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Why land ceilings hurt corporate investment

Transaction costs and a price premium disincentivise firms from investing in land

Sarmistha Pal Tiago Pinheiro & Zoya Saher 

As India strives to grow through liberalisation and industrialisation, firms find it difficult to purchase land; this often leads to tussles between farmers, industrialists and government. While the reasons behind this difficulty are unclear, anecdotal evidence suggests that the consequences are both visible and sizeable: Projects are delayed, relocated, or cancelled.

In this article, based on a paper by Pal and Saher, we shed light on some of the causes and consequences of firms’ difficulty in buying land. Specifically, did the land reforms that followed India’s independence, especially those related to land ceilings, make it more difficult to purchase land, and did these difficulties have an effect on corporate investment?

Our analysis particularly focuses on the role of land ceiling legislations defining the ceiling size of land holdings. By 1961-62, ceiling legislations were passed in all states. The size of the ceiling varied from state to state, and was different for food and cash crops. The unit of application of the ceiling also differed across states: In some states ceilings were based on “land holder”; in others they were based on “family”. To bring about uniformity, a new policy was introduced in 1971 based on the fertility of the land. Different land ceilings were imposed on three categories of land: Land cultivated with two crops, land cultivated with one crop, and dry land. The ceiling was the lowest for land cultivated with two crops.

India’s land ceiling legislations ultimately increased the transaction costs of buying land and the price premium firms pay when acquiring land. Faced with higher land costs, firms find it optimal to invest less in land and capital.

The reforms redistributed land from a few large landowners to many small owners. A firm looking to acquire a plot of a given size has to negotiate and buy land from a larger number of owners after the reform than before. Each such acquisition is costly, and the larger their number, the larger the transaction costs.

For the same reason, the price premium that firms pay to acquire land is higher after these land reforms. Once a firm acquires a substantial number of parcels of the plot it wants to buy, the landowners of the remaining parcels, knowing that it is costly for the firm to engage in multiple new transactions for a different plot, may refuse to sell or demand a premium — a rent — above the market price of their land.

Transaction costs and a price premium disincentivise firms from investing in land. The disincentive extends to capital investments, especially when land and capital are complements, such as in the case of the automobile sector, or when capital cannot easily substitute land.

The results from our empirical analysis support the conjecture that India’s land ceilings lead to less corporate investment. Using a dataset of publicly-traded companies between 1996 and 2012, together with state-level panel data for 16 major Indian states from 1960 to 1985, we assess the effect of land ceiling size on fixed and total capital-output ratios. We control for various observable economic variables, unobservable firm and state-level factors, and also time trends that may influence capital investment. The results suggest that there is a positive and statistically significant relationship between the ceiling size on the most fertile land and capital-output ratios; both fixed and total capital-output ratios increase significantly when ceiling size increases in our sample.

Accordingly, we conclude that controlling for other factors, states with low fertile-land ceilings tend to have lower investment in capital than those with high ceilings for fertile land. The result holds even after we drop Kerala and West Bengal — two states where the land reforms were implemented most successfully.

We also find direct evidence supporting the mechanism behind our conjecture: Specifically, the size of household landholdings is smaller in states with more restrictive ceilings. Smaller land plots suggest more land fragmentation, that is, a larger number of owners per unit of land, and thus higher transaction costs for acquiring a given acreage of land.

While we interpret the evidence as suggesting that lower land ceilings result in less corporate investment, one could also use the same evidence to support the reverse causal relation: States with expectations of low investment set more restrictive ceilings. However, as argued above, land ceilings were not under the control of state governments, ruling out reverse causality.

We rule out some competing explanations of our results: More restrictive land ceilings lead to less investment even after we control for soil fertility (a proxy for higher land price) and annual man-days lost because of strikes (a proxy for pro-worker regulation).

Our results thus highlight an unintended consequence of land ceilings on corporate investment. Ultimately, lower investment leads to lower economic growth. While one cannot reverse the adverse effects of land reform, in a land-scarce economy with growing population to feed, options for future policy development require closer scrutiny of the diversity across states.

Sarmistha Pal is professor of financial economics, University of Surrey (UK). Zoya Saher is a PhD candidate in finance at the University of Surrey. Tiago Pinheiro is a researcher in a non-academic institution, and has earned a PhD in economics from the University of Chicago.

Published with permission from Ideas For India, an economics and policy portal

First Published: Sun, April 23 2017. 09:00 IST