A big step forward

Special treatment for defence PSUs has ended

In a major step forward for India's reform process, for its private sector - and perhaps for national security overall - the government has withdrawn the excise and customs duty exemptions given to the Ordinance Factory Board and public sector undertakings (PSUs) in the defence sector. This removal is intended to provide a level playing field to the private sector vis-à-vis the public sector. It would take away the critical advantage the public sector enjoyed while quoting rates in open bids. Defence was the last sector where the public sector got such preferential treatment; thankfully, that too is history now. Many private companies, including multinational corporations, had long campaigned for this change. The exemptions, they claimed, gave an unfair competitive advantage to the state-owned companies. Effectively, this clause acted as a bar to the entry of foreign technology and capital into India in the defence sector. As long as the clause existed, multinational companies used to find it more worthwhile to tie up with public sector units, because it would translate into a significant cost advantage. Often, given the state of the public sector, this caused delays and led to the production of sub-standard equipment. With the exemptions gone, multinational corporations are likely to choose partners on the basis of efficiency and effectiveness alone. This should make the industry more vibrant and induce greater investment. For the public sector, the message is: shape up or ship out. In the long run, these units will have to survive on their own merit and not through government handouts like tax benefits.

Overall, the creation of a level playing field should give a huge boost to the private sector in defence. This has been one of the key sectors identified by the National Democratic Alliance government to revive manufacturing in the country. The logic for that is very simple: India is one of the biggest buyers of defence systems in the world and most of the equipment is imported. By producing them at home, the local economy can get a significant growth impetus. In addition, historically and across countries, the large and reliable contracts that are associated with government procurement for the military have served to spur innovation and investment from the private sector. It is with this intent that the cap on foreign investment in the sector was raised from 26 per cent to 49 per cent. Several Indian business houses, ranging from Tata to Mahindra and Godrej, have shown interest in being part of this industry. Apart from direct orders from the armed forces, they also have an eye on the sub-contract that can come their way: under the offset clause, overseas suppliers are required to plough back a chunk of their business into India. Some multinational corporations have openly questioned the ability of the public sector units to deliver, with whom they are forced to sub-contract because of the excise and customs benefits enjoyed by them. The removal of this clause will make them more confident about manufacturing in India.

Beyond this sector, however, this is a reminder that such schemes have created enough distortions in the market and need to be avoided. In the past, backward area tax benefits led businessmen to set up factories where they made little sense. Over time, they were bound to become unviable and sick. Similarly, the reservation of a large number of goods for production in the small-scale sector had disastrous effect: it created an incentive to stay small. This robbed industry of a great deal of efficiencies. Thankfully, the list of items reserved for the sector has been gradually reduced to zero. The removal of the duty advantage for public sector units in defence was another distortion that has now been ironed out.