slowed since the late 1990s, from an annual average of 6.6% from 1990/91 to 1998/99 to an annual average of about 3.7% from 1999/00 to 2002/03. Much of the recent slowdown is attributed to the impact of the droughts on agriculture and their spillover to other sectors. Tamil Nadu’s agriculture is vulnerable to periodic droughts due to its dependency on rainfall. More frequent than in the recent past, three annual droughts including the unprecedented century’s worst statewide drought in 2002, led to an annual average of –3.9% growth during 1999/00-2002/03 compared with an annual average of 4.5% in the previous nine years. The weak performance in the agriculture sector has spilled over to the service and manufacturing sectors whose growth has recently slowed down.

4. Although droughts are exogenous shocks, there are structural impediments, overcoming which could put economic growth on a higher trajectory path of 8% targeted by the GoTN to accelerate the pace of poverty reduction. Tamil Nadu’s agriculture faces challenges of growing water scarcity, land degradation, decline in farm sizes, and rising cost of agricultural labor.1 Rigid labor regulations, a complex and cascading indirect tax system, protracted exit and bankruptcy procedures, and infrastructure deficiencies are among the key constraints to better manufacturing performance in India. Although manufacturing is recovering in India and in Tamil Nadu, higher and sustained manufacturing growth requires second-generation reforms to improve the investment climate.

5. Higher manufacturing growth, together with the growth of the service sector, is critical to absorbing surplus agriculture labor and reducing rural poverty. The primary sector accounts for 50% of 1 Tamil Nadu Agriculture Policy Note focuses on agriculture growth issue. The focus of this paper is on manufacturing.

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total employment, industry accounts for 24%, and the tertiary sector accounts for 26%. Tamil Nadu has had higher rural non-farm employment than other Indian states, and industrial activities are more spread across the state than most Indian states. Non-farm activities—manufacturing and services—account for about 50% of rural household income. Faster expansion of the manufacturing and service sectors would help reduce the impact of seasonality of rural employment, with acute vulnerability during the droughts, on rural incomes. 6. Cross-country evidence has demonstrated a strong link between investment climate and growth. There could be considerable growth gains from improvement in investment climate in Tamil Nadu. Investment climate influences the expected returns and flow of foreign and domestic investment to a country or a location. In addition to macroeconomic policy, political stability and national policy towards foreign trade and investment, investment climate comprises of two critical factors: efficacy and transparency of regulatory framework for factor markets (labor, capital and land), for taxation policy and administration as well as for starting or exiting a business; and quality and quantity of available physical and financial infrastructure. Findings from the investment climate surveys (CII/DEC) in Tamil Nadu suggest that cumbersome and excessive regulation and infrastructure bottlenecks are major or serious constraints to growth.

Regulatory Burdens

7. The regulatory framework is broadly understood to include the following three areas: factor market regulations, i.e., regulations of labor, capital, and land markets; tax and customs administration; and regulations of entry, exit and operation through regulation requirements and bankruptcy laws.

8. Labor market rigidity. Labor market restriction on hiring and retrenching workers is one of the greatest challenges of doing business in India, according to the Global Competitiveness Report—India ranks 73rd of 75 countries. Labor regulations are largely within the purview of the central government. Rigid labor regulations have prevented Tamil Nadu from unleashing its full potential in labor productivity. Tamil Nadu is known for its good industrial relations and its highly educated, hard working and disciplined labor force.

9. There are three main issues with labor legislations. The federal Contract Labor Act 1970 restricts the hiring of contract labors. Any firm employing more than 100 employees must seek official permission for retrenchment or closure based on the federal Industrial Disputes Act of 1947. The regulatory maze is complex, leading to high compliance cost and rent-seeking. There are 23 Union Acts and seven State Acts and Rules which are enforced by the Labor Department in Tamil Nadu. For each of these subjects there are different enactments by the center as well as implementing rules by the state. Many regulations are excessive and outdated (e.g., no overlapping of shifts, capping of overtime, official permission required for working on Sunday or holidays, specified number of food cafeterias, and over 60 types of minimum wages).

10. Rigid labor regulations deter greater employment generation. Stringent labor institutions tend to benefit a narrow segment of the population comprising the organized and unionized labor, intermediaries in the labor market, and corrupt officials, at the expense of a much larger segment of the labor force comprising the unemployed, those employed in the unorganized sector, and/or agricultural laborers who are seeking jobs in the organized industrial sector.

11. Constraints in finance. The issues of access to and cost of finance are at the purview of the central government, thus affecting all states. The key obstacles are high interest costs, collateral requirements, and burdensome paperwork. Recent downward trend in interest rates has been a factor responsible for revival of industrial growth. India's SME sector still faces a relatively high cost of capital, owing to

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market and policy government failures. There is an adverse selection in the credit appraisal process for SMEs, and interest rate premia for the higher transactions costs in dealing with small borrowers, the lack of sufficient credit information on these firms, their frequent inability to provide collateral, problems in collecting on collateral (typically land/property) from small borrowers due to the lack of updated land/property records and the uncertainty surrounding land ownership, resulting in higher costs of default and contract enforcement.

12. Urban land market constraints. Urban land markets play a critical role in urban infrastructure. They provide the physical space for industrial, commercial and residential development as well as providing rights of ways for critical infrastructure systems such as roads, transit, water and sanitation and power networks. Significant and growing demand for urban land requires an efficient land delivery system, effective land zoning and a regulatory process for infrastructure and housing development review and permission. Rapid urbanization and demographic growth—from 19 million urban population to 27 million in the 1990s in Tamil Nadu—generate significant demands for urban land. In order for cities to grow, either agricultural land at the periphery or vacant and underutilized land in urban areas must be developed.

13. The initial assessment found the following systemic weaknesses in urban land market in Tamil Nadu: Master plan designations in the absence of complementary incentives and measures make the supply of land for development inefficient; land acquisition and project development is complex, time consuming and expensive; obtaining permission and license for building construction industry is complex and time consuming; floor space Indices (FSI) are overly restrictive; over-designed subdivision regulations exacerbate the effects of low FSI; rent control, though not enforced for all buildings, also limits supply by discouraging owners from redeveloping properties to more intensive uses; taxes on land transfers are high with stamp duties at 12-13% comparing with international practices; and considerable land across cities is held by government agencies immobilized. These systemic weaknesses have led to more expensive facilities and housing than necessary, promoting urban sprawl, and led to 1.3% lost GDP per year for India.

14. Constraints in the sales tax system. While the Tamil Nadu sales tax system generally is buoyant and the state has one of the highest own tax effort, it has a number of features which have a negative impact on the investment climate and long-term growth. Many of the problems, common across states, may be resolved with the introduction of the VAT system. But the central government has decided to postpone indefinitely VAT introduction nationwide. Given the federal fiscal relationship, the state’s role in designing tax policy and administration is limited but there are considerable rooms for reforms.

15. The existing sales tax regime, the main source of Tamil Nadu’s own revenues, is inefficient with multiple rates, non-standard classification of goods, and concentration of taxation on certain sectors. It has a relatively high tax burden on inputs, with the effective tax rate on inputs 6.7% and taxation on inputs accounting for 32% of the total collection. The complex structure induces high compliance costs, while the frequent ad-hoc changes in the tax regime generate uncertainty for businesses.

16. The tax on entry of goods into local areas, combined with the still restrictive trade policy of the central government, impact negatively on trade and investment. The tax is cascading for input imports, and the concession rate and offsetting are limited and nontransparent. The levy of entry tax on certain inputs currently not produced in the state also leads to higher cost of production and may thereby divert investment from Tamil Nadu to other states. A high stamp duty on conveyance of immovable property, combined with an unreliable property valuation system, result in high transaction costs, “lock in” effect of less efficient real estate transactions, under reporting of transactions, and administrative and judicial disputes. Recently, as part of the fiscal reform in Tamil Nadu, the effective stamp duty has been reduced to a uniform 8%, down from 12-13%.

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17. The tax administration imposes high compliance costs by, for example, lack of self-assessment in the sales taxation for large businesses and of electronic filing, cumbersome registration procedures, and time-consuming dispute resolution, which all encourage undesirable frequent contacts between businessmen and tax officials. Compliance management in Tamil Nadu continues to be enforcement-oriented, without enough focus on taxpayer service and information.

18. Regulation of entry and exit. Easy entry of new producers and exit of inefficient producers are a powerful force in driving industry-wide productivity growth. New producers bring innovation, risk taking, and dynamism into a sector, forcing existing producers to continue to innovate and improve productivity or exit.

19. Tamil Nadu has made progress in simplifying regulations over business entry. The sequential and protracted approval process involving multiple government departments/agencies has been replaced by a streamlined and coordinated one for large investment projects. However, 19 percent of business managers still identify license and permits as a major constraint. The streamlined process for large investment projects needs to be extended to all small and medium-sized projects. The process of getting a planning permission, construction and building licensing for the construction industry is time consuming, procedurally complex, lacks clarity of rules and coordination between concerned departments. Moreover, large projects throughout the state need to be sent to Chennai for review. The approval process can take up to two to three years.

20. An important entry deterrent has been the Small-Scale Industry Reservation (SSIR) policy by the central government. This policy discourages economies of scale and greater efficiencies—by inhibiting small firms from investing beyond the stipulated limits, expanding their operations in the domestic market, and then moving into exports. Although some of the important items have been de-reserved (e.g., garment, toy and leather products), SSIR has had significant negative impact over decades on the competitiveness of Indian industries.

21. Exit and bankruptcy procedures remain outdated and ineffective, leading to inefficiencies and making industrial restructuring almost impossible. The Amendments to the Companies Act (2002) should improve the bankruptcy framework. The effectiveness of the amendment will depend on the repealing of the Sick Industries Companies Act and the pace of labor market reform.

Infrastructure Bottlenecks 22. Infrastructure is more developed in Tamil Nadu than in many Indian states but compares poorly with other emerging economies. Close to 40% of surveyed managers and about 50% of exporters in Tamil Nadu view infrastructure as a major impediment to investments and growth. The infrastructure constraints are cross-the-board including power, transport, ports and water. Substantial investment requirements also arise from rapid urbanization in Tamil Nadu.

23. Power has become a top infrastructure constraint despite the relative efficiency of the state power utility and having the second largest power market in India. High power tariff to industries and poor quantity and quality of power supply reduce the competitiveness of Tamil Nadu industries. The financial stress of the state power utility, arising largely from cross subsidy to agriculture, has increasingly constrained its investment ability to improve the quality of power supply. Captive generation sets in operation as a share of total electricity sold in Tamil Nadu has reached 15%, with a statewide average captive plant load factor of 25%. The capital cost of captive generation sets constitutes about 11% of total fixed assets for small businesses.

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24. On transport, India has no access-controlled expressways linking the major economic centers, while for example China has built substantial expressway capacity (over 27,000 kilometers) since the mid-1990s. Poor riding quality and congestion result in truck and bus speeds on Indian highways that average 30–40 kilometers an hour, about half the expected average. Demand for road transport has been increasing rapidly in Tamil Nadu with vehicle registrations growing by about 14% annually during the 1990s. However, road network supply and quality have not kept pace with the growing demand, leading to serious network deficiencies in terms of slow response to growing demand, inadequate road capacity and maintenance, severe road congestion and high accidents.

25. There are complex administrative barriers, high transaction costs and delays relating to shipping, trucking, and customs administration of exports and imports at major ports. The entire cargo transport chain from inland to a European port is estimated to cost 15% higher, and many days of delay, than the reform scenario.

26. On water supply, unreliability and shortage are a major weakness in Tamil Nadu’s physical infrastructure. The problem, however, is not limited to Tamil Nadu but across India where about 54% of businesses rely on own wells. The problem in Tamil Nadu is more acute because of the absolute scarcity of water resources in the state. Renewable freshwater resources are scarce, owing to high variability of rainfall and resulting river flows and periodic drought. Ground water has been overly exploited. Many of the most important aquifers of the state have been tapped at an unsustainable rate. Businesses report an average of 11 days per month of interruption in water supply from the public line, against the all-India average of 4 days per month and only about half day per month in Malaysia. The economic cost of raw water is high, but water user charges are well below cost recovery. Industrial consumers pay substantially higher tariff to cross subsidize domestic users.

27. User charges and cross subsidy. A key challenge in infrastructure financing is the political difficulty of increasing user charges. This is most evident in the difficulty of metering agriculture pumpsets and reducing cross subsidy in the power sector. Agriculture metering and the introduction of power sector tariff for agriculture became contentious political issues in Tamil Nadu during the recent national elections. The political pressure has resulted in the reversal of the power sector reform. If cross-subsidy issue is not addressed, then either the state budget would have to bear an increasingly larger subsidy burden or the tariff of subsidizing users (e.g., industrial and commercial users) would have to be increased. Increasing industrial power tariff, which is already high, would force more industrial and commercial consumers to leave the state utility grid, putting further pressure on the state utility’ finances. Filling the financing gap from the budget could put strain on the fiscal recovery. Financing the deficit through arrears or guaranteed-backed borrowing would increase contingent liabilities and financing costs of the state utility.

28. Public and private partnership in infrastructure finance and development. Public financing of infrastructure is constrained by the fiscal distress in Tamil Nadu (as well as in other Indian states). Even with the success of the fiscal adjustment, capital outlay is estimated to increase gradually to about US$1.2 billion (about 2.0% of GSDP) in 2007/08, meeting only a fraction of investment demands. Another constraint is the limited local government revenues from user charges, under assessment of property taxes, and drying up of institutional financing backed by state guarantees. Public and private partnerships (PPP) in infrastructure financing and development are therefore not only a fiscal necessity but also within the broader reform context in India of creating sustainable financial structures which link liberalizing domestic capital markets with urban infrastructure financing needs.

29. Tamil Nadu has been at the forefront of experimenting with PPP. The state has undertaken a number of important reform initiatives in water supply and sanitation and road transport. Experiences with implementation have underscored the importance of the following key factors for a successful

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public-private partnership pilot: leveraging private equity and debt financing to multiples of initial public investment; user fees based on improved service delivery and cost recovery with cross subsidies between consumer categories; building in consideration of operations and maintenance spending when planning a project; and proactive support from the government in inter-departmental co-ordination, close monitoring and trouble shooting; and transparency in bidding and contracting. In addition, a supportive political environment, regulatory certainty, operational restructuring to improve the functioning of public institutions and initial equity participation are important in reassuring private promoters and attracting co-financing from financial institutions. The thrust of reforms should be on sustaining and enhancing project cash flows, rather than relying on government subsidies and guarantees.

30. Special economic zones. Special economic zones (SEZs) have been envisioned in India as a scaled-up version of the export processing zones (EPZs) to overcome the constraints of poor infrastructure and high regulatory burdens. GoTN has recently unveiled its own special economic zones policy providing broad guidelines with specifics being worked out. International experience of EPZs and SEZs is mixed, which can provide lessons for the design of a policy and regulatory framework for SEZs. Unless SEZs can significantly overcome key constraints facing the private sector, SEZs will simply be a physical scaling up of EPZs while experience of EPZs in India is mixed. State-wide broader regulatory reforms and infrastructure improvements continue to be important.

Reform Agenda 31. The challenging reform agenda will require an institutionalized dialogue between the Government, the private sector, and the civil society for setting priorities and finding solutions. The recent establishment of an Advisory Industrial Council, to act as a think tank for the government, is an important step forward. The Council and its Consultative Working Groups can serve as an apparatus to formalize the dialogue between the Government and the private sector.

32. Tamil Nadu may draw valuable lessons from the type of Councils which have been important to the development of international competitiveness in Asia, particularly in South Korea, Taiwan (China), Singapore, and some other countries. Key factors contributing to the success of these institutions include political support, a clearly-defined decision-making authority in the Council, an accountable implementation mechanism, broadly-based private sector participation that is not perceive as representing special interest groups, and a public information and education campaign to build a shared consensus that can transcend any changes at the political level.

33. Priority reforms concern labor market flexibility, a more responsive urban land supply system, a more efficient tax policy and administration, streamlining regulations over entry, exit and operation, power sector reform and scaling up PPP for sustainable infrastructure development. Several important issues are exclusively or largely within the purview of the central government: labor reforms, the introduction of VAT, exit policy and bankruptcy procedures, and key infrastructure such as national highways, international air markets, major ports and rails systems.

34. Within the federal framework, the reform agenda for Tamil Nadu includes:

Explore ways to rationalize the legal framework governing labor and statutory compliance requirements to create elbow room for contractual labor relationship and for easing threshold for retrenchment.

Rationalize regulations on urban land zoning and development controls, and project approval and land acquisition processes, and develop a more effective planning and management system to facilitate infrastructure development.

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Reduce the impact of taxing inputs and complexity of tax policy and administration and reduce transaction costs.

Streamline regulations concerning construction and real estate industries and extend the simplified entry regulation covering large investment projects to smaller projects in every level of investment.

Find political solution to the metering of agriculture power pumpsets and reduction of cross-subsidy to improve the competitiveness of industry and services. The new Electricity Act by the central government effectively empowers Indian states to accelerate power sector reforms in the direction of greater competition, better governance, and private sector investment. But detailed implementation arrangement of the Act remains unclear in key aspects.

Scale up public private partnerships in infrastructure finance and development by providing selective credit enhancement to ULBs and developing financing mechanisms with targeted use of state government contribution and guarantees and link municipal financing with domestic capital markets; and by establishing a policy, regulatory and institutional framework for user charge regimes, concessions and contracting out, and dispute resolutions, for attracting private financiers and operators.

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CHAPTER 1: TAMIL NADU’S ECONOMIC GROWTH ACHIEVEMENTS AND CHALLENGES

1.1 Tamil Nadu has emerged as the fifth largest economy in India (its population of 62 million is the seventh largest). Its GSDP is about US$37 billion at official exchange rate or over US$100 billion based on purchasing power parity. With the fourth largest industry in the country, higher than Indian average growth rate in the 1990s, solid agriculture performance in the past, a rapidly growing IT service sector, an educated, hard working and disciplined workforce, good law and order, and ongoing reforms, Tamil Nadu can accelerate its economic growth and quicken the pace of poverty reduction. ECONOMIC GROWTH 1.2 The liberalization in the 1990s accelerated economic growth, increasing GSDP growth rates to 6.5% in the 1990s from 5.4% in the 1980s.2 Growth was driven mainly by accelerated growth in industry, including manufacturing, and in services, despite one percentage slowdown in agriculture growth (Figure 1.1). The impact of liberalization appears to have exerted greater impact on Tamil Nadu compared with the all Indian-average. The relatively faster growth in industry and services than in agriculture has changed the share of these sectors in GSDP (Figure 1.2).

Figure 1.1: Tamil Nadu and all-India Economic Growth

Trends

4.4 4.6 6.6

5.4 5.6 3.4

6.2 7.9

6.4 5.8

0 1 2 3 4 5 6 7 8 9

Agriculture & Allied Industry Services Tamil Nadu India

GSD

P G

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th R

ates

1980s1990s

Figure 1.2: Sectoral Shares of Tamil Nadu GSDP

24.3

3540.7

15.3

31.2

53.5

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60

Agriculture & Allied Industry Services

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1.3 However, growth has slowed down since the late 1990s. Growth slowed from an annual average of 6.6% from 1990/91 to 1998/99 to an annual average of about 3.7% from 1999/00 to 2002/03. Much of the recent slowdown is attributed to the impact of the droughts on agriculture and their spillover to other sectors. Tamil Nadu’s agriculture is vulnerable to periodic droughts due to its dependency on rainfall. More frequent than in the recent past, three annual droughts including the unprecedented century’s worst statewide drought in 2002, led to an annual average of –3.9% growth during 1999/00-2002/03 compared with an annual average of 4.5% in the previous nine years. Despite vulnerability to droughts, Tamil Nadu’s agriculture has done better than the Indian average in growth and productivity in the past two decades. The weak performance in the agriculture sector has spilled over to the service and manufacturing sectors whose growth has recently slowed down. 1.4 Although droughts are exogenous shocks, there are structural impediments, overcoming which could put economic growth on a higher trajectory path of 8% targeted by the GoTN to accelerate the pace of poverty reduction. Tamil Nadu’s agriculture faces challenges of growing water scarcity, land

2 All growth rates refer to real compound growth rates, and in the case of multiple years, real compound annual growth rates.

de-gradation, decline in farm sizes, and rising cost of agricultural labor. Rigid labor regulations, a complex and cascading indirect tax system, protracted exit and bankruptcy procedures, and infrastructure deficiencies are among the key constraints to better manufacturing performance in India.3 The 2003 investment climate survey of the manufacturing sector in Tamil Nadu reaffirms this assessment.4 Although manufacturing is recovering in India and in Tamil Nadu,5 higher and sustained manufacturing growth requires second-generation reforms to improve the investment climate. The current manufacturing growth is significantly less than what Tamil Nadu (or India could potentially achieve. The manufacturing growth in China in the 1990s was about 12% per annum, with coastal better-performing provinces achieving even higher rates. 1.5 Manufacturing continues to be the largest sector in Tamil Nadu, measured by its share of GSDP (22%). Tamil Nadu also has the third largest manufacturing sector in the country, with its manufacturing accounting for important share of national industrial output (Table 1.1 below).

Table 1.1: Tamil Nadu’s Share of India Industrial Output

Industry Category Tamil Nadu’s Share in India’s Output (%)

Cars 21 Heavy commercial vehicles 33 Auto components 35 Railway coaches 49 Motor cycles and mopeds 46 Cotton yarn 32 Power driven pumps 50 Leather products 70

Source: Tamil Nadu 10th Plan. 1.6 Higher manufacturing growth, together with the growth of the service sector, is critical to absorbing surplus agriculture labor and reducing rural poverty. The primary sector accounts for 50% of total employment, industry accounts for 24%, and the tertiary sector accounts for 26%. Tamil Nadu has had higher rural non-farm employment than other Indian states, and industrial activities are more spread across the state than most Indian states. Non-farm activities—manufacturing and services—account for about 50% of rural household income. Faster expansion of the manufacturing and service sectors would help reduce the impact of seasonality of rural employment, with acute vulnerability during the droughts, on rural incomes. Accelerating manufacturing growth is a key source of poverty reduction in Tamil Nadu. In a recent paper, Ravallion and Datt (2002) find that growth in per capita non-farm output has a strong impact on poverty reduction in Tamil Nadu.

3 The World Bank and the Confederation of Indian Industries, 2002, “Competitiveness of Indian Manufacturing Results from a Firm-Level Survey.” 4 The World Bank and the Confederation of Indian Industries, Second Indian States Investment Climate Survey, 2003, preliminary findings. 5 The increase in new investment commitments in manufacturing from April 2001 to April 2003 was highest in Tamil Nadu compared with other major Indian states, based on data from the Center for Monitoring of Indian Economy.

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Foreign direct investment Figure 1.3 FDI Approvals by State, 1991-2003

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

800.00

billi

ons

0

5

10

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30

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Series2 132,154.16 186,763.68 236,780.79 92,709.17 495,356.55 82,292.13 236,532.65 89,552.83 340,621.21 204,357.42 756,358.99

Series1 4.63 6.55 8.30 3.25 17.36 2.88 8.29 3.14 11.94 7.16 26.51

AP Guj. KN MP Mah. Ori. TN WB Delhi Other Not

Indicated

1.7 Tamil Nadu is one of the most favoured investment destinations in India. Figure 1.3 shows FDI approvals by number and amount over the period 1991 to 2003. Karnataka and Tamil Nadu rank almost equal second (after Maharashtra) as an FDI destination by state—with around 8.3 percent of the FDI approved over this period going into each of these two southern states (after discounting for the attribution to Delhi which is either a misclassification of the investment locale or an indication of where the company has located its head office).6

Figure 1.4: Investment in Manufacturing by State, 2001and 2003

0

10,000

20,000

30,000

40,000

50,000

60,000

Mah

aras

htra

Guj

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il N

adu

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Utta

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1.8 More recent data on domestic investment into the manufacturing sector appear to bear out this proposition (Figure 1.4).7 As of April 2001, the top five recipients of manufacturing investment were Gujarat, Tamil Nadu, Andhra Pradesh, Maharashtra and Karnataka. The difference between the data in April 2001 (red) and April 2003 (blue) measures the new committed investment during this period. Tamil Nadu ranked first with new investment commitments. Given the lumpiness of investments, it is inevitable that the levels of investment will change considerably from year to year. 1.9 Tamil Nadu appears to be a preferred destination for both FDI and domestic investment—with its relative attractiveness possibly increasing more recently. This would certainly fit the anecdotal evidence, which indicates a boom in the Information Technology sector, and the IT Enabled Services (ITES) sector—which has been growing at around 40% per annum on average over the past four years. Figure 1.5 below shows 2001 and 2003 investment by state.

1.10 Despite Tamil Nadu’s relatively good position amongst the states in attracting FDI—India as a whole has significantly lagged behind some Asian countries, as indicated by Table 1.2 below. The Government of Tamil Nadu is not comparing itself with that of other Indian states. It aims higher, viewing significantly higher FDI as vital to its export-led growth strategy. 6 Unfortunately, these data do not provide a good inter-temporal picture of FDI into India. 7 Data are based on May 2003 published data from the Center for Monitoring of Indian Economy.

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Table 1.2: FDI Inflows in Selected ountries of Asia (Net US$ million)

Countries 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

C

South Asia

2 4 6 7 8 19 23 12 4 4 19 371 6 3

2 2 3,577 2,635 2,169 2,315 3,403

Asia 33 54 69 151 294 204 121 126 126 113

229 1,002 1,936 2,349 2,455 2,745 1,972 1,609 1,298 1,300

2 2

Nepal desh* Bangla 10 18 18 88 246 304 397 96 01 370

India n

74 227 550 973 ,144 ,426 Pakista 257 335 349 421 723 922 716 507 530 308 383 Sri Lanka 48 123 195 166 56 120 430 193 177 173 172

merging

E Cambodia 0 Vietnam

s385

Philippine 544 228 1,238 1,591 1,478 1,517 1,222 2,287 573 6

2,029 1,792 Thailand ,014 ,113 1,804 1,366 2,068 2,336 3,895 7,315 ,213 3,366 3,820 China 4,366 11,156 27,515 33,787 35,849 40,180 44,237 43,751 38,753 38,399 44,241 Source: Glob

Figure 1.5: Tamil Nadu - Total Exports (US dollars and percent growth)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1997-98 1998-99 1999-00 2000-01 2001-02

M ill

ions

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rs

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25

percent

Figure 1.6: Export of Computer Software & Electronic Goods

0

200

400

600

800

1,000

1,200

1,400

1997-98 1998-99 1999-00 2000-01 2001-02

Mill

ions

yea

r

dolla

rs

al Deve t s d e g t

xports

.11 Tamil Nadu accounts for 60% of a

s of growth have oscillated from 1.4% to 23% over this

.12 The strongest growth in exports

lopmen Finance 2001, WB taff estimates. FDI in Bangla esh: Issu s of Lon Run Sus ainability E 1merch ndise exports of four southern states, 15% of all India merchandise exports and 17% of all India IT exports.8 Tamil Nadu exported around US$6.5 worth of merchandise and US$1.2 billion worth of IT services in 2001/02. Historically, the single most important sub-grouping of export items have been—and continues to be—textiles and ready made garments, accounting for a little over one third of total exports. Three other items dominate the export base—leather and leather goods, engineering goods, and computing software (IT) and IT Enabled Services (ITES). Exports from the state had been growing at about 10% annual average in US dollar term from 1997/98 to 2001/02. However, annual rateperiod. 1has come from the IT and the ITES sectors which have grown at a rate of close to 40 percent per annum over this period; and continued to grow strongly into 2002/03. Exports from this sector are now well over $1.2 billion and represent around 17 percent of India’s total IT/ITES exports. Where as this sector represented 6 percent of Tamil Nadu’s total exports in

8 Tamil Nadu’s share in India exports increased from 15.3% in 1997/98 to 17.6% in 2001/02.

4

1997/98—this had risen to 16 percent of total exports four years later. Figure 1.6 below shows the growth of IT/electronics goods exports from the state over this period.

Box 1.1: Coimbatore—Home of Asia’s argest Medical Transcription Facility

welve kilometers outside Co plex of buildings. This is s

ms [KGISL], Asia’s largest medical transcription facility, which started ound-the-

standing of

ITES market never stands still. KGISL is already moving on to interesting new applications. It has started a second joint anies

“listen in” on these conference calls. Each transcribes

more specialized. A team of 40 mechanical engineering graduates will convert two-dimensional engineering

continuous new product development, KGISL is also rightly proud of its pioneering work with the blind. It has

l

L

T imbatore in farming countryside, there stands a most unexpected and remarkable comthe KG Campus, a 25 acre “walk-to-work” technology park, built around five office buildings totaling 100,00 sq. ft.. The campus also include500 homes, a 24-hour restaurant, shops, a place of worship, a sports field and gym. The campus is also home to a 300-bed eye hospital and a heart hospital. An engineering college is being constructed.

ne of the five office buildings houses KG Information SysteOoperations in 1996. It is a joint venture with HCR ManorCare, a US S&P 500 health-care company. Here, 1,200 employees work in rclock shifts at 300 workstations, as a “back office” for 40 US hospitals, and their 4,000 doctors. These doctors dictate their patient appointment notes. This voice information is sent immediately over data communication links from the United States to the satellite dishes on the roof of the KGISL building at the KG Campus. It is transcribed at the KGISL workstations, and sent back immediately over the same link. If required, a print-out of the transcript can be available for the doctor to give to the patient immediately, before the patient leaves the doctors office. Alternatively, KGSIL can supply the transcript within a few hours. KGISL is able to guarantee 99.5 percent accuracy.

hese employees are not medical graduates. They are school-leavers, who are especially trained by KGISL, to have a basic underTanatomy, physiology, medical terminology, surgical procedures, American phonetics, proof-reading and editing. The medical transcription market is booming. The business model is simple, and is now fully tested. KGISL expects future growth to continue in excess of 40 percent per annum.

owever, theHventure, this time with CCBN of Boston. Under new US regulations, the information given by the management of publicly quoted compto Wall Street analysts must also be made available to the ordinary shareholder. Yet, the top management of such companies regularly conduct telephone conference calls with analysts – which do not include ordinary shareholders.

he solution is with CCBN and KGISL in India. At KGISL, teams of three individualsTthe contents of the calls, including the important question-and-answer sessions at the end. A sophisticated software package then compares each of the three versions, to come up with the edited final transcript, guaranteed by KGISL to be 99 percent accurate. This accuracy is in spite of dictation being taken from normal conversational speech – sometimes quite heated. This transcript can be ready for posting on a public website within a few hours of the actual conference call. In addition, KGISL specialists produce an edited summary of each call, also accessible on the public website.

he next business process will be Tdrawings into three-dimensional on-screen “models,” in full color, and with moving parts. So, for instance, developers of new auto components in Detroit will be able to show their potential customers exactly how their new components will look, in three dimensions, and exactly how they will move and operate.

uite separately from itsQtrained graduates from the National Institute for the Visually Handicapped in Chennai, to work in medical transcription. They use special speech-activated software, which allows them to verify and edit their transcripts, and also allows them to refer to online English and medicadictionaries. Their acute hearing allows them to transcribe at a speed faster than natural speech. The first batch of blind graduates is already working at KGISL in medical transcription.

Figu

% S

ect

re 1.7: Tamil Nadu Exports - 1997/98 & 2001/02

0.000.050.100.150.200.250.300.350.400.450.50

Leather andLeatherGoods

EngineeringGoods

ComputerSoftware &electronic

Goods

Textiles and Readymade Garments

Other Commodities

or S

hare

1997/982001/02

.13 However, traditional 1manufacturing exports are short of their potential. Textiles and ready-made garments, the dominant traditional export sector, grew at only about annual average of 3.3% in US dollar term from 1997/98 to 2001/02. Leather and leather goods, the second most important traditional export item for Tamil Nadu, grew at an annual average of about 5.2% in US dollar terms over the same period. These, combined with strong IT growth and solid growth of some other sectors such as engineering goods of about 10%,

5

have reduced the share of the two important traditional export sectors from about 57% in 1997/98 to 45% in 2001/02. Figures 1.8 shows the composition of Tamil Nadu’s exports in 1997/98 and four years later in 2001/02. 1.14 Improving the competitiveness of Tamil Nadu exports is key to accelerate export growth, as analyzed in Chapters 2-4. Tamil Nadu is not content with its enviable export position of US$8 billion (2001/02) among Indian states. Instead, the State has the capacity to achieve higher exports growth. As pointed out by the Chief Minister, “While exports don’t yield revenues for the state, we are backing this strategy as the dominant theme has to be scale and volume, accompanied by nimbleness in information assimilation and decision making.”9 Tamil Nadu can accelerate exports growth by improving its investment climate, as experience in East Asia economies has shown. Take the example of Guangdong province in China (79 million) which had merchandise exports $79 billion in 1999 (not including exports from Hong Kong), and Shanghai of China with 16 million population and total merchandise exports $19 billion the same year.10 Key poverty outcome 1.15 Tamil Nadu’s performance on economic growth and poverty reduction was above the India average in the 1990s, but poverty remains high. As illustrated in Figure 1.8, Tamil Nadu’s per capita income growth ranked the second highest in the 1990s, and the reduction of poverty is faster than the India average based on official estimates of National Sample Surveys (NSSs).

Figure 1.8: Tamil Nadu’s performance on economic growth and poverty reduction

Decline in Poverty Rate between 1993/94-1999/00

0%

15%15%15%

16%24%

25%26%

28%

37%41%

45%

60%64%

OR

BHWBM P

APUPKN

M HRJTN

GJKRPJ

HY

Growth rate of per capita income during the 1990's

2.3%

2.3%

2.9%

2.9%

3.2%

3.5%

4.0%

4.2%

4.6%

4.6%

5.0%

5.5%

5.8%

5.4%

-0.7%BH

UP

OR

HY

PN

M P

RJ

AP

IndiaKR

M H

WB

TN

GJ

KN

Note: AP: Andhra Pradesh, BH: Bihar, GJ: Gujarat, HY: Haryana, KN: Karnataka, KR: Kerala , MH: Maharashtra, MP: Madhya Pradesh, OR: Orissa, PJ: Punjab, RJ: Rajasthan, TN: Tamil Nadu, UP: Uttar Pradesh, &WB: West Bengal. Poverty estimates are based on Deaton and Dreze (2002). Source: CSO, NSSO, Planning Commission, Census of India 9 Chief Minister Speech at National Council Meeting of the Confederation of Indian Industry, July 25, 2003. 10 Comparison with smaller developing countries would not be meaningful due to the size of domestic market.

6

Table 1.3: State-Specific Poverty Headcount Ratios in the 1990s (%)

Rural Urban Combined

1999/00 Reduction

from 1993/94

1999/00Reduction

from 1993/94

1999/00 Reduction

from 1993/94

Andhra Pradesh 26.2 3.0 10.8 7.0 21.7 4.5 Karnataka 30.7 7.2 10.8 10.6 25.1 8.1 Kerala 10 9.5 9.6 4.3 9.9 8.2 Maharashtra 31.9 11.0 12 6.2 24.2 9.5 Tamil Nadu 24.3 14.2 11.3 9.5 19.8 12.5 All-India 26.3 6.7 12 5.8 22.7 6.5 Source: Angus Deaton and Jean Dreze (2002), “Poverty and Inequality in India: A Reexamination,” Economic and Political Weekly, September 7. These figures differ from the GoI and WDI estimates since they make different adjustments for survey questionnaire changes and urban-rural price differentials. The GoI estimates show that Tamil Nadu’s poverty headcount was reduced from 35.4% in 1993/94 to 21.1% in 1999/2000.

1.16 Nonetheless, Tamil Nadu remains a poor state. With GSDP per capita of about US$500 (2001/02), Tamil Nadu remains a low-income state. About 12 to 17 million people live in poverty.11 Scheduled castes are highly represented among the poor. Rural poverty is concentrated among those with marginal landholdings and dependent on rain-fed agriculture. As one moves from the lowest- to the highest-income quintiles of rural household income, the contribution of agricultural wage income to total income decreases monotonically, while that of cultivation and non-farm sources increases monotonically. Reinvigorating agriculture growth and accelerating industrial growth, together with solid growth in the tertiary sector, remain critical for sustained poverty reduction. Data limitation prevents a fuller understanding of urban poverty12 million to 18 million people continue to live in poverty. 1.17 Important challenges in the non-income dimensions of poverty remain. In particular, the education challenges are to reduce the drop-out ratio, improve the quality of education, and continue to reduce gender, caste, inter-district, and urban-rural disparities. The gender gap in education is especially larger among poorer households. Scheduled castes and scheduled tribes also have significantly lower educational attainment than non-scheduled castes/scheduled tribes. With regard to health challenges the crude birth rate (CBR) has been hovering around 19-20, neo-natal mortality has been stagnating, and the female infant mortality rate remains high. There are significant rural-urban differentials and inter-district variations. Tuberculosis is reemerging in association with HIV/AIDS and non-communicable diseases are on the rise.

1.18 Economic growth is a key driver for sustaining and accelerating the pace of poverty reduction and the attainment of MDGs. Accelerating economic growth is the foundation stone of anti-poverty policies worldwide. A dynamic economy, growing strongly, is a powerful force for creating new and better employment opportunities for poor people, enabling empowerment, and reducing vulnerability. Most of the reduction in poverty in the recent period in India has been a result of the increase in average consumption driven by economic growth (Deaton and Dreze, 2002). In India, policies that foster overall economic growth have the greatest potential for reducing poverty further (Stern, et. al, 2003).

11 12 million poor is based on poverty incidence of 19.8% (Angus Deaton and Jean Dreze, 2002). 17 million poor is based on poverty incidence of 28.9% (Kijima and Lanjouw, 2003).

7

1.19 Tamil Nadu’s 10th Plan specifically set out an annual growth target of 8%, to be underpinned by a broad reform program. As articulated by Chief Minister in her address to the National Council Meeting of the Confederation of Industry, second generation reforms to improve the competitiveness of Tamil Nadu industries is critical to achieving the target. The reform consists of deregulation of complex procedures, building world-class infrastructure, labor reforms, and tax reforms. There reforms complement ongoing reforms in fiscal management, agriculture growth, social service delivery, gender and caste equity, social safety nets, and sustainable ecology to accelerate poverty reduction and social improvements.

Box 1.2: Incentive to Private Investment

“The incentive to invest should be not via tax concessions or by diluting the conditions for sitting requirements or attracting pollution-intensive industries. Investors must be attracted by adequacy and quality of infrastructural services at reasonable prices, availability of skilled labor, time-bound clearances of permits and licenses, removal of procedural obstacles, stable tax policy, disciplined labor force, law and order, speedy resolution of disputes and above all good governance.” -- Tamil Nadu 10th Plan.

Investment climate Figure 1.9: Estimated growth rate gains from improvement in

Investment Climate in India

8 .7 %8 .0 %

8 .4 %

7 .2 %

4 .8 %

6 .3 %

0 %

2 %

4 %

6 %

8 %

1 0 %

G o o d a n d b e s t cl im a te sta te s

Po o r cli m a tes ta te s

All In d ia

A nnual average G D P grow th rate,1992-98

Po te n tia l Ac tu a l

Source: World Bank and CII

1.20 Cross-country evidence has demonstrated a strong link between investment climate and growth. There could be considerable growth gains from improvement in investment climate in Tamil Nadu. The improvement of investment climate in states which are already characterized as having good or better investment climate (including Tamil Nadu) within India could improve growth by 1.5%, based on the work by the CII and the World Bank (2002).

1.21 What is investment climate? As summarized in a paper by the World Bank and the Confederation of Indian Industry (2002), the quantity and quality of investment flowing into India, or an Indian state, or any other country depends upon the returns that investors expect and the uncertainties around those returns. There are three broad and interrelated components that shape these expectations (the focus of this paper is on the second and the third elements, with a parallel fiscal paper dealing with the state-level fiscal policy):

• macroeconomic policy, political stability and national policy towards foreign trade and investment;

• efficacy and transparency of regulatory framework for starting or exiting a business, labor market, financing, taxation, and public interests such as environment; and

• quantity and quality of available physical and financial infrastructure. 1.22 Many policies and regulations affecting investment climate are within the purview of the central government. It is important to bear this in mind when analyzing investment climate in Tamil

8

Nadu and reform options. Table 1.4 outlines the jurisdictions of policy and regulations for the second and the third elements of the investment climate.

Table 1.4: Regulatory Jurisdictions over Factor markets and infrastructure

Issue List Labor regulations Concurrent Finance and capital market Union Land rights Mostly state Entry/exit (including SSIRs) Concurrent Taxation policy and administration Concurrent Power Concurrent Local transport (roads, minor ports) State Water supply and irrigation State Inter-state water dispute Union/states Major ports / air markets / national highways Union

Telecommunications Union

1.23 Overview of investment climate in Tamil Nadu. The findings from the investment climate surveys (Figure 1.12) indicate:

• Cumbersome regulation and infrastructure bottlenecks are viewed as major or serious constraints to growth in Tamil Nadu. About two in every three managers thought that excessive regulation and resulting corruption were a major or sever obstacle to growth. The figure would be even higher if we include under the same category complaints about the quality of the administration of tax (within the purview of the state government) and customs (within the purview of the central government). Following not far behind, and apparently with the same degree of gravity as each other are inadequate provision of infrastructure, poor access to and high cost of external finance, and concerns with macro stability and high tax burdens. The constraint of access to land is likely to be underestimated, as surveyed firms are incumbents, and not in real estate and construction businesses.

• Survey response was influenced by the exposure of the firm to international competition. As illustrated by Table 1.4, for every factor except for access to external finance, exporters responded more strongly than non-exporters. The ranking of factors are different between exporters and non-exporters in Tamil Nadu. For exporters, infrastructure is the second most important constraint together with tax/custom administration.

Table 1.5: Percentage of Surveyed Exporters and Non-Exporters in Tamil Nadu

Identifying Factors as Major Constraint

Constraint Exporter Non-exporter

Regulations & Corruption 72.3 56.2 Tax & Customs Admin. 48.9 35.6 Infrastructure 48.2 31.4 High Taxes 46.0 39.4 Macro & Policy Instability 45.6 37.6 External Finance 40.9 46.7 Skill Shortage 19.7 16.2 Access to Land 14.6 9.8

9

• It must be cautioned that the surveys indicate what business managers perceived as constraints relative to their own growth level and potential, but may not indicate absolute level of a certain indictor. For example, percentage of respondents identifying infrastructure as a major constraint is about the same in Tamil Nadu and China, but this does not lead to the conclusion that the level of infrastructure development is about the same. They could be very different. The survey results in Figure 1.11 merely tell us the key constraints to growth in Tamil Nadu as identified by firms there. In subsequent chapters, some objective comparison will be offered.

Figure 1.10: % of Respondents identifying factor as major or serious constraint to growth

0% 10% 20% 30% 40% 50% 60% 70%

Regulations & Corruption

External Finance

High Taxes

Tax & Customs Admin.

Macro & Policy Instability

Infrastructure

Skill Shortage

Access to Land

China

Malaysia Karnataka

Gujarat Maharastra

Tamil Nadu

1.24 The seriousness of infrastructure bottlenecks to growth are illustrated in Box 1.3 below, based on focus group discussion in May 2003 by the Bank with the Tirupur Export Knitwear Industrial Complex, one of the several industrial clusters in Tirupur. Tirupur is a small town in Tamil Nadu, with a population of only 420,000. The town has emerged as a dynamic export center of textiles and garments in Tamil Nadu, as well as India. Tirupur accounts for about 18% of total Indian garment exports, or two third of Tamil Nadu garment exports. Focus group discussions pointed to infrastructure, particularly power and road transport as the top growth constraints, as well as labor regulations. Exports from the Complex are quota based. After the phasing out of quota-based exports in 2005, Tirupur exporters will need to compete internationally based on cost effectiveness. The infrastructure problems identified therefore may serve as an indicator as to the seriousness of the constraints to higher economic growth that is linked with international competitiveness. Moreover, the entire Tirupur town does not have water supply and sanitation system (the new public-private partnership initiative is expected to resolve this constraint soon—see Chapter 3).

1.25 The rest of the paper is organized along the key constraints identified. Chapter 2 deals with government regulations, focusing on regulations of factor markets (labor, capital, and land), tax and its administration, and business entry/exit and ongoing operations. Chapter 3 deals with infrastructure

10

bottlenecks. Chapter 4 discusses how to institutionalize the reform process of improving the investment climate and concludes with an agenda of reform options.

1.26 The issue of macroeconomic environment for India is not within the scope of the work for Tamil Nadu, but fiscal reform for Tamil Nadu is covered by a parallel paper entitled Tamil Nadu Fiscal Reform and Sustainability. A key to external finance is to attract substantial foreign equity investment. As already discussed above (para. 1.10), foreign direct investment is low in India comparing with other emerging economies. The general regulatory environment and infrastructure are key determinants of FDI, so there is no separate discussion on external finance itself.

Box 1.3: Infrastructure Bottlenecks Facing TEKIC in Tirupur

The Tirupur Export Knitwear Industrial Complex (TEKIC) is one of the major industrial estates or clusters in Tirupur. Tirupur has a population of about 420,000, but exports US$1 billion in knitwear, accounting for about 18% of total Indian knitwear exports in 2000/01.

TEKIC has 189 laid out sheds situated in and around 100 acres of land and 148 industrial units with small and medium investment in operation. Most firms in the complex export to US and Europe markets. In the last three years, member firms have exported about Rs.1750 crore of knitwear (close to US$400 million). The complex employs about 10,000 workers.

Focus group discussions by a World Bank team in May 2003 with a dozen representatives of business activities in the complex revealed the following key infrastructure constraints to sustain and accelerate export growth:

Power cuts and fluctuation make it difficult to use precision machinery and equipment which are essential for export products; congestion on roads around the Complex and on those leading to the port.

Adding to these are the rigid labor regulations which make it difficult to efficiently adjust workforce to meet seasonal variations in business demand, while such variations are typical in garment exports.

TEKIC faces huge competitive pressure when quota-based export system will be phased out in 2005 when the Multi-Fiber Agreement comes into effect. Infrastructure investments are thus urgently needed to make it possible for TEKIC to prepare for competition. After 2005, without quota protection, Indian firms will need to compete internationally based on cost effectiveness.

The urgently required infrastructure improvements are:

(i) Setting up a power plant to provide reliable quality power supply (ii) Strengthening and widening the existing road and providing storm water drain (iii) Developing a new road connecting Vijayapuram in Tirupur (Kangayam road) and Periyapalayam in Tirupur

(Uttukkuli Road). (iv) A high bridge across river Noyyal to interconnect the above roads.

11

CHAPTER 2: REGULATORY BURDENS

Overview 2.1 The regulatory framework is broadly understood to include the following three themes:

• factor market regulations, i.e., regulations of labor, capital, and land markets; • tax and customs administration; and • regulation of entry and exit through licensing requirements and bankruptcy laws.

2.2 This chapter is organized along the above three themes. It begins with the analysis of factor market regulations (labor, capital and land), because the efficiency of factor markets is critical to more private investments, higher productivity, and faster economic growth. The Chapter will also analyze the impact of a highly complex and inefficient indirect tax system, which cascades taxes on intermediate inputs, serving as another barrier in factor market efficiency. The final section of the Chapter looks at regulations of business entry and exit, as streamlined and transparent business regulations improve productivity and accelerate growth.

2.3 Figure 2.1 shows indicators of the relative weights that surveyed managers attach to individual sources of regulatory burden. About 38 percent of respondents from Tamil Nadu identify tax administration as major-to-severe obstacle to growth. 30 percent put labor regulation in the same category. The corresponding figures for regulation via licensing and permit requirements are 19 percent. It needs to be noted that land market regulations have been identified by construction industry and real estate business as a major constraint, whereas the survey here focused on established manufacturing firms who may not have experienced similar problem.

Figure 2.1: % of respondents identifying factor as major or serious constraint to growth

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Tax admin

Labor regulation

Customs admin

Licensing and permits

Land mart. Regulation Tamil Nadu

Maharashtra

Karnataka

Gujarat

12

Table 2.1 Exporters and Non-Exporters response in TN (%)

Constraint Exporter Non-exporter Tax administration 72.3 32.4 Labor regulation 32.8 25.7 Customs administration 26.3 18.1 Licensing and Permits 19.0 18.1 Land market regulation 14.6 9.5

Labor market rigidity 2.4 Labor market restriction on hiring and retrenching workers is one of the greatest challenges of doing business in India, according to the Global Competitiveness Report—India ranks 73rd of 75 countries (China ranks 23rd). Box 2.1 summarizes the impact of labor market rigidity on India’s economic performance. Key labor legislations are set by the central government and states only have certain freedom in implementation.

2.5 Rigid labor regulations have prevented Tamil Nadu from unleashing its full potential in labor productivity. Tamil Nadu is known for its generally good industrial relations and its educated, hard working and disciplined labor force. Less than 1% of man-days are lost from strikes, and industrial violence is almost unknown. Also, the quality of education is rightly a matter of pride in Tamil Nadu.

Box 2.1: Do Labor Regulations Hinder Economic Performance in India?

A number of studies cite labor market rigidity for India’s poor performance in registered manufacturing sector. For example, Stern (2001) points to improvement of the investment climate as being critical to increasing productivity and reducing poverty and identifies reform of India’s cumbersome labor regulations as a priority. Zagha (1999) views the regulations having made it costly for firms to adjust to changes in market conditions and technology and encouraged firms to remain small and informal. Sachs, Varshney, and Bajpai (1999) point to restrictive regulations on labor redundancy as being a key reason as to why India has done poorly in terms of export performance. Using a survey of about one thousand manufacturing establishments drawn from ten Indian states Dollar, Iarossi and Mengistae (2001) show that the ‘cost of labor regulation’ is found to be important in explaining cross-state differences in productivity. Fallon (1987) and Fallon and Lucas (1993) argue that strengthening job security regulations through central government amendment of Industrial Disputes Act in 1976 and 1982 was associated with a reduction in labor demand in firms covered by the regulation but not in small firms uncovered by job security regulations. The stringency of employment protection regulation has thus been used to explain the phenomenon of jobless growth in industry during the last two decades. Evidence linking the direction of labor regulation and the pattern of manufacturing development in the Indian states comes from a study by Besley and Burgess (2002). They find that regulating in a pro-worker direction has been associated with lower level of investment, employment, productivity and output in registered manufacturing and the effects have been quantitatively significant. They also find that these pro-worker regulations have been a constraint on growth and poverty alleviation.

Source: a summary of Besley and Burgess (2002), Dollar, Iarossi and Mengistae (2001), Fallon and Lucas (1993), Sachs, Varshney, and Bajpai (1999), Stern (2001), and Zagha (1999).

13

2.6 There are three main issues with labor legislations.

• Business cannot legally use temporary workers to adjust the main workforce to meet variations in market demand. Such variations are the norm for Tamil Nadu’s key export markets such as garments and leather goods. Even for domestic markets, flexibility in the use of labor is intrinsic for an economy increasingly relying on market-based signals.

The Contract Labor (Regulation and Abolition) Act 1970 of the central government restricts the hiring of contract labors. Any person wishing to hire more than 20 contract workers needs to register their establishment with the state government, and contract labor can be used only for work of intermittent or casual nature (section 1(5)).12 The State government has abolished contract labor in categories of employment where the nature of work is necessary or incidental for the carrying on of the establishment, perennial in nature, ordinarily done through regular workmen, and it is sufficient to employ whole time workmen”. Furthermore, the abolition of contract labor gives an employee the right to be regularized in service. Thus contract labor cannot be used for process, operations and work that is of perennial nature to an establishment, which includes actual production of the factory’s outputs. Whether non-core activities such as packaging, cleaning or catering may be “perennial” is open to legal interpretation. As a result, outsourcing of services is severely curtailed. The other effect is that firms are encouraged to sub-contract work to very small informal operators. Unfortunately, quality and reliability are much more difficult to control with small sub contractors, as is compliance with other standards, such as on child labor and pollution. Thus, many foreign buyers now ban the use of sub-contractors. The Second National Commission on Labor has recommended only a very slight easing of these tight regulations whereby “for sporadic seasonal demand, the employer may engage temporary labor even for core production/service activity.”13 This recommendation is still being considered and even with the relaxation. However, the concept of “perennial in nature or core activities” would remain. What is needed is a practical and reasonable approach to contract labor. The recent move by AP to liberalize contract labor use can perhaps serve as a persuasive example for other states reform.

• Any firm employing more than 100 employees must seek permission from the state for

retrenchment or closure. The national Industrial Disputes Act of 1947, Chapter VB regulates “lay-off” (temporary workforce reduction), “retrenchment” (permanent reduction), and “closure” (all operations cease).14 Any of the above requires permission from the state labor authorities. Until 2001, such decision had been delegated to Joint Labor Commissioner in Tamil Nadu, but legal opposition led a withdrawal of the delegation and the decision rests now with the Minister of Labor. In addition to complex review procedures, granting a permission is inherently a political decision and rarely given.15

12 “Intermittent” is defined to exclude activities that was performed for more than 125 days in the preceding 12 months and if the activity is seasonal and done for more that 60 days in a year. 13 Commission Report, Para. 6.109. 14 Industrial Dispute Act Chapter VA regulates retrenchment by factories employing less than 100 workers through VRS package. 15 Such permission is given rarely across Indian states such as AP and Karnataka. Tamil Nadu is no exception. The total number of applications for layoff over the last 10 years was 200, and only 109 were granted permission. Out of 39 applications for retrenchment, only 7 were given. Out of 42 applications for closure, only 2 were given.

14

The Government of India has only recently announced its intention to raise the limit for seeking permission from 100 to 300 workers. This requires legislative changes by Parliament (repealing section 5B of the Industrial Disputes Act), and the political sensitivity of such changes is likely to make them very difficult to implement. It may still be possible for states to introduce flexibility within overall federal framework. The AP government is in the process of initiating amendment to Chapter VB to raise the number to 1000.

The foregoing restriction makes labor rationalization difficult and discourages businesses from expanding and hiring more labor as business management worry about not being able to downsize later. The regulations are especially burdensome for exporters competing with producers in other exporting countries where there are no such restrictions. This explains the tendency of FDI to focus on the India domestic market rather than use India as a base for exports.

Most firms avoid the requirements of this Act by offering workers voluntary retirement. However, VRS is more expensive, and is attracts the more productive individuals who are able to find new jobs more easily.

• The regulatory maze is complex, leading to high compliance cost and rent-seeking. There are

23 Union Acts and seven State Acts and Rules which are enforced by the Labor Department in Tamil Nadu (see Annex 2.1). There are also other central Acts such as the Factories Act which is enforced by the Inspector of Factories and Boilers. For each of these subjects there are different enactments by the center as well as implementing rules by the state. The list is so long and rules so complex that even a lawyer may not have full understanding of these statutes. There is clearly a disconnect between what firms are permitted to do—even pushing the envelope with the State Government to the maximum—and what they think that they can do. There are also different views between various levels of government officials as to how to interpret and enforce some aspects of the complex regulations.

Regulation of labor practices is cumbersome, and many are outdated. For instance, regulations do not permit the overlapping of shifts, a common practice elsewhere in the world. Also, the regular working week may not exceed 48 hours, and overtime is capped at 12 hours per week or 75 hours per quarter, whatever the circumstances, or the willingness of the workers to work longer. Prior notification to the authorities is legally required to work on a Sunday or a holiday and 1 day advance notification is needed for changes made thereto. These restrictions particularly hurt export firms, as international competitiveness requires operational flexibility. It is interesting to note that the IT industry is exempt from many of the labor regulations.

Though there is nothing in the Act that expressly prevents outsourcing of security, catering or cleaning, outsourcing of these can be deemed to be disallowed, as the law requires the factory to provide these facilities and services. Although the law is not enforced comprehensively and outsourcing of these activities has become a common practice, there remains the risk of litigation and that the court may order the principal employer absorb these contractors as permanent employees (as actual cases happened in Tamil Nadu).

The federal Minimum Wages Act (1948) and Rules 1950 of the state specify minimum wages for over 60 different industries, to cover various types of work. The courts have ruled that the minimum rate in section 14(1) of the Act is only applicable to those getting minimum wages and not those getting better pay and benefit under other statutory rules and factories have been exempted. Nevertheless, the requirement of the law goes beyond how minimum wage legislation is practiced elsewhere.

15

It is noteworthy that at the time of the framing of the Constitution of India, the statutes governing the labor market were already in existence. Due to the socialistic structure of the Constitution, which was specifically manifested by the 42nd Amendment, the labor market became regulated more by statutory controls that by contractual provisions. The present labor regulations are too cumbersome for the management to comply with and too complicated for the worker to rely upon.

Given the complex maze of regulation, full compliance is virtually impossible. The inevitable outcome is “collusion” (with or without bribes) between officials and private firms to ignore many infringements. Such regulatory burdens are particularly costly for smaller firms, as large firms can afford to employ specialist staff dedicated to compliance.

2.7 Rigid labor regulations deter greater employment generation. As explained in Box 2.2 below, stringent labor institutions tend to benefit a narrow segment of the population comprising the organized and unionized labor, intermediaries in the labor market, and corrupt officials, at the expense of a much larger segment of the labor force comprising the unemployed, those employed in the unorganized sector, and/or agricultural laborers who are seeking jobs in the organized industrial sector.

Box 2.2: Who Benefits from Stringent Labor Institutions? Stringent labor institutions, like large firing cost, strict labor standards, pro-union regulations, pro-labor minimum wage legislation, generous unemployment insurance, and central coordination in wage bargaining, tend to benefit a narrow segment of the population comprising the organized and unionized labor, intermediaries in the labor market, and corrupt officials, at the expense of a much larger segment of the labor force comprising the unemployed, those employed in the unorganized sector, and/or agricultural laborers who are seeking jobs in the organized industrial sector. A study by McKinsey & Co. on the Indian construction sector shows that, labor sub-contractors – mostly individual, non-registered entities—who directly procure and engage the labor required at the construction site make large profits by withholding labor benefits to the workers and by flouting various provisions in the labor laws, sometimes in collusion with corrupt government officials (see figure below). The labor laws that are commonly violated are those concerning contract labor, minimum wage, child labor, and industrial employment act. The violation occurs primarily due to high compliance cost of these regulations, inadequate enforcement, and lack of knowledge about their rights on the part of the laborers. The labor sub-contractors thus enjoy profit margins that average around 40 percent in an industry with no capital requirement! On the other hand, the laborers who are supposed to be protected by the legislations are denied their rightful benefits. More stringent laws and stricter enforcement of such laws thus tend to do more harm than good to the labor as a class. A study by IMF shows that generous unemployment insurance, larger firing costs, greater unionization, and higher direct taxes on households’ labor income and larger social security contribution tend to be associated with higher unemployment rate. A study on labor market regulations of the Indian states by Besley and Burgess, finds that pro-worker labor market regulations have failed to promote the interest of labor, and more worryingly, have become a constraint on growth and poverty alleviation. The study shows that, regulating in a pro-worker direction was associated with increases in urban poverty, which suggests that attempts to redress the balance of power between capital and labor can end up hurting the poor.

Source: based on AP growth study—a summary from McKinsey &Co. (2001), IMF’s World Economic Outlook (2003), and Besley and Burgess(2002).

85

54

1515

31

Revenues Actual wages paid Actual pro fit

46

M ostly due to evasion of labor laws and benefits

Prof itability of labor sub-contractots (Indexed to total revenue = 100)

Billed Labor

Profits and Overheads

2.8 Based on the survey, managers were asked to estimate the size of the labor force that they would have in their plant while producing at the current level of output but this time being free to choose their staffing levels. Figure 2.2 shows an average overstaffing ratio of 14 percent for the Tamil Nadu sample, which is more than twice that of Malaysia. The following are the reasons for overstaffing based on

16

percentage of managers rating these factors: social norm: 5%; labor union pressure: 14%; political pressure: 15%; labor laws: 34%; and anticipating of future sales: 62%.

Figure 2.2: % of Managers Reported Overstaffing

21.616.4

13.811.511.4

7.36.6

0.0 5.0 10.0 15.0 20.0 25.0

Guj a r a t

Chi na

Ta mi l Na du

M a ha r a sht r a

Ka r na t a k a

AP

M a l a y si a

2.9 The estimates of overstaffing may underestimate the problems for India in two respects. First, the mean employment size of firm in the Tamil Nadu sample is 154 workers comparing with 662 workers for the China sample. It is observed that firms in India tend to limit hiring in order to avoid threshold where retrenchment becomes near impossible (see para. 2.6). Second, the survey in India did not include firms who are sick and are under the bureaucratic restructuring process but cannot retrench their workers due to antiqued bankruptcy law. Bankruptcy in India is low (see para. 2.41). In China, other than state-owed enterprises (accounting for less than 20% industrial value added), factory closure and retrenchment are more frequent.

2.10 Field interviews with business managers in Tamil Nadu in May 2003 corroborated that labor regulations were a main obstacle to growth. Firm managers estimated that if they were freely able to use contract labor with flexibility in retrenchment, labor productivity could increase by around 20-30%. Admittedly, some firms do get around these problems, for example by breaking into smaller units. The solutions appear complex and add transaction costs.

Constraints in Financing 2.11 The issues of access to and cost of finance are at the purview of the central government, thus affecting all states. The key obstacles are high interest costs, collateral requirements, and burdensome paperwork (Figure 2.3).16 Comparing firm-level data from India with East Asian neighbors, Indian firms do report having a higher share of capital coming from bank loans relative to firms in East Asia. While a Tamil Nadu firm has more access to bank credit than some other states in India, it is half of that for Malaysia (Figure 2.4). While both China and India have low-inflation environments, India has much high interest rates on loans (12.3% compared to 5.9%). Thus, interest expenses are a higher share of costs for Indian firms. Comparing Indian firms with those in East Asia, interest costs over sales were a quarter higher for Indian firms. This places a burden on firms, both as they contemplate how to access external finance to take advantage of business opportunities and as they seek ways to make existing loans more affordable.

16 The World Bank Business Environment Survey.

17

Figure 2.3: Finance Obstacles

Finance Obstacles Percent of firms ranking issue as moderate or major obstacle

0 10 20 30 40 50 60 70 80 90 Banks lack money to lend Access to lease finance Access to foreign banks

Access to non-bank equity Access to Specialized export finance

Inadequate Credit

Special Connections Collateral Requirements

Bank Paperwork High Interest Rates

China India

Figure 2.4: Percent of firms who have outstanding bankloans

61%

47%

28%

17%

15%

12%

10%

61%

29%

28%

9%

13%

10%

9%

0% 10% 20% 30% 40% 50% 60% 70%

Malaysia

China

Tamil Nadu

AP

Gujarat

Karnataka

Maharashtra

All firms Small firms

2.12 Downward trend in interest rates has been a factor responsible for revival of industrial growth. The lower interest rates have resulted in huge windfall gains for larger-sized companies. Whereas such companies were paying 14% on one-year loans four years ago, today they are paying only about 8% (nominal terms). Borrowing rates for some of the largest corporations are up to 200 basis points lower than they were four years ago. Even in real terms, interest rates have fallen sharply. For some of the larger corporations, borrowing costs have fallen by more than 40%. Profits before taxes (PBT) have more than doubled as a result of declining interest rates, raising returns on equity to well above the cost of capital. If these lower interest rates are sustained, they are likely to bring about fundamental structural improvements in the industrial sector.

2.13 India's Small and Medium Enterprise (SME) sector still faces relatively high cost of capital, owing to market and policy failures. There is an adverse selection in the credit appraisal process for SMEs, and interest rate premia for the higher transactions costs in dealing with small borrowers, the lack of sufficient credit information on these firms, their frequent inability to provide collateral, problems in collection of collateral (typically land/property) from small borrowers due to the lack of updated land/property records and the uncertainty surrounding land ownership, resulting in higher costs of default and contract enforcement.

18

Urban land market constraints 2.14 Urban land markets play a critical role in the promotion of economic growth. They provide the physical space for industrial, commercial and residential development as well as providing rights of ways for critical infrastructure systems such as roads, transit, water and sanitation and power networks.

2.15 Significant and growing demand for urban land requires an efficient land delivery system. Rapid urbanization and demographic growth—from 19 million to 27 million urban population in the 1990s in Tamil Nadu—generate significant demand for urban land. In order for cities to grow, either agricultural land at the periphery or vacant and underutilized land in urban areas must be developed. An assessment of projected urban population and employment growth in Chennai, Coimbatore and Tirupur points to substantial demand for land for urban development.

Table 2.2: Projected urban population and employment growth in three cities

Metropolitan Area (LPA)

Annual Projected Population growth

Annual Employment

growth

Annual Projected Urban Land

Requirements hectares

Annual Projected Industrial Land

Requirements hectares

Chennai 1991-2011 180,000 24,400 1,900 250

Coimbatore (1991-2001) 46,000 17,600 600 160

Tirupur (2001-2021) 16,800 17,000 420 200

Note: Data from the master plans of the three cities. These estimates should be treated as rough orders of magnitude, subject to more careful assessment. They do however suggest the scale of land development requirements facing Chennai and two regional centers.

2.16 The estimates suggest that Chennai needs to convert approximately 1900 hectares of land to urban use per year. Of this amount, about 250 hectares are needed for industrial development. The demand for land in the regional towns is much smaller, but significant in terms of the scale of urban development taking place in their respective Local Planning Areas (LPAs).

2.17 Capturing a significant share of FDI and Indian domestic investments for higher economic growth will require an efficient land delivery system, including effective land zoning and a regulatory process for infrastructure and housing development review and permission.

2.18 The initial assessment found the following systemic weaknesses in the supply of urban land, urban planning regulations and project review procedures. These weaknesses, common across Indian states, have resulted in high land prices, sluggish market response of the industrial sector to emerging opportunities, and high levels of informality in urban development (see Box 2.3).

• Master plan designations in the absence of complementary incentives and measures make the supply of land for development inefficient. Insufficient land is programmed for development in some areas and too much in others. For example, attempts by the Madras Metropolitan Development Authority (MMDA) to control urban development in the 1970s and 1980s limited areas for industrial expansion in the city of Chennai, and proposed shifting industrial activities to outlying areas. While many governments limit the growth of industries in urban centers, it is only effective if supported by a package of measures. Such package measures have been lacking in Tamil Nadu. The MMDA’s 1975 Master Plan I proposed for 1991, 2,746 hectares of industrial

19

area in Chennai city.17 The actual industrial land use, in 1991, was double—4,705 hectares. In the suburbs the case was reversed—4,935 hectares was proposed in the outlying areas for 1991. In actuality, only 918 hectares were put to industrial use. The result of these distortions is to drive up land prices in major urban centers, and to suppress urban development in areas with too much industrially zoned but vacant land. Distortion-induced land price increases can be on the order of 10-25 percent higher in urban center areas.

• Land acquisition and project development, whether by the government or the private sector, is complex, time consuming and expensive. Either government or the private sector can acquire agricultural and vacant land for purposes of residential and industrial development. It is also possible for government and private sector entities to form join ventures to develop industrial estate projects. In either case, land acquisition can take from one to three years. The process is complicated by the fact that the Land Ceiling Act (still in effect) limits the size of agricultural holdings, thereby requiring the assembly of multiple parcels for large-scale residential and industrial estates. The Urban Land Ceiling Act, although repealed in 1999, still confounds land acquisition since it led to the parceling of urban plots to escape compliance with the Act.

• Obtaining permission for a building plan and license is complex and time consuming. Part of the problem stems from the lack of coordination between the Department of Town and Country Planning and local administration. Other problems include procedural anomalies, lack of clarity about various rules, overlapping powers of departments, and lack of rules regarding planning permission, construction and building licensing. A further problem is the requirement that large projects through out the state be sent to Chennai for review. The approval process can take up to three to five years depending on the size of the project and other factors.

• Floor Space Indices (FSI) in Chennai and other cities in Tamil Nadu are overly restrictive. They typically range from 1.0 to 1.5 for industrial and residential areas.18 In contrast, in San Jose, California, California’s Silicon Valley, FSI’s range from 2-4 for industrial development.19 FSI’s in other Asian cities range from 5 to 15 in central business districts. As Bertaud and Bruekner point out, low FSI’s promote sprawl and reduce the supply of development space in cities. These reductions in supply lead to increased prices of facilities space. Additionally, low FSI’s increase transportation costs and air pollution by promoting sprawl and low-density development.20

• Over-designed subdivision regulations exacerbate the effects of low FSI. For example, minimum lot sizes (75 square meters), frontages (6 meters), and set backs drive up housing costs. Road and subdivision infrastructure requirements make housing development more expensive than necessary. In total these costs could add 10-25 percent to the cost of residential housing costs.21

• Rent control, though not enforced for all buildings, also limits supply by discouraging owners from redeveloping properties to more intensive uses. If rents could rise, landlords will be inclined to renew older facilities and provide additional space on the market. Chennai seems to offer significant infill development potential if incentives were right.

17 Madras Metropolitan Development Authority, 1995, Master Plan for Madras Metropolitan Area-2011. Chennai: MMDA. 18 Chennai Metropolitan Development Authority, 2002, Development Control Rules for Chennai Metropolitan Area. 19 City of San Jose California, 2003, Zoning Ordinance. San Jose: City Planning Commission. 20 Alain Bertaud and Jan Bruekner [2003] India Policy Note on FAR Reform. Washington: unpublished document. 21 David E. Dowall "The Benefits of Minimal Land Use Regulations in Developing Countries," Cato Journal, Vol. 12, No. 2, 1992, pp. 413-423.

20

• Taxes on land transfers although reduced are still relatively high according to international norms with stamp and transfer duties at 8% (this compares transfer taxes ranging from 0.5-2% in Canada, 1-5% in the US, and 6% in Netherlands). High stamp duty makes the transfer of land expensive and encourages informal dealing and underreporting of transaction prices and in some cases the failure to register land transfers. Very low property taxes encourage landowners to withhold land from the market. Low taxes also make it more difficult to finance infrastructure development.

• Considerable land across cities in Tamil Nadu is held by government agencies and cannot be developed, as suggested by anecdotal evidence. Because agencies cannot sell land and retain the sales proceeds, land assets are often underutilized or inappropriately used. Housing supply data for1989-90 suggests the division of labor between the sectors (Table 2.2). With the public sector accounting for nearly 50 percent of all housing and plot production and 60 percent of formal housing and plots, Chennai’s housing market is highly dependent on the ability of the public sector to provide supply. If the public sector falls short, the entire housing market suffers.

Table 2.3: Public and Private Housing Supply in Chennai

Housing Supply Segment Plots and Units Share of Total

Public sector provided plots and dwelling units 9,000 45 % Approved private sector provided plots and dwelling units

6,000 30 %

Illegal subdivisions and hutments 5,000 25 % Total plots and dwelling units supplied 1989-90 20,000 100% Source: Madras Metropolitan Development Authority, Master Plan, 1995

2.19 A fundamental policy question is whether the public sector provides sufficient supplies of land to support the vast range of urban development projects required in the city.22 If it does not, as is often the case in fast growing cities, illegal subdivision and occupation of private land occurs for residential development. The lack of adequate supplies of industrial land usually limits industrial development, and occasionally leads to the illegal non-conforming development of industrial facilities in residential or commercial areas.

2.20 The situation with regard to industrial development is similar. Rough estimates indicate that government is responsible for 60 percent of all industrial estate projects and virtually all large-scale industrial development. This places enormous pressure on the government to provide industrial estate facilities for new and expanding firms. TIDCO, for example, operates 17 industrial estates across the state.23 Over dependence on public sector land delivery systems creates a strategic weakness that can undermine economic growth and long-term prosperity. 24

2.21 To conclude, zoning and development controls, such as the FSI are overly restrictive. Project approval and land acquisition processes are complicated and time consuming. Public sector domination of the urban land market—public industrial estates, housing estates and public enterprise land holdings immobilize a large share of urban land supply. Current government urban land planning and management policies have led to more expensive facilities and housing than necessary, promoting urban sprawl. 22 David E. Dowall "From Central Planning to Market Systems: Implications of Economic Reforms for the Construction and Building Industries," Housing Policy Debate, Vol. 3, Issue 4, 1992, pp. 977-994. 23 TIDCO Tamil Nadu Industrial Development Corporation [2002] Policy Note on Industries. Chennai: http:www.tn.gov.in/policy2002-3/ind2002-03-3.htm. 24 See for example, David E. Dowall "The Karachi Development Authority: Failing to Get the Prices Right," Land Economics, Vol. 67, No. 4, November 1991, pp. 462-471.

21

2.22 GoTN has already started undertaking steps to address some of the above issues. For example, a private industrial estate (Mahindra) has been under development and the Government has been very responsive to the Tirupur Exporters Association’s request to develop a private industrial estate. The focus so far has been to provide enclave regulatory relief to industrial estate developments, information technology projects and creating special economic zones that would be largely exempt from the application of existing policies and regulations. While such a policy may work in the short run, the medium and long-term solution requires systemic reforms to improve the economic efficiency of Tamil Nadu’s urban areas.

2.23 With the Bank’s technical assistance, GoTN has formed a partnership with the non-public sector to carry out a comprehensive land market assessment and a regulatory audit of land use planning controls for Chennai and potentially two other cities. This exercise is to develop a better understanding of the relationship between real estate markets, land management, urban planning, infrastructure planning and urban economic development outcomes. Based on the results of the assessment and audit, GoTN can explore how to improve the performance of the urban land market and the regulatory systems.

Box 2.3: Impact of Land Market Distortions

Common land market distortions:

• Unclear ownership of land—most land parcels in India—90 percent by one estimate are subject to legal disputes over ownership. Lack of clarity over ownership impedes real transactions and restricts the supply of land available for development. It also constrains the development and asset-based financing of real estate projects.

• Widespread public ownership of land thwarts private sector access to land to build residential, commercial and industrial projects.

• Inflexible zoning, rent and tenancy laws: effectively freeze land in city centers that would otherwise be available for redevelopment for retail stores, new residential flats and office buildings.

• Restrictive Floor Space Indices (in the range of 1:1 to 1:1.5) limit the density of urban development and foster urban sprawl.

• Counterproductive taxation mechanisms—low property taxes, poor tax collection and subsidized user charges for power and water leave local authorities unable to recover investments in infrastructure—thereby limiting the development potential of urban and suburban areas. On the other hand, stamp duties on real estate transfers are very high 8-10 percent of the value of the property changing hands. This too discourages real estate transactions.

These distortions drive up urban land prices and make housing and other facilities more expensive that they should be. They have led to 1.3% lost GDP per year for India. The following table compares land prices relative to income for India and other Asian cities.

Land Costs Relative to Income Levels India Indexed to New Dehli-100, Ratio of land cost per sq. m. ti GDP per capita in 1999

0

20

40

60

80

100

120

Kula Lumpur Sydney Bangkok Tokyo Singapore Jakarta Seoul Taipei Bangalore New Delhi Mumbai

Source: McKinsey Global Institute, 2001

22

Inefficient tax system 2.24 While the Tamil Nadu tax system generally is buoyant and produces substantial revenues (the state has one of the highest own tax effort), it has a number of features which risk to have a negative impact on the investment climate and long-term growth.25 Many of the current problems may be resolved with the introduction of the VAT system. Given the federal fiscal relationship, the state’s role in designing tax policy and administration is limited but there is considerable room for reform.

2.25 The existing sales tax regime generates multiple distortions and imposes a relatively high tax burden on inputs. Sales taxation, the main source of Tamil Nadu’s own tax revenues, has a cascading effect and imposes a relatively high effective tax burden on inputs. The regime consists of multiple layers of taxes (particularly, Tamil Nadu General Sales Tax (TNGST), additional sales tax, surcharges, resale tax, and central sales tax), but does not have an effective mechanism to relieve tax on inputs, except for the special tax treatments granted to export oriented units. To mitigate tax on inputs, the state allows for a concession rate (3%) applicable to the purchase of selected inputs and capital goods used in a manufacturing enterprise. Certain restrictions apply, however, and input purchases including those subject to the concession rate are not credited in the subsequent stages of the production-distribution chain. The problem becomes more acute with the introduction of a resale tax, which is a turnover tax.

2.26 As a consequence of the tax cascading, the tax burden on inputs can be relatively high, compared with many other countries. A simple estimation based on the sales tax data for 50 major commodities in 2002/03 indicates a significant share of sales taxes on inputs in total sales tax collection. TNGST on inputs accounted for more than 30% of the total TNGST collection. The effective rate of TNGST, alone, on inputs—defined as the ratio between TNGST on inputs and taxable turnover of inputs—is approximately 5.7%. The total TNGST, additional sales tax, and surcharges on inputs accounted for almost 32% of the total collection, and the effective tax rate was 6.7%. Figure 2.5 below shows the high tax rates on a selective list of 10 input-intensive commodities.26 This compares with 120 countries world-wide where VAT has been implemented and inputs are rebated, while VAT raises, on average, roughly a quarter of all the government revenues. The VAT has spread quickly in South Asia such as Nepal, Bangladesh, Pakistan, Sri Lanka, and Asia such as China, Indonesia, Thailand, and Vietnam.

Figure 2.5: Effective Tax Rates on Selective Commodities (2002/03)

0%

5%

10%

15%

20%

25%

30%

Commodities

Tax

rate

s

Data: Commerical Tax Department. IMFL (including beer, brandy, whisky etc) is excluded in estimating the effective tax rate of the other commodities because its rate is too high (55%) and considered as an outlier.

25 Many issues are common across Indian states. 26 The category “others” in the figure includes all other commodities, except for those 10 presented and the India-made foreign liquor (IMFL).

23

2.27 Tamil Nadu also imposes an additional sales tax on the sales turnover in excess of certain threshold at mildly progressive rates. This tax regime may encourage certain businesses to split at the potential loss of economies of scale.

2.28 The complex structure of the sales tax regime induces high compliance costs, while the frequent ad-hoc changes in the tax regime generate uncertainty for businesses. The current sales tax regime is characterized by multiple rates combined with the non-standard classification of goods. For the TNGST alone, there are 13 rates with wide dispersion ranging from 1 to 70% of the turnover. For comparison, the Tax Reforms Committee in the state of Karnataka recommended a reduction of the rate number from 11 to 7 (0, 1, 4, 8, 12, 20, and 25%) in 2001. Some countries in Anglophone African countries that applied the manufacturer’s sales tax before introducing the VAT had much simpler rate structures than the existing one in Tamil Nadu. Specifically, the rate structure in Kenya and Malawi consisted of four and two rates respectively. This creates high uncertainty among taxpayers and tax administrators, which is aggravated by the practice of frequent ad-hoc changes, generally on an annual basis, in both the rate structure and the tax base. Greater stability and predictability of the tax burden on businesses therefore would be highly desirable.

2.29 A high stamp duty on conveyance of immovable property raises transaction costs and distorts resource allocation. The stamp duty cum transfer duty on conveyance of immovable property was fixed until recently at 12% and 13% of the market value of the property depending on its location. A registration fee of 1 percent (with no cap) of the market value applies in addition. These rates are high compared with the ones in some other states in India and are in sharp contrast to international practice (0.5-2% in Canada, 1-5% in the US, 6% in the Netherlands, maximum rate of 6 percent with first 5,000 pounds exempted in the Republic of Ireland, and maximum rate of 4 percent with exempt threshold of 6,000 pounds in the United Kingdom). The high burden of stamp duties is economically inefficient, as it induces, inter alia, a “lock in” effect and property tends to be held longer than economically desired. An unreliable property valuation system determines guideline values as the basis for stamp duty calculation which frequently is not accepted by the business community and causes administrative and judicial disputes. Property transactions and the registration of a change of ownership thus can be delayed substantially and prevent businesses from either selling or acquiring business property. Recently, as part of fiscal reform in Tamil Nadu, the stamp duty on immovable property transfer has been reduced to a uniform 6% from 8% in urban areas and from 7% in rural areas. The transfer duty on immovable property, which was set at a uniform 5%, has also been reduced to 2%. The effective stamp duty is hence a uniform 8%, down from 12-13%.

2.30 The tax on entry of goods into local areas intensifies the unintended problems in the current trade policy set by the Central Government27 and exerts negative impact on trade and investment. The primary objective of the entry tax is to enhance the State’s revenue collection and to avoid trade diversion. Many Indian states have entry tax. Initially, the tax in Tamil Nadu was levied on only 6 items but was quickly expanded to cover 28 commodities. The tax is cascading for input imports and hence induces a high cost state economy. Although offsetting has been recently allowed for certain scheduled inputs, all exempt firms (including exports) bear the burden of the tax on their inputs because they do not pay sales tax on their outputs for the setoff.28 Also, the concession rate and offsetting are allowed for

27 Despite significant progress in the recent trade reform, the trade policy pursued by the Central Government of India remains largely restrictive, characterized by the high tariff rates—relative to the World standards—and inefficient administration of various schemes to exempt or offset the import duties for export manufacturers. 28 Effective from July 1, 2002, some concessions were introduced. First, entry tax can be set off from the TNGST and CST payable on the resale of scheduled goods. Second, certain inputs imported by manufacturers are subject to a concession rate of 3 percent, and certain raw materials used for manufacturing for sales are allowed to offset up to 50 percent of CST and 100 percent of TNGST.

24

certain raw materials only, and the cascading effect and incidence of the input tax burden are not transparent. Some inputs used in export manufacturing subject to entry tax are not allowed for credit and do not get concession rates (examples are maida, sooji, rava, wheat floor, steel rods and semis, and marble); so that the lingering tax burden on firms’ inputs would put them in a disadvantaged position in the world markets.

2.31 The business community also is concerned about the levy of entry tax on certain inputs currently not produced in the State. The tax-induced higher cost of production hurts firm competitiveness and thereby may divert investment from Tamil Nadu to other states. In this context it is of particular importance that from the fiscal year 2003-04, Karnataka abolished the entry tax on all raw materials and inputs (except for those used in tobacco products and liquor). Tamil Nadu could follow suit. For exporters, access to duty-free and indirect tax-free inputs at the world market prices is of vital import.

2.32 The duty-drawback system for exporters, administered by the central government, is reported to be slow and inefficient. Indian exporters use duty-drawback system to get rebate on tariff on imported inputs and central tax on inputs. The system does not rebate indirect taxes by the state. These put Tamil Nadu exporters in a disadvantage situation comparing to countries where exporters access inputs at world market prices (e.g., Singapore where there is no indirect tax on inputs). The VAT system, if ever introduced and implemented well, could resolve the current problems.

2.33 Tax administration organization and procedures increase costs and do not facilitate compliance. The tax administration is not business friendly, and compliance costs tend to be higher than necessary. There are a number of organizational and procedural elements of tax administration, which could be improved to facilitate voluntary compliance. A key issue is the lack of a self-assessment scheme in sales taxation. Assessment of the tax liability by the tax administration with desk audits of tax returns is a cumbersome procedure in particular for larger businesses and requires undesirable frequent contacts between businesses and the tax administration. The lack of the possibility to file tax returns electronically increases compliance costs in particular for larger businesses. Cumbersome registration procedures are an additional burden on businesses. The process of issuing a sales tax number can take up to one month and thus is far longer than what is usually required for the allocation of a taxpayer identification number. The requirement to re-register businesses every year does not create sufficient benefits for tax administration management to justify the burden on businesses. The dispute resolution mechanism has been substantially improved recently, in particular in the area of sales tax disputes, but dispute resolution still is time-consuming and requires payment of part of the disputed tax.

2.34 Compliance management in Tamil Nadu continues to be seen primarily as an enforcement-oriented task. However, more focus should be given to the importance of taxpayer service and information. A dedicated taxpayer service function in the tax administration with specific services and information targeted to the business community would be desirable.

Regulation of entry and exit 2.35 Easy entry of new producers and exit of inefficient producers are a powerful force in driving industry-wide productivity growth. New producers bring innovation, risk taking, and dynamism into a sector, forcing existing producers to continue to innovate and improve productivity. There are systemic differences in productivity performance of new entrants, exiting incumbents and exiting producers. Competitive pressure forces inefficient producers to shut down and exit (Liu, 1993).

2.36 Tamil Nadu has made progress in simplifying regulations over business entry. The new system of parallel approval has replaced the old system of “sequential process” (see Annex 2.1). Under the old system, approval for starting a business were to be obtained in sequential process, where

25

clearances would be obtained sequentially from a bureaucratic chain—from local government, inspector of factories, Tamil Nadu Pollution Control Board and Ministry of Environment from GoI, boilers, other project specific clearance, authorities for infrastructure such as water supply and power.

2.37 Under the new system for large investment projects (over Rs.250 million), Single Window committees give composite in-principle approval to enable project to start implementation. Agencies that provide infrastructure support—land, power, water, etc.—and statutory approval process proceeds simultaneously in parallel. There are time limits specified for each of the key steps in parallel processing. A Common Application Form has replaced over 10 separate application forms for obtaining all pre-project clearances and infrastructure support. There is an online web-based application form and investment tracking managed by the Documentation and Clearance Center of the Guidance Bureau, Industry Department. There are nodal officers assigned for each chain of application process. For small scale industries, there are district-level Single Window committees.

2.38 More can be done. 19 percent of business managers still identify license and permits as a major constraint to growth. Although some local governments have made efforts in streamline entry approval (e.g., Coimbatore), the streamlined process for large investment projects would need to be systematically extended to all small and medium-sized projects. It will then be important to monitor if the implementation of entry clearance is uniformly practiced by various levels of Government particularly in smaller cities and towns where capacity tends to be more limited.

2.39 The process of getting permission for a building plan and license has been identified as a problem by construction industry. The process is time consuming, procedurally complex, lacks coordination between two concerned departments, and lacks clarity of various rules regarding planning permission, construction and building licensing. Moreover, large projects throughout the state need to be sent to Chennai for review. The approval process can take up to two to three years depending on the size of the project and other factors.

2.40 A most important entry deterrent has been the Small-Scale Industry Reservation (SSIR) policy by the Central Government. Under the policy, over 800 products (until recent reduced number of 674) are reserved for small-scale industries only (defined as cumulative investment in plant and machinery per factory unit not exceeding Rs.10 million, or less than US$250,000). This policy discourages economies of scale and greater efficiencies—by inhibiting small firms from investing beyond the stipulated limits, expanding their operations in the domestic market, and then moving into exports. Although some of the important items have been de-reserved (e.g., garment, toy and leather products), SSIR has had significant negative impact over decades on the competitiveness of Indian industries.

2.41 Exit and bankruptcy procedures remain outdated and ineffective. These problems, all at the purview of the Central Government, have led to inefficiencies in the system, making industrial restructuring almost impossible.

2.42 Under the Companies Act, the tasks of restructuring, amalgamating and winding up companies are performed by the high courts and district courts, while the revival/rehabilitation of sick companies was assigned to the Bureau of Industrial and Financial Reconstruction (BIFR). Recent

Figure 2.6. Bankruptcies as a Share of Total Firms

0

1

2

3

4

USA Hungary France Czech Republic

Turkey Chile Thailand India

Percent

26

estimates show that it is common for proceedings to take more than two years, and more than 60% of liquidation cases before the High Courts have been in process for more than 10 years.29 Not surprisingly, when looking at the share of firms that go bankrupt, India has a much lower share (0.04%) than other emerging markets (Figure 2.6) and the US. BIFR has shown to be a protracted and cumbersome process.

2.43 The Amendments to the Companies Act (2002) should improve the bankruptcy framework. They stipulate the abolition of the Bureau of Industrial and Financial Reconstruction and the creation of a new umbrella body—the National Company Law Tribunal—that will restructure, amalgamate, and wind down companies (previously performed by the high courts and district courts) and revive and rehabilitate sick companies (previously assigned to the restructuring bureau). Under the new framework, courts will no longer have any powers in mergers and liquidations, and this should help expedite the restructuring and liquidation of sick companies.

2.44 The effectiveness of the amendment will depend on the repealing of the Sick Industries Companies Act, and the pace of labor market reform since the successful winding down of companies may be hampered by problems in retrenching workers. The recent law on the enforcement of creditors’ rights should help industrial restructuring, unlocking the resources tied up in non-performing enterprises for more productive use. But to help the restructuring of small firms, the law needs to be extended to cover them.

2.45 Regulation of business operations is being simplified by GoTN. A significant reform is ongoing by combining 53 registers and returns as required by different labor laws by GoI (e.g., the Factory Act, the Contract Labor Act, the Payment of Wage Act, and the Minimum Wage Act, with 23 central acts in total) and related seven legislations/rules by GoTN into one single annual return (Annex 2.2 lists these 53 returns). Such undertaking involves changing legal rules/regulations underpinning each of the 53 registers/returns and will substantially reduce paper work by business managers.

2.46 More reform can be done. As in the rest of India, firms face a complex maze of legislation and regulation. As already explained in labor regulations, full compliance is virtually impossible. There should be considerable room for simplification.

2.47 An important regulation of business activities in Tamil Nadu (as well as India) is the fiscal incentives offered by the government to registered small scale industries (SSI) via tax credit or other incentives. The state offers nine different “schemes” (after recent reduction and consolidation) and the Union Government offers another twelve. All have their different rules and remain complex and difficult to target well. Together with the Industrial Disputes Act (para. 2.6) which discourages expansion of employment beyond certain size in the registered sector as well as the SSIR policy, these schemes have built the “anti-growth bias” into the system.

29 Mathur, Ajeet N. (1993) “Industrial Restructuring and the National Renewal Fund”, Asia Development Bank mimeo.

27

CHAPTER 3: INFRASTRUCTURE BOTTLENECKS

Overview 3.1 Without good infrastructure, faster economic growth is not possible, neither is poverty reduction. The importance of rural infrastructure such as road network is recognized as crucial to increase the access of the poor to markets, schools and health care. Tamil Nadu is urbanizing rapidly, already being the third most urbanized state in India with 43% of population in urban areas. However, investment in infrastructure has not kept pace with urbanization. Rapid urbanization presents unprecedented challenges of massive investment requirements in physical infrastructure to facilitate economic growth and employment, with emphasis on sustainable and equitable urban development. 3.2 Infrastructure is more developed in Tamil Nadu than many Indian states, but compares poorly with other emerging economies. Inadequate infrastructure impedes private investment and makes the realization of 8% growth target difficult. Close to 40% of surveyed managers or about 50% of exporters in Tamil Nadu view infrastructure as a major or serious constraint to growth. Providing quality infrastructure is thus a key item in GoTN’s reform agenda. as reflected in the 10th Plan. 3.3 This Chapter will examine critical infrastructure bottlenecks. The Chapter will focus on power, road transport, maritime transport, and water supply, respectively. The final section analyzes key policy and regulatory issues concerning a greater role for the private sector and communities in infrastructure service delivery. A greater role for the non-public sector could help infrastructure financing, as fiscal stress in Tamil Nadu, like the rest of India, is a major constraint in public financing of large-scale backlogs in infrastructure investments and maintenance. The operational efficiency of the non-public sector in infrastructure service delivery has also received increasing recognition. Power 3.4 Tamil Nadu has the second largest power market in India (after Maharashtra). Total sales in the state were 36726 GWh in 2002/03. Supply constrained electricity sales have grown at 6% per annum over the last 7 years. Per capita consumption of electricity in the state is 484 kWh per annum as against the national average of 355 kWh and average of 400 kWh for the four southern states. Industrial sales comprise about a third of the total sales of Tamil Nadu Electricity Board (TNEB), commercial sales have a share of about 10%, domestic sales comprise about 24%, and agriculture sales comprise about a fourth with 1.66 million consumers. TNEB has a total of about 15.2 million consumers. 3.5 The state power utility board is among the more efficient state power utilities in India. TNEB till recently had monopoly in the electricity transmission, distribution and supply business.30 TNEB is relatively more efficient than most other state power utilities, with lower technical and distribution loss (about 16% comparing with 30-40% in most Indian states), consistently high collection efficiency of over 95% (among the best in the country), and effective detection and penalty for power theft. 3.6 However, power has become a serious infrastructure constraint in two aspects, despite the relative efficiency of TNEB and the larger size of industrial power consumption in Tamil Nadu.

30 The Electricity Act 2003 passed by the Government of India in June 2003 allows entry of new players in the distribution business, although such competition may not emerge immediately.

28

High power tariff to industries reduces the competitiveness of Tamil Nadu industries. Although average power tariff for industry in Tamil Nadu is less than that in AP, Karnataka and Gujarat, it is significantly higher than that in Maharashtra and some other countries. Industry in Tamil Nadu pays an average tariff of Rs3.95/kWh (as against an average cost of public power supply of Rs3.05/kWh) and actual cost of industrial supply estimated to be much lower. The high industrial tariff (common for other states in India) is mainly the result of cross subsidies that use industrial tariff to subsidize domestic and agriculture consumers.

Figure 3.1: Average Power Tariff for Industry, 2001/02

(cents/Kwh)

0 2 4 6 8 10 1

US & WesternBrazil

ThailandChina

Tamil Nadu

KarnatakaGujarat

Andhra PradeshDelhi

West BengalKerala

MaharshtraTamil Nadu

2

Comparison with Indian States

Comparison with Selected Countries

Figure 3.2: Trend in subsidy and cross-subsidy

0

1000

2000

3000

1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03

in R

s cr

ores

Total Subsidy to Domestic Total Subsidy to Agriculture Cross-subsidy

Power cuts, unreliable supply, erratic power quality (low voltage coupled with fluctuation) also reduce the competitiveness of Tamil Nadu industries. Due to severe financial stress, TNEB’s ability to make investments to improve the quality of power supply has been increasingly strained.31 Figure 3.3 below compares percentage of output lost due to power outages in Chennai with selected Indian state capitals and countries.32

31 See the Fiscal Reform and Sustainability Paper, Chapter 5 for an analysis of TNEB financial performance, and the causes for its deterioration. 32 The loss could be due to downtime (or idle capacity) forced by outages. It could, alternatively, be wastage of material that would have been in-process at the point of the outage and could not be used when production subsequently resumes. It could also be in the form of additional cost of equipment maintenance directly attributable to physical damages done by outages.

29

3.7 Many firms have 100% back-up generators. Some firms leave the public grid all together, relying completely on their own power generation. There are estimated to be 19,260 captive generation sets in operation in Tamil Nadu with a capacity of 3094 MVA (or 2475 MW). Measured by a ratio to total electricity sold in Tamil Nadu, this comes to 15%, with a statewide average captive plant load factor of 25%. In India, the captive generation capacity is 22,000 MWs, accounting for 20% of total capacity of the power utilities. The capital cost of captive generation sets constitutes on the average about 11 percent of total fixed assets for small businesses.

Figure 3.3: Percent of Output Loss due to Outages

2.123.88

6.29 6.44

11.77

02468

101214

Ahmed

abad

Mumba

i

Hydera

bad

Chenn

ai

Banga

lore

3.8 Several initial reforms had been undertaken since late 2001 but reform has experienced setbacks. As a part of broader fiscal and sectoral reforms, GoTN had initiated the following reform in the power sector: Tamil Nadu Electricity Regulatory Commission (TNERC) was made functional; there were two major tariff adjustments since December 2001 to reduce cross subsidy and improve financial health; a direct subsidy scheme to small and marginal farmers and hut dwellers, later expanded to more farmers were implemented as a step toward separating subsidy from power tariff; TNEB’s past dues to the central utilities of Rs.1,962 crore were securitized by GoTN to create a cleaner balance sheet for TNEB; and measures to further improve efficiency are under implementation. However, the introduction of power tariff for agriculture in March 2003 and the planned expansion of metering agriculture pumpsets have become a contentious political issue. The electoral loss for the Government during the 2004 national elections and the resulting political pressure led to reverting to the policy of free power to farmers. The government will provide budget support to the TNEB for agriculture tariff levied on farmers.

3.9 Removing the power constraint will require substantial reform in the sector. Future reform priorities are summarized by Box 3.1

The average estimate of losses that survey respondents attributed to these sources is expressed as a percentage of actual output

30

Box 3.1: India Power Sector Reform

Priorities are rationalizing power tariffs, depoliticizing tariff-setting, and implementing a phased reduction in cross-subsidies that operate against industrial consumers. Several states have begun to depoliticize tariff-fixing by establishing statutory regulatory authorities—and others should follow suit. Andhra Pradesh and Karnataka have introduced price incentive schemes to encourage industry to shift to the grid. The initial results for Andhra Pradesh are encouraging, with a 22% increase in demand in 2003. Time-of-day tariffs need to be introduced for industries with peak and off-peak rates. To minimize financial losses to the power utilities, cost recovery needs to be enhanced by charging higher tariffs to agriculture and residential consumers.

These measures must be accompanied by steps to encourage greater private investment in power. Key reform measures include improving the financial and operational performance of the SEBs and increasing distributional efficiency through commercialization and privatization. The strategy for privatizing distribution should focus on the commercially viable segments of the network and develop alternatives for improving services and targeting subsidies in rural areas. Going after a broader range of investors and mitigating the perceived risks will be keys to privatizing the distribution business. Trading by industries with self-generation, along with other power suppliers, should be encouraged by providing open access to the transmission and distribution networks and eliminating cross-subsidies over an agreed time frame.

Since power reform is primarily the responsibility of the states, alleviating bottlenecks requires the full commitment of state governments. The central government can support them by introducing legislation to foster reforms to encourage private involvement. The new Electricity Act (2003) should help through its provisions for moving to open access, removing entry barriers to new generation, de-licensing off-grid supply in rural areas, trading distribution licenses, stopping theft, and deepening regulatory reforms.

The new legislation effectively empowers Indian states to accelerate power sector reforms in the direction of greater competition, better governance, and private sector investment. But many implementation details remain to be decided, and the act’s success will depend on state action. The central government has also introduced a scheme to provide financial assistance to states willing to adopt power reforms. More critical, however, are continuing government efforts to maintain a hard budget constraint for state utilities, including rigorous policies on payments to central generation and transmission utilities.

Source: World Bank India Development Policy Review, 2003

Road transport 3.10 Tamil Nadu has a more extensive trunk road network than most Indian states. Its primary road network extends over 18,000 km, including national highways (3,850 km), state highways (7,163 km), and major district roads (7,362 km). Road transport is the dominant mode of transport in Tamil Nadu accounting for 80% of freight and passenger trips facilitating trade and economic development.

Table 3.1: Road Network in Selected States (Km per 1000 sq. km)

National Highway State Highway MDR+ODR Total Kerala 39.88 85.69 363.58 489.15 TamilNadu 29.72 54.87 371.07 455.66 Maharashtra 11.97 107.83 290.51 410.32 Gujarat 8.01 100.28 156.73 265.02 Karnataka 19.42 51.19 155.63 226.24 AP 10.66 31.71 NA UP 14.95 32.95 NA

Note: UP and AP has MDR data, but not ODR data. Total does not include village and other roads. MDR: Major District Road; ODR: Ordinary District Road.

31

3.11 However, the state as well as India seriously lag behind other emerging economies in road transport. India currently has no interstate expressways linking the major economic centers, and only 3,000 kilometers of four-lane highways (China has built 27,000 kilometers of four- to six-lane, access-controlled expressways, of which 25,000 kilometers have been built since 1995). Poor riding quality and congestion result in truck and bus speeds on Indian highways that average 30–40 kilometers an hour, about half the expected average. It will be difficult for Tamil Nadu to substantially improve its international competitiveness while the state has no access controlled, four- to six-lane expressway while major exporting provinces in China have substantially built up their capacity (e.g., 774 km for Zhejiang province, 1500 km for Guangdong, and 1386 km for Jiangsu, and 2077 km for Shangdong). 3.12 Demand for road transport has been increasing rapidly in Tamil Nadu with vehicle registrations growing by about 14% annually during the 1990s. Demand is projected to grow at least 8-9% in the foreseeable future and even more, if reforms stimulate more private investments and productions. 3.13 However, road network supply and quality have not kept pace with the growing demand, leading to serious network deficiencies in terms of slow response to growing demand, inadequate road capacity and maintenance. Road congestion is severe and accidents are high. Private sector lists congested road transport as a key infrastructure constraint. More than 50% (about 8,727 km) of the state highways and Major District roads are of less than two lane width (7.0m). The 40,963 km of other district roads and 73,300 km of village and urban/town roads are generally single lane. 3.14 Funding for road maintenance has been insufficient, resulting in more than 35% of roads being in poor condition. This implies that 5,075 km of roads in the core network of 14,500 km are in bad condition. There is a sizable backlog of funding of Rs.750 crore for maintenance of roads, leave alone widening and strengthening of these roads. 3.15 There is a greater need and urgency to formulate policy measures and further the reform agenda in the road sector. The bulk of investment will continue to come from public funding and indeed getting the pubic finances for the sector will be foundation for new private money. Across the globe, second-generation road funds with public/private oversight and explicit and transparent link between road tariff and road expenditure have contributed to the development of the road transport. Road development requires substantial capital investments, which cannot be financed by the state budget alone (paras. 3.31- 3.33). Even with increased budgetary support from the government, most of the road network remains in need of maintenance and upgrading. The gap in investment can be bridged by the private sector if sector reforms take place and a more conducive policy framework is put in place. 3.16 Several reforms have been initiated. The state is planning to establish a road maintenance fund, and in the future be able to leverage its resources in the domestic capital markets. The East Coast High Way undertaken by Tamil Nadu Road Development Company (TNRDC), a joint venture between GoTN and IL&FS, is an excellent example of public private partnerships for rehabilitation and maintenance of roads, and could be applied more widely to upgrade the road network (para. 3.35 and Annex 3.1). The provision of state equity and other financial support such as “viability gap funding” are also methods of leveraging public funds, which GoTN is considering. A clear regulatory framework for support of public private partnerships needs to be put in place which would define the role of the government and the private sector, lay out the risk sharing principles and also regulate the tariff regime for private roads.

32

Maritime transport 3.17 90% of Indian foreign trade is routed through sea. Efficient maritime transport including ports is therefore essential to Tamil Nadu’s (as well as India’s) integration with the global markets. Almost 99% of Tamil Nadu’s port traffic is handled at its three major ports33—at Chennai, Ennore and Tuticorin administered by the central government. 3.18 Varying degrees of privatization have improved efficiency of the three major ports. The majority of trade by value is handled at the state’s two container terminals, at Chennai and Tuticorin. Despite a slow pace of reform and labor disputes, eventual privatization of the container terminal in Chennai (November 2001) and of that in Tuticorin (December 1999) to reputable international operators have significantly improved their operational efficiency (best measured by number of containers per crane per hour which for example increased from 11 to 19 in Chennai). Also, all operations in the Ennore port (handles only coal so far) have been privatized and are up to international standards. Port users (shipping lines, importers and exporters) confirmed the improvements at three ports. Further, most of the trade by volume is handled with high speed modern equipment at specialized bulk cargo terminals. Therefore, the pervasive problem of low labor productivity is limited mainly to the general cargo berths, whose volumes are declining in line with international trends. 3.19 Prospects for developing minor ports are limited. The state minor ports account for 1% of port traffic, far below the national average. The mission therefore examined the prospects for developing the minor ports. The arguments in favor of their development include: high inland transport costs because there is no significant port along 600 km of coast between Chennai and Tuticorin; the negative impact of lack of local ports on local economic development and employment; and the absence of alternatives to the two federal monopoly Trust Ports at Chennai and Tuticorin. There are no regulatory, policy or institutional obstacles to minor ports development. The Tamil Nadu Maritime Board has opened up the state ports to private sector operations and there is little need for further reform of the regulatory framework. 3.20 However, the prospects for development of the minor ports were found to be limited. The main obstacles are economic due to initial high costs of port development: (a) there are few natural harbors on the coast, so that expensive breakwaters have to be built; and (b) dredging costs are high because of the littoral draft. The picture is the same in other states. Very few minor ports in other states of India have berths. Almost all are only anchorages, and the minor ports’ share of 25% of national port traffic consists mainly of bulk liquids. 3.21 Although major ports have improved their operational efficiency, reforms are needed on two fronts (at the purview of the central government).

• To extend privatization beyond container terminals in Chennai and Tuticorin, to withdraw the Port Trusts from a day-to-day operator to a landlord role in line with international practice, and to address substantial overstaffing. Although bulk and container cargos—92% (36 million tonnes) of total cargo in the Chennai port are handled relatively fast, there are potential savings with faster handling of general and other cargos which account for 8% (3 million tonnes) of the total. There are potential 40% savings in cost for these cargos. The average ship used for these general and other cargoes costs about $6000 per day in the Chennai port. There are about 1500 tonnes per day on average, resulting in a cost of ship time per tonne handled of $4 per tonne (i.e. 6000/1500). If the handling speeds were increased to more normal levels, say, to 2500 tonnes a

33 India has 12 major port under the federal government and about 140 minor ports under the state governments. The major ports of India handled 75% of national port traffic and the minor ports handled 25% in 2002.

33

day, there would be a saving of $1.6 per tonne handled. The total saving for the 3 million tonnes per annum would therefore be close to $5 million per annum.

• To remove complex administrative barriers and reduce transaction costs and delays related to shipping, trucking, and customs administration of exports and imports. Specifically, the reforms required are: (i) abolishing the cabotage reservation laws which are partly responsible for Tamil Nadu being served by small and expensive feeder ships rather than cost-efficient large ocean going container ships; (ii) abolishing the requirement to post a bond for container transport by road; (iii) abolishing the requirement for shipping lines to post a bond for containers landed in India; and (iv) simplifying regulations of documentation, customs formalities, paperwork and reducing agency fees at and around the ports. (ii) and (iii) are rarely practiced internationally and reduce the competitiveness of Indian exports.

3.22 The implementation of these reforms could lead to potential savings in cost and time in the entire cargo transport chain from inland to an European port, as illustrated in Box 3:5 below. The estimates of the potential savings of $191 per TEU (twenty foot equivalent unit) are in broad illustrative terms, it should be emphasized. Not all the container traffic would benefit from all these deregulatory measures. For example, not all containers come on feeder ships, and not all of the containers travel as far as 450 km inland, the distance used in the example. But if the existing container traffic (425,000 TEU per annum) were to benefit from, say, half of the saving shown, the total savings would be around $50 million per annum.

34

Box 3.2: Cargo shipping from Tamil Nadu inland to a European port Potential savings in costs ($/TEU) and time (day)

Proposed Deregulation

i. Abolition of reservation of cabotage for Indian ships, which would encourage direct calls by large ships, as the ability to feed would increase volumes at Chennai.

ii. Abolition of need to post a bond for containers landed in India iii. Abolition of need to post a bond for road transport of containers, which would increase door to port (or

vv) movement by container iv. Continuing reform of customs procedures, documentation, etc.

Proposed

de-regulation Cargo transport chain Cost with existing regulations

Cost with de-regulation

Cost Savings ($/TEU) 1,323 1,132

i and ii Freight rate from Europe to hub port (Colombo/Singapore) 750

700

i and ii Freight rate from hub port (Colombo/Singapore) to Indian port 100

50

850 750

Container handling charge at Chennai Container Terminal 48 48

iii Transport from port to CFS, unstuffing, and transfer to conventional truck 75 0

iii Road haulage to Coimbatore from CFS at Chennai (450 km) 250 284

325 284

iv Forwarding/documentation/customs/agency charges to cargo owners 100

50

Reduction in delays (days) 10 1

i Waiting for connections at hub ports (Colombo/Singapore) 5 0

iii Transport to CFS, unstuffing and loading to conventional truck 2 0

iv Import customs, documentation, clearances 3 1 Notes: (a) International freight rates are quite low at present, due to the world recession. (b) The feeder rate will be higher when the recession in the shipping market ends. At present the shipping lines absorb much

of the cost of feeding, whereas previously they had passed on the cost to customers. (c) This total includes a large number of procedures, signatures, etc. (d) This road cost assumes carriage in conventional trucks, each carrying about 8 tonnes, @ $125 per truckload for a 450 km

trip, which is equivalent to $250 per TEU. (e) Assuming the elimination of the need for shipping lines to post bonds for landing containers. This is assumed to save

$2000 (the container value) multiplied by interest at 2.5% covering the 3 months elapsing before repayment of the bond = $50 /TEU.

(f) Assuming that ending the regulation prohibiting foreign shipping lines from running feeders would result in a surge in direct calls by ocean going ships. The ending of cabotage reservation is probably a necessary but not a sufficient condition for direct calls.

(g) This assumes that the end of the obligation for a container truck to post a bond would allow port-to-door inland container transport. The cost of a 40’ trailer trip is estimated at R20,000, or, with and average of 1.5 TEU per trailer, about $284 per TEU.

35

Water supply 3.23 Unreliability and shortage of water supply is a major weakness in Tamil Nadu’s physical infrastructure. The problem, however, is not limited to Tamil Nadu but across India where about 54% of businesses rely on own wells. Nevertheless, the problem in Tamil Nadu is more acute because of the absolute scarcity of water resources in the state. Renewable freshwater resources are scarce, owing to high variability of rainfall and resulting river flows and periodic drought. Ground water has been overly exploited. Many of the most important aquifers of the state have been tapped at an unsustainable rate. 3.24 Businesses report an average of 11 days per month of interruption in water supply from the public line, against the all-India average of 4 days per month and only about half day per month in Malaysia (see Figure 3.4). The town of Tirupur, with a population of about 420,000, is a major hub for Tamil Nadu’s textile exports that account for 28% of India’s total textile exports. However, there is no reliable water supply system in the town. The water-intensive textile dying firms relies on around-the-clock truck arrangements to get the needed water from a distance of almost 25 km away (the Tirupur Water Supply Scheme, the first pilot public and private partnership in India on water supply, is aimed at resolving this problem, see Annex 3.1).

Figure 3.4: Number of interruptions in water supply (per month)

12.0

9.2

3.0

1.8

0.6

12.1

9.4

3.4

2.0

0.5

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0

Karnataka

Tamil Nadu

Gujarat

Maharashtra

Malaysia

All firms Small firms

3.25 Access to drinking water is constrained for a majority of the population (e.g., water is supplied for a few hours every three days for domestic use in Chennai and only for an hour during summer every few days in the city of Tiruchirapalli). Water supply varies from 34 lpcd in Town Panchayats to 74 lpcd in Corporations, significantly below the state norm of 90 lpcd. While Tamil Nadu has achieved significant success in achieving basic minimum service level of drinking water supply to most of its rural population, in terms of service levels, only about 35 percent of its 80,400 rural habitations34 have at least 40 lpcd supply of safe water. The level of environmental sanitation in rural areas is extremely low, coupled with lack of knowledge results in poor health and productivity. 3.26 The economic cost of raw water is high, but water user charges are well below cost recovery. Due to water scarcity and increasing demand for water, the economic cost of water is rising rapidly. But water user chargers do not even cover operation and maintenance (O&M), let alone capital costs. The estimated benchmark for covering O&M in Chennai is Rs.13 (US$0.26) per cubic meter. But

34 The 1992 survey had 66,631 habitations, which have now increased in the new 2001 survey because of redefinition of habitations.

36

the charges to residential consumers are typically a flat rate of Rs.60 per cubic meter per month.35 Further, the connection charges are well below the capital cost of expanding the network, ranging from four times below the cost in large cities to eight times below in poorer areas. Low cost recovery and the fiscal stress of the state make it difficult to expand public investment in the water sector, further constraining water supply. On average 4% of all government subsidies in India are directed to the water sector, with states picking up 90 percent of this cost. The gap between affordable tariffs and cost recovery tariffs can be narrowed by improving utility performance. Full cost recovery tariffs would clearly be beyond the reach of a substantial majority of households, therefore capital subsidies are likely to remain an important feature of the sector. 3.27 Industrial consumers pay substantially higher tariff to cross subsidize domestic users. In Tiruchirapalli, the industrial rate is Rs.225 per cubic meter per month and the commercial rate is Rs.275 per cubic meter, comparing with domestic users mostly pay a flat charge of Rs.60 per month. The unit cost supply of water to industrial users is lower due to large trunk mains instead of tertiary distribution networks for domestic users. Although in many countries, industries subsidize domestic users, the degree of subsidization is much higher in India.

Figure 3.5: Ratio of industrial to domestic water tariffs

0

5

10

15

20

25

30

35

40

45

50

upto 2 2 - 4 4 - 6 6 - 8 > 8

Ratio of industrial to domestic price

Perc

enta

ge o

f citi

es

MetroOthers

Note: Ratio based on a normalized consumption of 100 cubic meters per month. Source: Adapted from NIUA, 2002

3.28 A number of reforms have been initiated. These include: providing financing access and build capacity in ULBs to meet the basic service standards for water supply and other urban infrastructure; a number of notable initiatives in public private partnerships (PPP) in providing water and sanitation within the broader framework of PPP in provision of infrastructure in Tamil Nadu (section below discusses PPP); the establishment of the Tamil Nadu Urban Development Fund (TNUDF) in 1996 has been instrumental in credit enhancement and providing capital market access to urban infrastructure projects; and decentralizing water user charges to local governments albeit under state guidance.

35 Although Chennai does have block rates for domestic consumers, with Rs.15 per cubic meter for consumption beyond 20 cubic meter per month, the lack of water availability and pressure makes it physically infeasible to measure water use by meters. Therefore a very small fraction of Chennai’s connections are metered and the flat rate is the norm.

37

Public private partnership in infrastructure service delivery 3.29 To address the infrastructure constraints, investment requirements are substantial. This is partly explained by the rapid urbanization in Tamil Nadu. In the 1990s, urban population grew from 19 million to 27 million, making Tamil Nadu the third most urbanized state in the country as per the 2001 census after Maharashtra and Gujarat. About 43% of population is urban. 60% of this urban population lives in Class I towns and about 15% in the single metropolitan city of Chennai. This has resulted in a large number of small towns leading to low thresholds for employment generation, creation of a sustainable economic base and viable capital infrastructure investments.36 Reinvigorating agriculture growth would also require investments in such as irrigation and rural roads.

3.30 An example is the road network. To upgrade the capacity deficient 8,000 km of state highways and major district roads to two-lane all-weather road is estimated to cost about US$2.4 billion (at an average of about US $0.3 million/km). As indicated in para. 3.11, India has no access-controlled expressways, while for example China has built substantial expressway capacity since the mid-1990s. If a six-lane divided fully access controlled expressway is to be built, it would make sense to link Chennai (the state capital) to Coimbatore (the second largest city and economic center in the state). The estimated cost would be in the range of US$1.2 billion. Another example of huge financing requirements to meet basic service delivery norms is urban water and sanitation, estimated at about US$1.8 billion for 2002/03-2006/7, as illustrated in Table 3.2. Similarly in the power sector, the addition of 30% capacity as announced by GoTN would require substantial private sector investments.

Table 3.2: Sectoral Investment Requirement 2002-2007

Rs. in crores Local Body Corporations Municipalities Town Panchayats Total % Water Supply 506.20 673.37 1409.41 2588.98 31.86 Sanitation 409.34 391.28 41.67 842.29 10.37 Solid waste mgmt. 115.95 33.75 20.48 170.18 2.09 Storm water drains 747.94 1101.63 684.47 2534.04 31.19 Roads 310.81 204.37 406.51 921.69 11.34 Lighting 43.19 43.58 125.30 212.07 2.61 Others 341.68 231.03 282.91 855.62 10.53 TOTAL 2475.11 2679.01 2970.75 8124.87 100

Source: State Finance Commission Report II, 2002

3.31 But public financing of infrastructure is severely constrained by the fiscal stress of the state. The rapid fiscal decline since 1998/99 in Tamil Nadu has severely constrained the government’s financial capacity to finance large-scale infrastructure. The fiscal reform since August 2001 is aimed at reversing the fiscal decline. However, medium-term efforts are required to reverse the decline and restore the financial health of the state. A key goal of the fiscal reform is to rebalance expenditure priorities by reducing salary and pension (accounting for over 92% of the state’s own tax revenue in 1999/00) and other recurrent expenditures so as to create fiscal space for capital investments and non-wage O&M on growth-enhancing expenditures including infrastructure.

3.32 The total capital outlays of the state budget are expected to meet only a fraction of infrastructure investment demands. GoTN’s capital outlays covering all sectors is about US$700

36 The focus of this paper is on constraints to industrial and service growth. The importance of infrastructure on agriculture growth and rural development has long been recognized, as for example rural roads are critical to the access of the poor to school and health center as well as productive opportunities. Irrigation infrastructure is linked closely to poverty reduction, as the poverty incidence for non-irrigated land is higher than irrigated land for each size of land holdings in Tamil Nadu (see Poverty Note for Tamil Nadu, a part of the phase I AAA work for the state).

38

million, or 1.8% of GSDP, much above the US$300 million in 1997/98 (1.1% of GSDP) at the onset of the fiscal crisis. Even assuming the success of fiscal reform, which could bring about the reduction of consolidated fiscal deficits as well as the reduction of recurrent expenditures, the capital outlay per year is estimated to gradually increase to about US$1.2 billion a year or about 2% of GSDP in 2007/08.

3.33 Public financing of infrastructure is also constrained by limited local government revenues and capacity and regulatory policies. Insufficient revenues from user charges, under assessment of property taxes, and drying up of institutional financing backed by state guarantees (due to more cautious use of state guarantee and contingent liabilities for fiscal correction) have contributed to limited financial capacity in local governments. Mandatory implementation of schemes by the Public Sector (e.g., Tamil Nadu Water and Drainage Board) has led to inefficient use of funds, costly time and cost overrun, and lack of prioritization. The resulting high cost is borne by the Urban Local Bodies (ULBs).37 The investment in infrastructure has almost entirely been financed by debt with little attention to viability of financing and linkages to tariff levels (for example urban water supply). Consequently, ULBs have been burdened with large debts on their balance sheets (Rs.1089.66 million as of 1999/00). There is also a lack of capacity in ULBs to put together technically sound and financially viable projects and to prioritize and manage their investments.

3.34 The well-developed domestic capital and financial markets in India offer possibilities for private financing of infrastructure both through bonds and commercial debt. Recognition of the funding gap has resulted in nearly universal acceptance that the private sector can and should play a larger role in the financing of infrastructure in partnership with the public sector, whether actively as a project sponsor or passively as an institutional bond investor or commercial lender. A developing legal framework for concessions, contract enforcement, bankruptcies and lender remedies is important for a receptive debt market.

3.35 Tamil Nadu has already undertaken a number of reform initiatives, all first in India, to involve a greater role of private participation in infrastructure service delivery. Examples are the Tirupur Water Supply Scheme, Alandur Sewerage Scheme, revenue-backed bond financing of the Madurai Inner Ring Road, the unique financing and concession structure of East Coast Highway, and the use of pooled financing for water supply and sanitation for 15 municipalities by TNUDF, all are first in India. These reforms have shown that private sector participation under appropriate regulatory arrangements would not only help address the fiscal constraints of the state but also bring to the fore the benefits from increased efficiency in infrastructure financing, delivery and management. Summarized below are four reform cases (for details see Annex 3.1).

37 Urban Local Bodies and Rural Local Bodies are the third tier of the government after federal and state governments in India.

39

• Providing financing access and building capacity in ULBs. Total transfers to municipalities have steadily increased over the last few years. The annual statutory devolution given monthly to ULBs provides them an opportunity to leverage resources for up-gradation of basic services. Local bodies are also allowed to mobilize financing for projects through upfront deposit collection in advance of project implementation towards meeting capital expenditure needs. They are also in principle free to set rates for water charges. On the institutional side, the amendment of the TWAD Act in 1997 for example allows ULBs the choice to implement water and sanitation projects privately for stand-alone schemes.

Figure 3.6 Total Transfers to Municipalities

24.3234.43 29.29 26.75

43.8659.15

73.59

157.67

174.5181.29

0

20

40

60

80

100

120

140

160

180

200

1990

-91

1991

-92

1992

-93

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1999

-00

1998

-100

(pro

v)

Rs.

in c

rore

s

• Tamil Nadu Urban Development Fund for credit enhancement capital market financing of urban infrastructure projects. Financed through a World Bank Loan, GoTN Line of Credit, and equity from banks in 1996, the Fund had approved loans of Rs.492.27 crore as of March 2003. Notable projects are Karur Toll Bridge, Madurai Ring Road, and Pooled financing for smaller towns for water and sanitation, solid waste contracts and storm water drains. TNUDF has structured investments in basic civic amenities on the basis of debt servicing capabilities of ULBs and assisted in technical and financial capacity enhancement of ULBs. The Fund has achieved a repayment rate of 96% and made a profit of Rs. 848 million in the financial year ending 2003. The few privately contracted projects have so far had a good track record of implementation. TNUDF lends to those ULBs which are receptive to undertaking institutional and financial reforms.

• The Tirupur Water Supply Scheme, the first water sector related project developed under the PPP framework in India. After a gestation period of almost 10 years, GoTN accelerated and completed legal, financial and management agreements between July 2001 and March 2003. The construction is on schedule. A total of Rs.45 crore equity and subordinated debt financing from GoTN has leveraged additional equity financing of Rs.217 crore and leveraged a debt of Rs.700 crore including financing from Tirupur Exporters Association and foreign investors. The project will supply water to the fast-growing garment export industry in Tirupur, domestic consumers in Tirupur Municipality and surrounding villages, as well as a sewerage system for the Tirupur Municipality and onsite sanitation facilities for slums. User charges are based on cost recovery with cross subsidies between industrial and domestic consumers.

• The Alandur sewerage project is the first such project in India using a PPP framework (BOT format) to provide underground sewerage to a town of 125,000 people near Chennai. Public awareness and support was sought through an extensive communication campaign. Some 15,000 households out of 17,000 have contributed Rs.5000 per household representing one third of the project cost. A notable feature is the tariff structure, developed on full user charge recovery with cross subsidies for the poor. The first community participation project, has also suffered a number of set backs due to some lack of forward planning, i.e. delays in selection of an operator for O&M of the sewerage scheme; miscommunication on the distinction between upfront payment of

40

capital cost through community participation and a separate connection fee to each house to be levied separately. This has led to much discontent in the community. These are lessons, which can be incorporated in repeat or scaling up projects.

• The East-Coast Highway Project on road upgrading, operation and maintenance. The Tamil Nadu Road Development Company (TNRDC) was set up in 1998 to catalyze private sector investment in the road sector and commercialize O&M. Its equity of Rs.10 crores was split 50:50 between public and private funds. The first upgrading project financed by TNRDC is the 113 Km. long East Coast Road (ECR) connecting Chennai and Pondicherry at a cost of Rs 60 crore. A Rehabilitate-Improve-Maintain-Operate-Transfer (RIMOT) framework was applied and commercial operations on the road commenced in March 2002. The RIMOT framework requires user charges to recover improvement and maintenance costs only, leading to lower tolls; project returns are capped at 20% and surplus if any, is reinvested in the road sector in Tamil Nadu. The framework is a viable option as compared to green field projects. Creative solutions in upgrading roads such as optimizing road space by paving road surfaces and effective segregation of traffic, helped mitigate the risk of low traffic density and high capital costs that normally accompany a four-lane option. The present stepped up toll structure and discount travel cards for regular users and exemption of toll for economically weaker groups have found acceptance with the toll payers

3.36 These PPP experiments have demonstrated potential benefits and lessons:

• Leveraging public equity investment multifold. The Tirupur Water Supply Scheme is the first water sector related project developed under the PPP framework in India. The total project cost is Rs.1023 crore. A total of Rs.45 crore equity and subordinated debt financing from GoTN has leveraged additional equity financing of Rs.217 crore and leveraged a debt of Rs.700 crore including financing from Tirupur Exporters Association and foreign investors. The project will supply water to the fast-growing garment export industry and domestic consumers in Tirupur Municipality and surrounding villages. The project also covers a sewerage system for the Tirupur Municipality and onsite sanitation facilities for slums. In Alandur project, some 15,000 households out of 17,000 have contributed Rs.5000 per household representing one third of the project cost.

• User charges based on cost recovery with cross subsidies between consumer categories. In the Tirupur Water Supply project, industry cross subsidizes domestic consumers, and in Alandur project, user and connection charges are based on cost recovery.

• Importance of the clarity of a regulatory framework for investor and consumer confidence. In the case of the East Coast Road, post-contract signing downward revision of tolls, delays in issuing toll notification orders by the state, and delays in agreed toll escalation are issues which need to be addressed if public private partnerships are to become a viable and a popular form of financing infrastructure. In the case of Alandur, the miscommunication on the distinction between upfront payment of capital cost contribution collected from the community and the connection fee to each house to be levied separately and the treatment of non-refundable deposit has led to a lot of discontent.

• O&M consideration in design phase. Some PPP experiments incorporate sustainability of O&M in project design phase (e.g., the East Coast Highway project). However, the Alandur project has suffered a number of setbacks, due to lack of O&M arrangements for the sewerage scheme, unclear sewer connection rules, delays in connections to the sewerage system, over estimation of costs, and unsatisfactory mechanism for billing and collection.

41

• Proactive support from GoTN in inter-departmental co-ordination and transparency in bidding and contracting are some of the key features critical in implementation. These have contributed to the success of the East Coast Highway by making it operational. and to the implementation of the Tirupur water supply project.

3.37 As steps toward scaling up these initiatives, GoTN has recently announced the enactment of the Infrastructure Development Enabling Act together with the setting up of an Infrastructure Development Board. This Act would lay out the policy and procedure for the involvement of private sector investment in various areas of infrastructure development, either in collaboration with a Government agency or by itself. An Infrastructure Fund with an initial corpus of Rs.200 crores is also being be created. The need to link urban infrastructure financing requirements with domestic capital markets is also well understood. Regulatory and institutional reforms and performance benchmarking of ULBs should aim to strengthen this link and leverage private public resources.

3.38 There are some key challenges for substantially scaling up PPP for sustainable infrastructure financing. Given the large and growing mismatch between the cost and revenues, there are significant challenges in systematic scaling-up from the pilot phase. Private sector participation and co-financing from financial institutions have occurred in cases where ULBs or utilities have made considerable operational restructuring. It also requires supportive political environment, and regulatory changes in terms of user charge regimes, contracting and legal framework providing clear and stable rules of engagement, clear process for dispute resolution and ability to enforce contracts. State government support by way of equity financing has made significant difference, as strong and reliable promoters are one of the primary considerations for lenders. Co-financing from financial institutions with management support is also vital. The entire thrust of reforms should be to sustain and enhance cash flows generating capacity, rather than relying only on subsidies and guarantees by the higher levels of government. There is need for deregulation of state-level laws. Reduction in process times for clearances, independent regulator for tariff setting and initial equity participation by state bodies would facilitate such financing. Chapter 4 discusses reform priorities in improving investment climate, including the scaling up of PPP.

3.39 Infrastructure service delivery cannot be separated from broader regulatory reforms. A case in point is the design framework for special economic zones (SEZs), which is envisioned by India as a scaled-up version of the export processing zones (EPZs) to overcome the constraints of poor infrastructure and a high regulatory burden. SEZs were announced by GoI and the implementing policies are still involving. GoTN has recently unveiled its own special economic zones policy providing broad guidelines with specifics being worked out.

3.40 Key design issues concerning SEZs include:

• The smaller the regulatory burden within the general economy, the smaller the attraction of locating within an enclave.

• Unless SEZs can significantly overcome key constraints facing the private sector, SEZs will simply be a physical scaling up of EPZs while experience of EPZs in India is mixed (the EPZ in Tamil Nadu administered by GoI is viewed as unsuccessful).

• International experience of EPZs and SEZs is mixed, which can provide lessons for the design of a policy and regulatory framework for SEZs.

• There is considerable uncertainty whether the labor law can be simplified particularly concerning the federal Contract Labor Act and Industrial Dispute Act.

• Large size SEZs (1000ha plus) will require an enormous scale of investment in infrastructure to support users which may take years to complete while tying up substantial capital that could be better utilized elsewhere.

• State-wide broader regulatory reforms and infrastructure improvements remain critical.

42

CHAPTER 4: REFORM AGENDA FOR IMPROVING INVESTMENT CLIMATE

INSTITUTIONALIZING THE REFORM PROCESS

4.1 The reform agenda is challenging, covering a wide range of areas. As clear from previous Chapters, the reform agenda deals with not only regulatory policies and practices concerning all factor markets (labor, land, and capital), but also regulation of entry/exit and tax policy and administration. Further, removing substantial infrastructure bottlenecks—power, road network, water supply, etc.—tops the reform agenda. The wide scope of issues is not surprising, given that international competitiveness involves all critical chains of investment, production and marketing.

4.2 This agenda will thus require an institutionalized dialogue between the Government and the private sector for setting priorities and finding solutions. The private sector must be a sounding board and source of information in formulating policy for the business environment. The Government has in the past sought to engage the private sector in policy discussions, primarily on an informal and ad hoc basis, such as the consultation with the private sector on the design of the value added tax through the Revenue Reform and Augmentation Commission.

4.3 GoTN has taken an important step in institutionalizing the dialogue in support of the reform. The Government has recently announced the establishment of an Advisory Industrial Council to be chaired by the Chief Minister, to act as a think tank for pressing forward with reforms. Standing Consultative Working Groups will be set up involving business associations, financial institutions and government agencies on the subjects of (i) WTO and import/export issues; (ii) industry, labor laws and regulatory issues; and (iii) infrastructure. The Council and the Consultative Working Groups can serve as a formal apparatus to formalize the dialogue between the Government and the private sector. Tamil Nadu may draw valuable lessons from the type of Councils which has been key in the development of international competitiveness in Asia, particularly South Korea (one of the earliest models), followed by Taiwan (China), Singapore, and some other countries.

4.4 Key factors contributing to the success of institutionalized dialogue elsewhere include:

• Top-level political support (in Korea, for example, the monthly meetings were chaired by the President of the country).

• Accountability of Ministers and senior public officials (in some countries, these officials are required to reply to the proposals and complaints of the private sector within short, defined time periods).

• A clear and defined top-level decision-making authority in the Council. • Broadly-based private sector participation that is not perceived as that of a limited special interest

group (for example, in the Philippines, prior to the establishment of the Export Council, the main forum for Government/private sector dialogue was with the large firms of protected industries, which had no interest in developing international competitiveness), and Secretariat of the Council should at least be shared between the private sector and the Government, in order to ensure that the agenda of the Council maintains its focus on the issues of concern to the private sector.

• A public information and education campaign to build a truly broadly shared consensus that can transcend any changes at the political level. From the beginning, this dialogue should be held in public, with the media in attendance; if this happens, it will strengthen public commitment to Government policy-making and programs, as it builds support for a broadly shared commitment to private-sector led growth. For example, after all the changes in government in Ireland over the last 30 years—and there have been many—an immediate and highly publicized action of the incoming administration on each occasion has been to reassure the business community and the

43

public at large that the pro-business and welcoming approach to foreign investment will be maintained.

An Agenda of Reform Options for Tamil Nadu

4.5 Priority reforms comprise of the following areas: labor market flexibility; a more responsive urban land supply system; a more efficient tax policy and administration; continuing reform of entry and operation; power sector reform; and scaling up PPP for sustainable infrastructure development. Many of the issues concerning investment climate are exclusively or largely within the purview of the central government. Labor reforms required at the central government level are to: (i) raise the threshold of retrenchment/downsizing/closure from 100 workers to 1000 and allow contract labor to be used for core business. Both are politically difficult. VAT, postponed by the central government, remains a key priority particularly to reduce cascading input taxation. Exit policy and bankruptcy procedures which are predominantly central issues impact the efficiency of turn over and productivity growth. Several key infrastructural developments are within the purview of the central government. These include power, national highways, international air markets, major ports and rails systems.

4.6 The following sections discuss options for the reform agendas which are partially or mainly within the purview of the state government. It must be recognized that there is a balance between comprehensive reform and strategic selectivity. Therefore, the proposed agenda serves as a menu of options from which a strategic yet programmatic reform agenda could be formulated based on the Government’s own internal consultation, opportunities and constraints. Many of the proposed reforms involve complex institutional reform that will take efforts beyond the medium term. The forthcoming mission will discuss with the Government on the proposed reforms, toward reaching agreement on a medium-term reform program.

Labor market flexibility

4.54.7 Within the constraint of federal legislation (see para. ), the state government can explore ways to rationalize the legal framework governing labor and statutory compliance requirements to create elbow room for contractual labor relationship and for easing threshold for retrenchment. More specifically, the following can be considered.

Short term 1. Carry a complete review of the entire spectrum of Labor Laws governing Tamil Nadu and the

machinery needed to implement these laws. 2. Bring in flexibility to Factory Act on working hours, overlapping of shifts work days, working on

holidays either through State Amendments of the Act or through exemption under section 65. 3. Bring in State Amendments to the Contract Labor(Regulation and Abolition) Act 1970. Through

the amendment, redefine what constitutes a "core" activity and reclassify many activities to the "non-core" list, allow hiring of contract labor in activities, like sanitation works, security services, canteen and catering services, health services, courier services, gardening and maintenance services, transport services, and other activities of intermittent nature even if they constitute core activities (e.g. hiring contract labor in production line to meet unexpected export orders). Furthermore, the decision should be left with the firms to decide what is core and non core.

4. Amend the notifications under the Shops and Establishment Act to remove inflexibility regarding working hours and also dismissal of employees.

5. Review licensing procedures in all the labor related laws to remove unnecessary procedures, simplify and ensure compliance.

6. Remove inflexibilities introduced in the past by the state related to the Industrial Disputes Act. Initiate State Amendments to amend Chapter VB like Maharasthra government and perhaps

44

follow the example of the Andhra Pradesh Government, which is the process of initiating amendment to Chapter VB to raise the number to 1000.

Medium term

1. Amend Section 16 of the Trade Union Act, 1926, which contemplates constitution of a separate fund for political purposes. Empower the Registrar of Trade Unions to adjudicate upon a dispute as to which of the office bearers are validly elected and limit the number of unions in any establishment.

2. Initiate State Amendments to the Industrial Disputes Act 1947 and Shops and Establishment Act to allow termination under reasonable grounds, differentiation between the termination of temporary and permanent employee, introduction of probation period and confirmation period, removal of compulsory regularization of a person who works for more than 2 years and to provide for court awarded compensation instead of reinstatement and permitting compulsory retirement under the Industrial Disputes Act.

3. The Presiding Officers of the Labor Courts to be given Special Training or to have trained personnel for the resolution of the disputes.

4. Evaluate the need for Minimum Wages Act (1948) and the Rules 1950. Extend the exemption if necessary.

Longer term

1. Consolidate the 27 Central and 7 State Laws into Industrial Relations and labor matters. Like most other developing countries, steps need to be taken to consolidate labor regulations to 5 main legislation to govern, first the relationship between employer and employee (Employment Act), second to govern quasi judicial body that arbitrates between employer and employee (Industrial Disputes Act), third to govern the activities of employees in unions (Trade Unions Act), fourth to govern welfare and compensation (Workman Compensation Act) and fifth to govern safety and security at work (Occupational Safety Act).

2. Carry out institutional reengineering to make the regulation of labor effective and cost efficient. 3. Consider establishing an independent body like Labor Regulatory Authority to deal with

retrenchment and closure of factories.

Urban land market reform

Reform agenda is at the hands of the state government. The focus should be on rationalizing regulations on zoning and development controls, project approval and land acquisition processes, and developing a more effective planning and management system to facilitate infrastructure development.

1. Initiate a land market assessment in the Chennai metro area and select towns to identify an inventory of publicly owned land.

2. Complete a through review of real estate and land development regulations (regulatory audit). 3. Identify needed reforms. 4. Prepare report and seminar presentation on the results of the assessments. 5. Hold series of series of meetings with government and private sector stakeholders on the results. 6. Follow up support to assist government and private sector to implement reforms. 7. Monitor implementation of reforms and assess and evaluate their effects.

Tax policy and administration

Given the federal fiscal relationship, the state’s role in designing tax policy and administration is limited but there is considerable room for reforms. The focus is to reduce the impact of taxing inputs and reduce complexity of tax policy and administration to reduce transaction costs.

45

Tax policy

1. Implement VAT. 2. If VAT introduction is going to be delayed then streamline existing state sales tax:

Apply the HSN for classification of goods. Introduce a two-tier sales tax structure consisting of the TNGST and a special tax on selected

commodities, while abolishing additional sales tax, resale tax, and surcharges. Specify a revenue-neutral or enhancement rate structure with 2 standard rates for TNGST and three—or fewer—for special sales tax.

Curtail the list of exemptions for TNGST and include services in tax base if Central government permits.

3. Review and streamline rate and base structure of other state taxes (excise on liquor; motor vehicle tax; luxury taxes; electricity tax; Entry taxes on motor vehicles and goods).

4. Study net revenues impact of each minor taxes (e.g., betting tax, advertisement tax) and remove any, with which costs of collection outweighs revenues.

Tax administration

1. Prepare a five-year tax administration reform strategy. 2. Streamline reporting and accountability arrangements for revenue collection. 3. Establish a Central Valuation Committee for fixing guideline values. 4. Establish a vigilance unit in the CTD. 5. Issue a uniform taxpayer identification number and revise taxpayer registration process. 6. Create a pilot Large Taxpayer Unit (LTU) in the CTD, structured along functional lines. 7. Prepare an annual audit plan and training for auditors. 8. Prepare an HR audit and training plan. 9. Introduce self-assessment for large taxpayers. 10. Roll-out LTU concept: creation of functional tax offices. 11. Abolish assessment circles and transform circle offices into service points where appropriate. 12. Transfer responsibility for collecting other taxes to the Commercial Tax Department.

Streamlining regulations of entry and operation

Given the constraints of the central legislation, the state government can continue in the direction of reforms already undertaken, by focusing on relaxing remaining entry regulations particularly concerning construction and real estate industries and by ensuring easy entry in every level of investment.

1. Work with private sector representatives in the construction and real estate business to review problems in the entry regulations.

2. Develop an action plan. 3. Identify clearance delays if any. 4. Complete the ongoing exercise reforms to consolidate 53 returns/registers into one common form. 5. Extend the simplified entry approval system for large investment projects (Rs.250 million) to

cover small and medium projects as well.

Power sector reform

4.8 This is a top infrastructure constraint. There are no easy solutions, as the sustainability of the sector depends on politically difficult decisions in agriculture metering and tariff setting. The new

46

Electricity Act by the central government effectively empowers Indian states to accelerate power sector reforms in the direction of greater competition, better governance, and private sector investment. But detailed implementation arrangement of the Act remains unclear in some key aspects. Given these, key reform and implementation issues for Tamil Nadu are38:

1. Formulate a realistic business plan on financing requirement of the sector. 2. Combine agriculture metering with a package deal to improve service delivery and can be piloted

with improved metered power supply, cost recovery level tariff, efficient pump sets, alternative less water intensive crops, and direct subsidy to the poor.

3. Agriculture subsidy should be de-linked from using the power tariff as an instrument of subsidy and be implemented through a direct and transparent subsidy from the Government’s budget.

4. Reduce high IPP costs and introducing competition in the power sector. 5. The open access provisions in the Act, if carefully implemented, can result in substantial private

investments in generation with reasonable costs. 6. Improved cost recovery from rural areas essential to balance increase in costs with improved

service delivery, so as to prepare for the reduction in cross-subsidy.

Scaling up private sector involvement in infrastructure service delivery

4.9 Even with the success of the state’s fiscal reform, the public resources for the entire capital investment is expected to be a fraction of what is required for the substantial backlog in infrastructure investment and maintenance. Tamil Nadu can build on its several PPP reform initiatives where it is ahead of the rest of the country. However, challenges are substantial. Key issues include political support, implementation capacity of ULBs utilities and government agencies, regulatory framework for user charge regimes, concessions and contracting out, dispute resolutions, for attracting private financiers and operators.

4.10 The government has set up an infrastructure fund. An enabling regulatory architecture for facilitating PPP is being studied. All of them aim to scale up PPP in the development of infrastructure. These new initiatives have had positive response from the private sector. In going forward, key issues the Government may consider are:

1. Mobilize private capital and reduce dependence on national and state budgets by promoting access of ULBs, utilities and government agencies to adequate and sustainable sources of infrastructure finance including domestic and foreign capital markets and commercial borrowing.

2. Strengthen creditworthiness of local bodies and state utilities for accessing private capital by providing selective credit enhancement where required to enable them to set a track record for future borrowings. Develop financing mechanisms with targeted use of state government contribution and guarantees and link municipal financing with domestic capital markets.

3. Foster competition among multiple lending sources for financing business so that long term financing at lower costs can be mobilized for infrastructure projects resulting in financially viable projects with low tariffs to consumers.

4. Use domestic subsidies and international financial institutions to leverage private domestic capital.

5. Choose and select projects which best fit state/local priorities for economic development and have sound economic value.

38 Fiscal Paper Chapter 5 has detailed discussion on these.

47

4.11 In order to mobilize financing in a robust PPP framework, the following essentials would need focus:

1. Develop an appropriate and comprehensive regulatory environment which establishes rules of the game for PPP and PS participation; determining service ownership, developing legal framework for concessions, contract enforcement, bankruptcies and lender remedies.

2. Bring about financial discipline and enhance revenues through, depoliticising tariffs/user charges, implementing overall cost recovery and creating dependable infrastructure revenue streams.

3. Link state transfers to performance benchmarking for ULBs and utilities. 4. Build and enhance capacity in local bodies for project design and structuring, project evaluation,

contracting and implementation, financial planning, budgeting, and strategic planning. 5. Develop a bottom-up reform process by strengthening of research and development, staff

training, and professional institutions.

48

ANNEX 2.1: ACTS AND RULES ENFORCED BY THE LABOUR DEPARTMENT

Central Acts and Rules: 1. The Workmen’s Compensation Act, 1923 2. The Trade Unions Act, 1926 3. The Payment of Wages Act, 1936 and Rules, 1937) 4. The Industrial Employment (Standing Order) Act, 1946 and Rules, 1947 5. The Industrial Disputes Act, 1947 6. The Minimum Wages Act, 1948 and Rules, 1950 7. The Plantations Labour Act, 1951 8. The Working Journalists and other Newspaper Employees’ (Conditions of Service &

Miscellaneous Provisions) Act, 1955 9. The Motor Transport Workers Act, 1961 and Rules, 1965 10. The Maternity Benefit Act, 1961 and Rules, 1967 11. The Payment of Bonus Act, 1965 and Rules, 1975 12. The Beedi and Cigar Workers (Conditions of Employment) Act, 1966 and Rules, 1968. 13. The Contract Labor (Regulation and Abolition) Act, 1970 and Rules, 1975 14. The Payment of Gratuity Act, 1972 and Rules 1973 15. The Equal Remuneration Act, 1976 with Rules, 1976 16. The Sales Promotion Employees (Conditions of Service) Act, 1976 with Rules, 1976 17. Inter-State Migrant Workmen (Regulation of Employment and Conditions of Service) Act, 1979 and

Rules, 1983. 18. The Cine Workers and Cinema Theatre Workers (Regulation of Employment) Act, 1981 and Rules,

1984. 19. The Child Labour (Prohibition and Regulation) Act 1986 and Rules, 1988. 20. Standards of Weights and Measures Act, 1976 21. Standards of Weights and Measures (General Rules), 1987 22. Standards of Weights and Measures (Packaged Commodities) Rules, 1977 23. The Standards of Weights and Measures (Enforcement) Act, 1985 and the Tamil Nadu Standards of

Weights and Measures (Enforcement) Rules, 1989. State Acts and Rules: 1. The Tamil Nadu Shops and Establishments Act, 1947 and Rules, 1948 2. The Tamil Nadu Catering Establishments Act, 1958 and Rules, 1959 3. The Tamil Nadu Industrial Establishments (National and Festivals Holidays) Act, 1958 and Rules,

1959 4. The Tamil Nadu Labour Welfare Fund Act, 1972 and Rules, 1973 5. The Tamil Nadu Industrial Establishments (conferment of Permanent Status to Workmen) Act, 1981

with Rules 6. The Tamil Nadu Payment of Subsistence Allowance Act, 1981 with Rules 7. The Tamil Nadu Manual Workers (Regulation of Employment and Conditions of work) Act, 1982

and Rules, 1986

49

50

ANNEX 2.2: BUSINESS REGULATIONS IN TAMIL NADU

Pre-Project Clearances & Infrastructure Support

1. Local Body clearance Building Plan approval Fire service clearance

2. Environmental clearance 3. Registration under Factories Act 4. Permission under Boilers Act 5. CEI Safety Certificate 6. Land use reclassification

(if applicable) Approvals for

Entry

Infrastructure Support

Pre-Project Phase

1. Power supply 2. Water supply 3. Land allotment by SIPCOT / TIDCO

/ SIDCO 4. Access Roads 5. Drainage / Effluent disposal

Pre-Projects Approval Process: Old System

Local Body clearance for 1. Planning permission 2. Building plan approval 3. Permission for m/c erection 4. Running license

Inspector of Factories for approval of

Plans & Registration

Environmental clearance from

TNPCB

Boiler clearance

Ministry of Environment &

Forests, GoI Land use Reclassification If required

Fire service

clearance

Public health clearance

Metro water for

1. Ground water clearance 2. Water supply

PWD – if requirement exceeds 1 mgd

1. Technical Sub-committee 2. Water Utilization Committee

CEI Safety Certificate including

1. Drawing approval 2. Permission for Connecting power

TWAD Board

Investor

Other Product Specific

clearances

TNEB Power Supply

1. Temp 2. Per

Water Supply

New Approval Process Under old system, approvals were to be obtained in “sequential process” that delayed the projects

Under New system, Single Window committees give composite in-principle approval to enable

project promoters to go ahead with project implementation Agencies that provide Infrastructure support – Land, Power, water, etc., and Statutory approvals

process “simultaneously and in parallel” Time limits defined for such “parallel processing”

Single Window Mechanism – New System

Single window approval system covers both pre-project approvals and infrastructure support Single Window Committees:

State Investment Promotion Board – for projects above Rs.100 crores Projects Approvals authority – for projects above Rs.25 crores Investment Facilitation committee for projects between Rs.5 - 25 crores District Level Single Window Committees for projects up to Rs.5 crores

Common Application Form for getting all pre-project clearances and Infrastructure support at the State level Guidance Bureau – designated as Single window documentation agency Web-based application form and Investment Tracking District level Single Window Committees for SSI

52

New Approval Process

Investor fills common application form

Guidance Bureau – Single window Documentation Centre Single Window Committee gives approval in 30 days subject to:

F

or R

ectif

icat

ion

of

defe

cts i

f any

Tim

e: 30 days

Scrutiny by Guidance and Nodal officers

Composite Approval by Single Window Committee

Project implementation by investor

Single Window Committee gives approval in 30 days subject to:

Project is non-polluting It is proposed to be located in Industrial park / industrial use zone It conforms to building plan norms

53

ANNEX 2.3: REGISTERS AND RETURNS AT A GLANCE

GoTN is consolidating all the 53 forms listed below into one common form.

The Factories Act, 1948 and the Tamil Nadu Factories Rules, 1950

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Humidity Register FORM 6 Section 15(1) – Rule 22 26 & 27 Record of Lime-washing, painting, etc. FORM 7 Section 11(1)(d)

Rules 16 & 105 (c) 28

Report of Examination of Pressure Vessel or Plant FORM 8 Section 31 – Rule 56` 29

Report of Examination of Water-sealed Gas holder FORM 8-A Section 31-Rule 56-A 31

Register of Compensatory Holidays FORM 9 Section 53 – Rule 77 32

Overtime Muster Roll for the Exempted Workers FORM 10 Section 59 – Rule 78 33

Register of Adult Workers FORM 12 Section 62 – Rule 80 34 Register of Young Person Workers FORM 14 Sections 68 & 69 –

Rule 86 35

Register of Leave with Wages FORM 15 Sections 83 & 112 – Rule 87 36

Health Register FORM 17 Section 10(4) – Rule 14 (5) 37

Health Register FORM 17-A

Section 10(4) – Rule 95 Schedule XXX Sub-

Rule (3) of “Cautionary Note”

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Muster Roll FORM 25 Rule 103 50

Muster Roll for Adult Workers FORM 25-A Rule 103-A 51

Register of Accidents FORM 26 Rule 104 53 Register of Dangerous Occurrences FORM 26-A Rule 104 54

Register of Exemptions FORM 28 Rule 105(a) 57 Particulars of Rooms in the Factory FORM 29 Rule 105 & 106 58

Register of Specially Trained Adult Workers FORM 35 Rule 53 59

Report of Examination of Hoists and Lift FORM 36 Section 28 – Rule 55 60

Record of Eye Examination FORM 38 Rule 61-K(4) 63 Pre-Employment Health Register FORM 39 Section 87 – Rule 95 63

Inspection Register FORM 29, 29, 7 Rule 105(a) 57, 58, 28

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The Contract Labour (R & A) Act, 1970; the Contract Labour (R &A) Central Rules, 1971 and the Tamil Nadu Contract Labour (R & A) Rules, 1975

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of contractors FORM XII Rule 74 220 *Register of workmen employed by the contractor FORM XIII Rule 75 221

*Muster Roll FORM XVI Rule 78 (1)(a) 224

*Register of Wages FORM XVII Rule 78(1)(a) 225 *Register of Wage -cum- Muster Roll FORM XVIII Rule 78(1)(a) 226

*Register of Deductions FORM XX Rule 78(1)(a) 228

*Register of Fines FORM XXI Rule 78(1)(a) 229

Register of Advances FORM XXII Rule 78(1)(a) 230

Register of overtime FORM XXIII Rule 78(1)(a) 231

The Payment of Wages Act, 1936 and the Payment of Wages (Mines) Rules, 1956

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of Fines FORM I Section 8(8) – Rule 3 260 Register of deductions for damage or loss FORM II Section 10(2) – Rule 4 261

Register of wages FORM III Section 10(2) – Rule 4 262 Register of work done by Piece Workers FORM IV-A Rule 17(1) 264

Register of Advances FORM VI Section 12 – Rule 19(3) 268

The Payment of Wages Act, 1936 and the Tamil Nadu Payment of Wages Rules, 1937

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of Fines FORM I Section 8(8) – Rule 3 277 Register of deductions for damage or loss FORM II Section 10(2) – Rule 4 277

Register of Advances FORM III Section 12 – Rule 17(4) 278

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The Minimum Wages Act, 1948 and the Minimum Wages (Central) Rules, 1950

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of Fines FORM I Rule 21(4) 294 Register of deductions for damage or loss FORM II Rule 21(4) 294

Overtime Register for Workers FORM IV Rule 25(2) 296

Muster Roll FORM V Rule 26(5) 296

Register of Wages FORM X Rule 26(1) 305

The Minimum Wages Act, 1948 and the Minimum Wages (Tamil Nadu) Rules, 1953

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of Fines FORM I Rule 21(4) 310 Register of deductions for damage or loss FORM II Rule 21(2) 311

Overtime Register of Workers FORM IV Rule 26(2) 314

Muster Roll FORM V Rule 27(5) 315

Register of Employees FORM XI Rule 27(6) 328

The Equal Remuneration Act, 1976 and the Equal Remuneration Rules, 1976

NAME OF THE REGISTER FORM NO. SECTION & RULE PAGE NO.

Register of workers employed FORM D Section 8 – Rule 6 334

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ANNEX 3.1: PUBLIC PRIVATE PARTNERSHIP IN INFRASTRUCTURE SERVICE DELIVERY

Alandur Sewerage: Community Participation in Infrastructure Provision

This Rs.330 million project is an example of community-public-private participation in sewerage and provides a model for the towns in Tamil Nadu to emulate with appropriate modifications and incorporation of lessons learned. Similar projects are being planned in other municipalities, including the Valsaravakkam Town Panchayat. The Alandur Sewerage project was made possible because of the strong desire of the community to improve the general conditions of the surrounding environment, and the leadership provided by the municipality and GoTN. Public awareness and support was sought by the municipality through an extensive communication campaign. Some 15,000 households out of 17,000 have contributed Rs.5000 per household representing one third of the project cost. The policy framework, bidding process, contract formulation, financing arrangements and project implementation have been structured to maximize benefits to consumers, creating security mechanisms for lenders and private operators, ensuring a transparent bidding process in procurement and detailed monitoring of implementation progress. The Phase-I of the sewerage project for Alandur (20 km trunk/ main sewers and 50 km branch sewers and laterals, one pumping station of 24 Mld and a 6 km long force main) was completed in February 2003. An extended aeration process sewage treatment plant (STP) of 12 MLD capacity was constructed in September 2002 (about 6 months ahead of target completion date), under a 14 year BOOT arrangement. The STP will be operated by a private operator. The arrangements for operation and maintenance of sewerage system are being firmed up. Like most other municipalities, the Municipality of Alandur does not have the capacity for the operation and maintenance of the sewerage system and is exploring with operators including Chennai Metro Water. The municipality plans to collect a sewerage charge Rs. 150 per month for domestic connections, Rs. 450 per month for commercial connections and Rs. 750 per month for industrial connections. An annual increase at the rate of 6%, subject to the ceiling of Rs. 180, Rs. 540 and Rs. 900 for domestic, commercial and industrial connections, will be enforced. The sewerage charges are estimated to generate adequate revenue to cover expenses such as the BOOT operator’s fees and full cost recovery of the sewerage system. However, a lack of clarity on the rules for providing sewer connections and the levy of additional connection charges, not previously disclosed, has led to delays in connecting the properties. As a result, the newly built sewerage system and the sewage treatment plant are not operational and there is evident discontent among the beneficiaries. The municipality plans to provide about 7,000 sewer connections to 17,000 dwelling units in the next few months (beginning from July 1, 2003). While replication and scaling up of sewerage systems based on this community participation model are certainly the way forward, it is important to note that the delays in operationalizing the system are due to poor financial and operational planning on part of the municipality.

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Tamil Nadu Urban Development Fund: Facilitating ULBs to Capital Market

The urban financing challenge for developing economies in general, and Tamil Nadu in particular, given the high urbanization trends and under supply of civic infrastructure is self-evident. Municipal Development Funds provide a much-needed link between civic infrastructure financing needs and domestic capital markets. Within India, TNUDF has established itself as one of the best run municipal funds in the world.

TNUDF is the first public-private partnership providing long- term debt for civic infrastructure on a non-guarantee basis. The Fund was set up with a view to attracting private capital into urban infrastructure and facilitate better performing ULBs to access capital markets. TNUDF, was established in November 29, 1996 as a Trust with equity contributions from three all India financial institutions namely, ICICI Bank Limited (formerly ICICI Ltd), Housing Development Finance Corporation Limited (HDFC) and Infrastructure Leasing and Financial Services Limited (IL&FS). The Fund is managed by a Corporate Trustee viz., Tamil Nadu Urban Infrastructure Trustee Company Limited (TNUITCL). Tamil Nadu Urban Infrastructure Financial Services Limited (TNUIFSL) is the Fund Manager of TNUDF.

The three key objectives of TNUDF are: ♦ Finance urban infrastructure for improving the living standards of the urban population. ♦ Facilitate private sector participation in urban infrastructure. ♦ Improve the financial management of urban local bodies, enabling access to debt finance from

markets. The Fund has so far approved 179 projects at a total project cost of USD 154 million. The projects supported by TNUDF primarily include environment enhancing infrastructure such as water, waste water treatment and solid waste management, as well as revenue generating commercial complexes, wholesale markets and transport terminals. TNUDF aims to reduce asymmetric information in credit markets by attracting private capital to finance public infrastructure and linking capital markets and small city financing needs. TNUDF has raised the equivalent of USD 25 million from the domestic capital markets on the basis of an LAA+(SO) rating. The Fund facilitated the Madurai Corporation in floating the only Revenue Bond in India for USD 6 million backed by tolls collected from road users of the Madurai Inner Ring Road. TNUDF is also positioning itself as a pooled financing entity to mobilize competitive finance for urban infrastructure available on a long-term basis. For investments by ULBs in poorer areas of the city, the Fund blends its loans with Government grants to provide low cost financing. The experience in operating the fund underscores three basic urban sector issues. Firstly, need to build capacity within City Governments for efficient and responsive urban service delivery. Second, given the investment requirements, the imperative to access long tenor debt and eventually create a market of municipal debt, thereby linking urban needs with domestic debt market. Third, since debt financed projects require substantial tariff changes, the need for political consensus and participatory project structuring. These three components would form the basis of TNUDF's future urban work plan.

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The East Coast Highway: Public Private Partnerships in Road Maintenance and Operations

The Tamil Nadu Road Development Company (TNRDC) has initiated a new framework in highway management. It was established in 1998 to implement the Public Private Framework for roads in Tamil Nadu. A 50:50 joint venture between ILFS and TIDCO, with total equity of Rs. 10 Crores, TNRDC was set up with the objective to catalyze private sector participation and investment in the road sector. Its mandate is to initiate commercialization of operations and maintenance of road assets to leverage state resources and develop road sector initiatives.

The 113 Km. long East Coast Road (ECR) connecting Chennai and Pondicherry at a cost of Rs 60 Crores is the first project under TNRDC. A Rehabilitate, Improve, Maintain, Operate and Transfer (RIMOT) contract was signed between GoTN and TNRDC on December 22, 2000. Commercial operations on the road commenced on March 24, 2002.

The TNRDC concept entails the entrusting of existing public assets to private sector for capacity augmentation and efficiency improvement and periodic and annual maintenance, leveraging and freeing up scarce public resources for other projects.

The RIMOT framework requires user charges to recover improvement and maintenance costs only, leading to lower tolls; project returns are capped at 20% and surplus if any, is reinvested in the road sector in Tamil Nadu.

The RIMOT framework is a viable option in infrastructure development through private sector participation in operations maintenance and upgrading of roads as compared to green field projects. Creative solutions in upgrading roads such as optimizing road space by paving road surfaces and effective segregation of traffic, helped mitigate the risk of low traffic density and high capital costs that normally accompany a four lane option.

The present stepped up toll structure and discount travel cards for regular users and exemption of toll for economically weaker groups have found acceptance with the toll payers.

Proactive support from GoTN in inter-departmental co-ordination; transparency in bidding and contracting; assistance in toll compliance and maintaining law and order are notable features of government support. On the other hand, revision of tolls downward post-contract signing; and delays in issuing toll notification orders; and delays in agreed toll escalation are issues which need to be addressed if public private partnerships are to become a viable and popular form of financing infrastructure.

The project framework is highly replicable for projects with high maintenance and operations costs for e.g. water supply and sanitation.

TNRDC has been working with State Government and Ministry of Road Transport & Highways, Government of India, for taking up the development, improvement and maintenance of select National Highways stretches in Tamil Nadu on the ECR framework.

New Tirupur Area Development Corporation Limited (NTADCL): Private Water Public Benefits NTADCL was set up in August 1995, as a special purpose vehicle with the primary objective of implementing the Tirupur Area Development Project (TADP), India’s first commercially structured water supply and sewerage project developed on a private - public participation basis. The equity participation is from GoTN, ILFS, the Tirupur Exporter Association, and the private consortiums consisting of the EPC

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contractor such as Bechtel, Mahindras and United Utilities, and Insurance Companies such as LIC and GIC. The concession is based on a Build Own Operate Transfer (BOOT) model and is for minimum of 28 and a maximum of 38 years. The project is being constructed at a total cost of Rs. 1023 Crores and would initially supply 185 Mld of water to the industrial and residential areas.

Table: Financing Structure

Sources of Funds: (Rs. Crores) Equity 322.70 Subordinated Debt 86.50 Senior Debt 613.8 Total 1023

TADP was developed to improve local infrastructure by addressing the infrastructure bottlenecks, mainly water supply and sewerage, in Tirupur Municipality, local village Panchayats and industries located in the Tirupur Local Planning Area. The project would provide water supply to the predominant Dyeing and Bleaching industries in Tirupur and the domestic consumers in the municipality as well as 15 village Panchayats and 3 Town Panchayats. The Service Area also includes five Wayside Unions, which lie enroute the pipeline. After a long gestation period, the project is now under construction and is expected to be completed by… The Tirupur project is an excellent example of private public partnership in delivering infrastructure services. Notable is the fact that the project had full commitment of the Tirupur Export Association and the benefits would include the rural community and the domestic users in the Tirupur Area. The water charges for industrial use are based on full cost recovery, however, domestic and rural users are cross subsidized. The expected tariffs for water under the scheme are: Rs 45 /kilo litre for industries; Rs 5 /Kilo Litre for Municipal domestic consumers and Rs. 3.50/Kilo/litre for rural consumers. The project was driven by the industrial interests of the Dyeing and Bleaching Industry where water is a major requirement and has a captive industrial market. Whether the project can be replicated in its entirety, in other areas remains a question due to the lack of reliability of revenues and low user charges.

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Besley, Timothy and Burgess, Robin. (2002), “Can Labor Regulation Hinder Economic Performance? Evidence from India”, London School Economics Working Paper, February 18, 2002.

Deaton and Dreze, 2002, “Poverty and inequality in India: a reexamination,” Economic and Political Weekly, September 7, 2002. Dollar, Iarossi and Mengistae (2001), “Investment Climate and Economic Performance: Some Firm Level Evidence from India” mimeo World Bank

Fallon and Lucas (1993), “ Job Security Regulations and the Dynamic Demand for Labor in India and Zimbabwe” , Journal of Development Economics.

Ferro, Rosenblatt, Stern, 2003 “Policies for pro-poor growth.” World Bank International Monetary Fund (2003), “World Economic Outlook”

Kijima and Lanjouw (2003), World Bank paper Lili Liu, 1993, Entry-exit, Learning, and Productivity Change, evidence from Chile, Journal of Development Economics, 42. McKinsey & Company, Inc. (2001), “ India: The Growth Imperative.” Michel Bellier and Yue Maggie Zhou (2003), Private Participation in Infrastructure in China: Issues and Recommendations for the Roads, Water, and Power Sectors. World Bank Working Paper No. 2. Ravallion and Datt, 2002, “Why has economic growth been more pro-poor in some states of India than others?” Journal of Development Economics, 68, 381-400. Sachs, Varshney and Bajpai (1999), “India in the Era of Economic Reforms” Stern, Nicholas (2001), “A Strategy for Development”, The World Bank. World Bank & CII Report (2002), “Competitiveness of Indian Manufacturing Results from a Firm-Level Survey,” The World Bank Zagha, Roberto (1999), “Labor and India’s Economic Reforms” from Sachs, Varshney and Bajpai “India in the Era of Economic Reforms,” Oxford University Press.

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