Paper for Festchrift for Dr. Manmohan Singh



Deepak Lal
James S.Coleman Professor of International Development Studies,
University of California, Los Angeles.


Address: 8369 Bunche Hall,
Dept. of Economics,
UCLA, 405 Hilgard Ave., January 1997
Los Angeles, CA 90024.
Tel : 310-825 4521
Fax: 310-825 9528



Deepak Lal



The process of economic liberalisation in India, as much as the economic repression that preceded it has had economists in a leadership position in both the formulation and implementation of the relevant policies. But the only one who will live on as the architect of the Indian reforms is Manmohan Singh, and I am delighted to be able to honour him on this occasion.

Many, though not all the "government" economists involved in justifying and setting up the dirigiste Nehruvian economic system have now issued some form of mea culpa . Manmohan has done much better. As one of the earliest Indian economists to question the export pessimism that underlay the Nehruvian strategy, and particularly after the tragic and untimely death of V.K.Ramaswami, his voice in the government was always geared towards a more liberal economic regime than his other government colleagues and his political masters were willing to stomach. But he bade his time, and most important of all , built up a superb team of young liberally minded and technically competent economists under the leadership of another Sikh- Montek Ahluwalia. When as Finance Minister in the Narasimha Rao government he got the opportunity, he boldly began the overdue process of economic liberalisation. Despite fears that his departure would lead to a reversal of the reform process, under his successor P.Chidambaram it is still in place, though stalled. But ever since the reform process began, the dirigiste bands have always tried to forestall it by their demands for "adjustment with a human face". As this slogan continues to be a thorn in the flesh of reformers in India, the best way in which I can honour Manmohan in this volume is to provide an antidote. A recent comparative study of the political economy of poverty, equity and growth in 21 developing countries -which did not include India- which Hla Myint and I have recently published provides the means, and much of this paper is based on our book.

The paper first, briefly identifies the policies which need to be adopted in the next stage of Indian economic reforms. It then notes the continuing philosophical divide between supporters of some form of egalitarianism and those concerned with poverty alleviation. Next, it distinguishes three different types of poverty by their causes, and uses the Lal-Myint findings to show that, there need be no conflict between the undoubted need for further and accelerated reform in India and alleviation of all three types of poverty.


Even in the areas of past reform there is a great deal of unfinished business: notably to eliminate quotas on consumer good imports, and to move to full convertibility of the rupee by eliminating exchange controls. There are also whole areas which the reform effort has not yet touched. The common feature of this next phase of reform can be succinctly described as the rescinding of the unviable entitlements to income streams that past dirigisme has created. These have both deleterious macro and micro-economic effects.

On the macroeconomic front, problems remain in removing the large budgetary subsidies for fertilizers, energy, the public distribution system, and those implicit in carrying loss-making public enterprises and redundant labour in the central and state bureaucracies and parastatals. On the micro-economic side, India's 19th century labour laws have hobbled Indian industry for much of this century (see Lal(1988)). They need to be reformed if not repealed. Without the reform of the labour market, the essential privatisation of the inefficient and still substantial public sector is well-nigh impossible. Moreover, in the growing global competition for footloose direct foreign investment, these antiquated labour laws pose a serious disincentive for investors in India, when compared with the defacto privatised labour market that now exists in East Asia, most notably in southern China.

These labour market reforms, and the rescinding of other unviable entitlements created by past public interventions is resisted on the grounds that they would worsen either the distribution of income or increase poverty. There is sufficient evidence (see Bhagwati, Lal (1988)) that these claims are unfounded. Most of these entitlements have done little to improve income distribution or to alleviate poverty, their most discernible effect is to impair economic efficiency and to corrupt the polity. But precisely for this last reason, politicians will be wary of rescinding them for fear of losing support. Thence, the politically convenient slogan "adjustment with a human face".


To make sense of this slogan it is first important to note an important difference between improving the distribution of income (an aim favoured by egalitarians) and alleviating poverty (one favoured by most other people). A theoretical case for a link between the two was made on the basis of the so-called Kuznets curve- on which more below. But even if valid, this case for improving income distribution would be as an instrument in alleviating poverty and not to promote equality per se. Hopefully after the events of 1989, socialists of various hue in India are at least chastened about the feasibility of promoting egalitarianism, even if they think it is still desirable.

Without entering into the sterile debates about the morality of egalitarianism, and those to reconcile so-called "positive" and "negative" freedom, all we need note is that, the egalitarians have now retreated to a position where they claim that, the establishment of full-fledged Western style welfare states in the Third World is required to alleviate its poverty. This is particularly ironical given that the Western welfare state is everywhere on the defensive if not in retreat. It is this contemporary socialist mutation which is now increasingly identified with the term: blank (fill in any economic policy you like) "with a human face".

But is this "social democratic" case for dirigisme any more valid than the old socialist one for planning, and will an acceleration of India's reforms require the simultaneous creation of a Western type welfare state to alleviate poverty? That is the central question I wish to address.


In answering it, there are two distinctions worth noting. The first is between extensive and intensive growth. Extensive growth has occurred for millennia in most parts of the world with aggregate output rising, pari passu, with the expansion of population that has taken place since our ancestors came down from the trees. Per capita income was however relatively low and stagnant during this phase. By contrast the modern era has been marked by intensive growth with a secular rise in per capita incomes as the growth of output outstripped that of population. There has been a two centuries dispute whether such rises in per capita income will alleviate poverty, that is whether the fruits of intensive growth will "trickle down" and alleviate poverty?

Answering this question is my first task. In doing so it is useful to distinguish between three types of poverty, based on their causes. These are (i) mass structural poverty, (ii) destitution and (iii) conjunctural poverty. It is worth noting that though this distinction was well known in the past- for instance in discussions in England since the Elizabethan Poor Law- one strategic linguistic move by socialists was to conflate all of them, so that, structural poverty- about which nothing could be done until the era of modern growth- was conflated with destitution - for whose relief most societies have adopted remedial measures. A similar confusion for instance surrounds the whole recent discussion by a distinguished NRI theorist of what he calls An Enquiry into Well-Being and Destitution (Dasgupta (1993)). What he is discussing is mass structural poverty reflected for instance in malnutrition and ill health, which though ubiquitous in the past - and more widespread than it need be in India today- is different from true destitution.

(i) Mass Structural Poverty

Mass structural poverty has for most of history been mankind's natural state. For, till recently, most economies were agricultural economies, or what the economic historian E.A. Wrigley has called "organic" economies, whose growth was ultimately bounded by the productivity of land. In such an economy there is a universal dependence on organic raw materials for food, clothing, housing and fuel. Their supply is in the long run inevitably constrained by the fixed factor -- land. This was also true of traditional industry and transportation -- depending on animal muscle for mechanical energy, and upon charcoal (a vegetable substance) for smelting and working crude ores and providing heat. Thus in an organic economy once the land frontier has been reached, diminishing returns will take their inexorable toll. With diminishing returns to land, conjoined to the Malthusian principle of population, a long run stationary state where the mass of people languished at a subsistence standard of living seemed inevitable. No wonder the classical economists were so gloomy.

Even in an organic economy there was some hope for intensive growth. The system of market "capitalism" and free trade outlined and defended by Adam Smith could increase the productivity of an organic economy somewhat from what it was under mercantilism, which together with the lowering of the cost of the consumption bundle, would lead to a rise in per capita income. But, if this growth in popular opulence led to excessive breeding, the land constraint would inexorably lead back to subsistence wages. Technical progress could hold the stationary state at bay, but the land constraint would ultimately bite.

The Industrial Revolution led to the substitution of this organic economy by a mineral based energy economy. Intensive growth now became possible, as the land constraint on the raw materials required for raising aggregate output was removed. In particular, coal, which began to provide most of the heat energy of industry, and with the development of the steam engine, virtually unlimited supplies of mechanical energy. Thus the Industrial Revolution in England was based on two forms of "capitalism", one institutional, namely that defended by Adam Smith -- because of its productivity enhancing effects, even in an organic economy -- and the other physical: the capital stock of stored energy represented by the fossil fuels which offered mankind the prospect of eliminating mass structural poverty for the first time in its history. It is possible, as many countries in East Asia for instance have shown, to eradicate mass poverty within a generation, because neither of the twin foundations of the gloomy classical prognostications, diminishing returns, nor the Malthusian principle are any longer secure. A market based liberal economic order which promotes labor intensive growth can cure the age long problem of structural mass poverty.

A crude measure of the extent of mass structural poverty is the socalled, "headcount index" of the proportion of the population below some national but time invariant real poverty line. Using this measure the Lal-Myint country authors found that there was a clear positive effect of per capita income growth on mass poverty redressal in all their countries over the period of study 1950-85. Whilst Gary Fields (1991)- for the same study - found for a larger sample that, in most but not all cases poverty tends to decrease with growth, and that poverty tends to decrease most the more rapid is economic growth.

For India, Tendulkar and Jain (1995) have recently examined the effects of growth on poverty alleviation- taking account of alternative social welfare orderings- for the period 1970-71 to 1988-89. As they conclude "in comparison to the 1970s, the doubling of annual growth rate of per capita GDP in the 1980s was associated with improvement in both the poverty and social welfare situation" (p.40). In India as elsewhere growth thus does alleviate mass structural poverty. In his famous "tryst with destiny" speech on India's independence Nehru had stated: "the ambition of the greatest man of our generation has been to wipe every tear from every eye". But the policies he followed made this impossible because they damaged growth performance. Even the slowly rolling retreat from this past dirigisme has led to higher growth rates and in consonance with all the international evidence, to some sustainable alleviation of Indian mass poverty. If only India could sustain the spectacular growth rates that East Asia now has shown can be attained even by large economies like China, it is indubitable that mass structural poverty could be eliminated in India within a generation. That is the prize on offer. Nothing stands in the way but political impediments that irrational past dirigisme itself has created.

(ii) Destitution

With mass structural poverty ubiquitous till recently, the problem of "poverty" has historically been confined to destitution. Most of these traditional organic economies were labor scarce and land abundant. The destitute lacked labor power to work the land because they were physically disabled and had no families. This remains a major source of destitution in land-abundant parts of Africa.

With population expansion and the emergence of land scarce economies in Europe and in many parts of Asia, there arose "the poverty of the able- bodied who lacked land, work, or wages adequate to support the dependents who were partly responsible for their poverty" (Iliffe, p. 5). Their poverty merges with mass structural poverty and growth will, as it has, lead to its amelioration.

No estimates of destitution in India- as far as I know- are currently available. Michael Lipton's attempts to find some correlates of destitution, based on village studies, however, show the extremely heterogenous composition of this group. Thus, for instance Dasgupta's seemingly reasonable assertion that widows are "routinely forced into destitution" in India (p. 323) has been shown to be false by Dreze and Srinivasan (1995) who find "in terms of standard poverty indices based on household per-capita expenditure, there is no evidence of widows being disproportionately concentrated in poor households, or of female -headed households being poorer than male headed households".

(iii) Conjunctural Poverty

This leaves conjunctural poverty. In organic agrarian economies, climatic crises or political turmoil are its main cause. Its most dramatic manifestation is a famine. Since the Indian Famine Code was devised by the British Raj in the late 19th century, it has been known that to deal with what Sen (1982) labels the "entitlement failures" precipitating a famine, the government should provide income directly (through public works or food for work schemes ) to those suffering a temporary loss of income generating employment. This administrative solution has eliminated famines in India.

Finally, the Industrial Revolution has introduced its own source of conjunctural poverty in the form of the trade cycle and the unemployment that ensues in its downturns. But in India's primarily agrarian economy, the seasonal unemployment of landless labor in rural areas is likely to be of greater importance than urban industrial unemployment. Rural public works schemes like the Maharashtra Employment Guarantee scheme (see Ravallion (1991)), have been effective both in preventing famines and in dealing with problems of short run income variability. But their success lies in the self-targeting that is made possible by offering a wage that only the truly needy will accept.

(iv) Income Transfers and Poverty Alleviation

Income transfers are the only way to tackle destitution and conjunctural poverty. Traditionally these have been provided by private agencies -- the church, private charity, and most important of all, transfers within extended families.

These private transfers were however replaced in most Western societies by public transfers through the Welfare State. In assessing the case for Western style welfare states in dealing with the continuing problems of destitution and conjunctural poverty, it is useful to first distinguish between social safety nets and welfare states.

The distinction between the "welfare state" and a "social safety net" essentially turns upon the universality of coverage of transfers under a welfare state as opposed to the restriction of collectively provided benefits under a social safety net to the truly needy. The World Bank's, Poverty Reduction Handbook, [PH] noted two essential elements in any design of a social safety net: "identifying the groups in need of assistance, and the means of targeting assistance to those groups cost-effectively." It went onto ask: "Are these questions for public policy, or are they adequately addressed by the traditional family network?" ([PH], pp. 2-13)

By contrast, welfare state advocates favor universality as it alone in their view provides a feasible means to achieve the ends sought to be subserved by a social safety net, because of problems concerned with obtaining the requisite information for targeting. Some have argued that, because of the ubiquitousness of imperfect information, markets for risk will be inherently imperfect. Hence, universal welfare states are required as part of an efficient solution to deal with "market failure". To deal with this argument would take me too far afield. Suffice it to say that this is a form of "nirvana economics" -- currently fashionable on the left -- but it provides no credible justification for a welfare state.


An implicit objective of those who argue against targeting and in favor of universal welfare states is distributivist. To judge its validity it is useful to contrast two rival ethical and political traditions: the classical liberal and the distributivist egalitarian, which continue to jostle for our attention and color the various policies offered for alleviating poverty.

(i) Classical Liberalism

For the classical liberal it is a contingent fact that there is no universal consensus on what a "just" or "fair" income distribution should be, despite the gallons of ink spilt by moral philosophers on trying to justify their particular prejudices as the dictates of Reason. Egalitarianism is therefore to be rejected as the norm for deriving principles of public policy.

This does not mean that classical liberals are immoral! The greatest of them all Adam Smith after all wrote The Moral Sentiments. Both of the great moral philosophers of the Scottish Enlightenment- Smith and Hume- recognized benevolence as the primary virtue, but they also noted its scarcity. However, as Smith's other great work The Wealth of Nations showed, fortunately, a market economy which promotes "opulence" does not depend on this virtue for its functioning. It only requires a vast number of people to deal and live together even if they have no personal relationships, as long as they do not violate the "laws of justice". The resulting commercial society promotes some virtues - hard work, prudence, thrift and self-reliance -- which as they benefit the agent rather than others are inferior to altruism. But, by promoting general prosperity, these lower level virtues do unintentionally help others. Hence, the resulting society is neither immoral or amoral.

A good government, for the classical liberal, is one which promotes opulence through promoting natural liberty by establishing laws of justice which guarantee free exchange and peaceful competition. The improvement of morality being left to non-governmental institutions.

But from Smith, to Friedman and Hayek, classical liberals have also recognized that society or the State should seek to alleviate absolute poverty. On the classical liberal view, as my colleague Al Harberger has noted, there could be an externality, whereby "the [poor] recipient's consumption of particular goods or services (food, education, medical care,housing) or his attainment of certain states (being better nourished, better educated, healthier, better housed) that are closely correlated with an 'adequate consumption of such goods" enters the donor's utility function. As it is the specific consumption of these commodities, not the recipient's "utility" which enters the donor's utility function, there is no "utility" handle which can be used as on the alternative distributivist view to allow distributional considerations to be smuggled into the analysis of poverty alleviation programs.

Thus the indigent and the disabled are to be helped through targeted benefits. For various merit goods-health, education and possibly housing -- these involve in-kind transfers. This is very much the type of social policy package that was implemented in Pinochet's Chile, and which succeeded not only in protecting the poor during Chile's arduous transformation to a liberal market economy, but also led to dramatic long-term improvements in its various social indicators.

(ii) Distributivist Egalitarianism

The alternative technocratic approach to poverty alleviation is by contrast necessarily infected with egalitarianism because of its lineage. At its most elaborate it is based on some Bergson-Samuelson type social welfare function, laid down by Platonic Guardians. Given the ubiquitous assumption of diminishing marginal utility underlying the approach, any normative utility weighting of the incomes of different persons or households leads naturally to some form of egalitarianism. But this smuggling in of an ethical norm which is by no means universally accepted leads to a form of "mathematical politics". Poverty alleviation becomes just one component of the general problem of maximizing social welfare, where given the distributional weighting schema, all the relevant tradeoffs between efficiency and equity, including intertemporal ones can be derived in terms of the appropriate distribution cum efficiency shadow prices. If the concern is solely with those falling below some normative "poverty line", this merely implies a different set of weights with the weight of unity say to changes in consumption (income) above the line, and increasing weights to those who fall progressively below the poverty line.

But this is a thin edge of a very big wedge, as far as the defenders of the market economy are concerned. Besides leading to recommendations for all sorts of redistributive schemes, it also leads to a vast increase in dirigisme. To alleviate poverty, an end embraced by classical liberals, they are on this route being led to endorse the creation of a vast Transfer State, which in the long run is incompatible with the preservation of a market economy.

A usual riposte to the classical liberal position of separating questions of alleviating absolute poverty from inequality is that, in theory, a market based growth process could lead to such a worsening of the income distribution, that instead of the poor seeing a rise in their incomes as part of the growth process, they could be immisserized. This view was strengthened by the so-called Kuznets hypothesis which stated that, inequality was likely to worsen in the early stages of development before it

declined, as per capita incomes rose towards current developed country levels. All the empirical evidence, to date, is against the Kuznets hypothesis, and its corollary that growth might not alleviate absolute mass poverty.


Are public transfers needed -- as the welfare state advocates claim to deal with destitution and conjunctural poverty, and as some assert even to deal with mass structural poverty? We need to briefly examine the relative efficacy of private versus public income transfers.

(i) Private Transfers: Kin based transfers, reciprocity arrangements and interlinked factor market contracts have been the major way that traditional societies have dealt with income risk. They have been fairly effective. With the inevitable erosion of village communities it is feared that these private insurance arrangements will break down and that no private alternative will be available to counter destitution and conjunctural poverty in increasingly atomistic industrial economies.

It is in this context that the role of private inter-household transfers is of great importance. Cox and Jimenez (1990) provide evidence to show that they are of considerable quantitative importance.

For example, among a sample of urban poor in El Salvador, 33% reported having received private transfers, and income form private transfers accounted for 39% of total income among recipients. Ninety-three percent of a rural south Indian sample received transfers from other households. In Malaysia, private transfers accounted for almost half the income of the poorest households. Nearly three quarters of rural households in Java, Indonesia, gave private transfers to other households. About half of a sample of Filipino households received private cash transfers. (p. 206) Moreover since the oil price rise of the early 1970s the poor in South Asia and parts of Southeast Asia have found remunerative employment in the newly rich oil states and their remittances to their Third World relatives has helped to alleviate their poverty.

Private transfers have by now been largely "crowded out" by public transfers in the West. The potential for such "crowding out" in developing countries has been estimated for Peru, and the Philippines by Cox and Jimenez (1992, 1993). There is potentially a large "crowding out" effect if public transfer systems were to be instituted in these countries. For example for the Philippines they find that, if a public transfer program was instituted which gave

each household the difference between its actual income and poverty line income, after private transfers adjust, 46% of urban and 94% of rural households below the poverty line before the program began would remain below the line after it was implemented!

Moreover, the evidence suggests that private transfers are efficient. By relying on locally held information, and on extra economic motivations like trust and altruism, private transfers overcome many of the problems of adverse selection, moral hazard etc., which have so exercised the "nirvana" economics 'market-failure' school. For as Cox and Jimenez summarizing the empirical evidence conclude: "private transfers equalize income; private transfers are directed toward the poor, the young, the old, women, the disabled and the unemployed" (p. 216).

(ii) Public Transfers: Perhaps public transfers can do even better, so that we should not worry if they crowd out private transfers? Public subsidization of the two merit goods -- health and education -- are the major public transfers in nearly all developing countries. In addition social security is important in many Latin American countries.

One question on which there is some empirical evidence is the incidence of the benefits from subsidies for merit goods. This overwhelmingly suggests that their incidence is generally regressive, and that they are very imperfect means of helping the poor.

A revealing piece of evidence suggesting that public transfers not only are more inefficient in poverty redressal than private transfers but also crowd them out is provided by a 1990 World Bank study. This

traced public social sector expenditures for nine Latin American countries in the 1980s ... [and] found that real per capita public social spending on health, education, and social security fell during some part of the 1980s in every country in the study. The share of health and education expenditures in total government expenditures also fell, even as that of social security rose. In spite of lower funding, and no apparent increases in equity and efficiency, social indicators generally improved in the 1980s. (Grosh (PH Box 3.4))

Apart from obvious statistical and other biases which might explain this anomaly, the most plausible explanation provided is that, it might be due to "the growing role of non-governmental organizations, and the response of the market oriented private sector to enhanced expectations and demand". That is there was probably a "crowding in" of more equitable and more efficient private transfers to replace the decline in public ones!

(iii) Political Economy of Transfer States

The "middle class capture" of the benefits of social expenditure is not confined to developing countries. It has also been documented for the welfare states of the OECD. A systemic process is clearly at work. It is the political economy of redistribution in majoritarian democracies. In a two party system, politicians will bid for votes by offering transfers of income from some sections of the populace at the expense of others. Models of this political process (which do not need to assume a democracy, but rather the interplay of different pressure/interest groups) show that there will be a tendency for income to be transferred from both the rich and the poor to the middle classes -- the so-called "median voter". Even if social expenditures are initially intended to benefit only the needy, in democracies such programs have inevitably been "universalized" through the political process, leading to what are properly called transfer rather than welfare states, which primarily benefit the middle classes.

The poverty alleviation that may occur as a by product of the expansion of the transfer state is moreover bought at a rising dynamic cost. With the universalization of various welfare schemes, political entitlements are created whose fiscal burden is governed more by demography than the conjunctural state of the economy. With the costs of entitlements rising faster than the revenues needed to finance them, the transfer state, sooner or later, finds itself in a fiscal crisis. This process is discernible both in developing and developed countries.

For developing countries the Lal-Myint study shows how this process is clearly visible in those countries in our sample (Uruguay, Costa Rica, Sri Lanka, and Jamaica) that under the factional pressures of majoritarian democracies have created and expanded welfare states. All four welfare states were financed by taxing the rents from their major primary products. With the expansion of revenues during upturns in the primary product cycle, political pressures led to their commitment to entitlements, which could not be repudiated when revenues fell during the downturn in the price cycle. The ensuing increase in the tax burden on the productive primary sector (to close the fiscal gap) led to a retardation of its growth and productivity, and in some cases to the "killing of the goose that laid the golden egg". Thus whilst there was undoubtedly some poverty redressal as a result of the expansion of these welfare states, over the long run these entitlements damaged the economic growth on which they were predicated, and hence eventually became unsustainable. Similar processes leading to the fiscal crisis of the state are to be found in many other developing countries. Not surprisingly, many of these countries with over extended welfare states are now seeking to rein them back.

Very similar problems are also visible in the more mature welfare states of the OECD. In some countries which had gone furthest down the public welfare route, the late 1980s and 1990s saw a growing questioning of the welfare state in the West, and in some cases its partial or virtual dismantling.


What are the conclusions for policy which follow from this discussion.

The first is that nothing should be done to damage the existing private institutions and channels providing private transfers. "Forbear" should be the watchword for every proposed scheme which seeks to alleviate poverty through public transfers.

The second is that, if for whatever reason, public money is sought to be transferred to the "needy", this is best done through private agencies. Particularly for the "merit goods" -- primary health care and primary education -- even if there is a case for public financing there is none for public production.

The third, is that the very problems of moral hazard, adverse selection and monitoring cited by "nirvana economics" as requiring public insurance, in fact argue for fostering the alternative private route which capitalizes on the comparative informational advantage of private agents with local knowledge. These private welfare channels can be promoted by various methods of co-financing them with public funds.

A radical proposal maybe worth considering. This would channel all foreign aid and domestic public expenditure on social programs and on "safety nets" to alleviate destitution and conjunctural poverty through NGOS (national and international charities). But to avoid the crowding out of private by public transfers this public funding should only be provided on a matching basis. The only reservation I would have about such a scheme is the continuing economic illiteracy shown by so many NGOs's .

Finally, there is the important question of severance payments that will be needed to slim the over extended and inefficient public sector as well as the bureaucracies which were set up

to manage controlled economies and are redundant with the move from the plan to the market. Such structural adjustment faces political resistance from the public sector workers who face retrenchment and/or cuts in their real wages. Such workers can exert political pressure to prevent the rescinding of their politically determined entitlements to future income streams which are above what they would be able to obtain in the free market. The capitalised value of the difference between their expected public sector earnings (including pension and other benefits), and those they could get in the private sector (adjusted for the probabilities of being hired and fired in the market), represent the rents, public sector workers are currently receiving. If their resistance is to be overcome they might need to be compensated for these rents. This is a political rather than an economic argument for severance payments, over and above those that might already exist in the contractual arrangements that maybe in force in the respective labor markets .

Given the heterogeneity of the labor force, the rents derived from public sector jobs will differ for different workers, being highest for the "bad" workers whose market opportunities relative to their entitlements in the public sector are the worst. With imperfect knowledge of each worker's rents, and the difficulty in devising perfectly discriminating severance payment schemes, if the severance compensation is set to persuade the last "bad" worker to leave the public sector, the intra marginal workers will be receiving more compensation than the capitalised value of their public sector rents. This could mean a very high cost to the fisc. But in some cases (e.g., where the public enterprise is producing negative value added at world prices), shutting down the enterprise even with this high cost may lead to a gain in net GDP. In others where the enterprise might still be viable after restructuring and privatization, which involves retrenchment, the problem of

tailoring a severance package remains.

The most attractive plan which would meet both the objectives of limiting political opposition and reducing the fiscal burden would be one limited to workers not hired by the newly privatized enterprise. This tackles the adverse selection problem whereby the "good" workers take the severance package and the "lemons" are left with the new firm. The severance package for those made redundant should be based on the principle of tailoring the benefits to the median redundant worker's public sector rents. This would imply that, if the severance package offered uniform compensation at the level of the rents to the median retrenched worker, all those with lower rents would be better off, and they would provide the political support for the scheme to override those workers whose rents were greater than the median and would be worse off. Little more can be said in principle about the specific terms of these programs which need to be tailored to local conditions, and in particular the relative bargaining power of public sector workers vis a vis the state.


Our conclusions can be brief. There is no case for attempting to institute a Western style welfare state in India. There are feasible ways of dealing with the inevitable pain that the necessary reform of India's labour market will involve. But it is going to require political courage. Lacking that, only a fiscal crisis- which spills over into an inflationary and balance of payments crisis- of the kind that led to the partial reform of Indian commodity and financial markets, is likely to lead to these desperately needed reforms. Without them the accelerated growth required to banish structural mass poverty from the sub-continent in the near future will not occur.


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