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Indian federalism is being rewired in a fundamental way.

The states will in effect be giving many of their tax powers to New Delhi once the goods and services tax (GST) becomes a reality. But the spending power of the states is increasing as more taxes are transferred to them thanks to the award by the Fourteenth Finance Commission.

So India is seeing fiscal centralization and fiscal decentralization at the same time. The very fluidity of the transition will create its own opportunities.

One common worry is that state governments are likely to waste the opportunity given to them because of their spendthrift ways. The data shows that these dangers are overstated.

In fact, the states seem to have managed their budgets better than New Delhi has in recent years. The combined revenue deficits of the states has come down sharply over the past decade, even as the central revenue deficit has been persistently high (see graph).

State governments are still in the midst of the new budget season, so the data considered here stops at the budget estimates for fiscal year 2016. Some fiscal deterioration seems likely in the new fiscal year, given the need to put money aside for the bailout of discoms under the Ujwal Discom Assurance Yojana as well as to budget for higher staff salaries following the recent pay commission recommendations. The bond markets have been jittery over the past few weeks because of the extra borrowing by the states. And it remains to be seen whether the states respond to higher spending by cutting investment in new capital assets.

There will be more clarity on these issues only when all states have announced their budgets. But it is still important to look at the trend over a slightly longer period. The states have actually run revenue surpluses in recent years, though there are variations between states. What this essentially means is that state governments are funding their revenue spending from annual tax collections. They have been borrowing only to create capital assets. The trend is even more stark when you consider primary revenue deficits, or revenue deficits minus interest payments. The upshot: the states have actually been more disciplined than New Delhi over the past decade.

Economics offers two insights here. First, it has been shown in several studies that political units with more homogenous populations find it easier to agree on the provision of public goods, while governments with more heterogenous populations tend to use spending programmes directed at one part of the population to buy out voters.

The ability of the states to run revenue surpluses could be linked to the fact that states are more homogenous in terms of their population than the nation as a whole, which has led to the rise of powerful chief ministers with broad political mandates.

Second, free trade integrates economies but also provides incentives for smaller political units that are no longer hindered with a small domestic market thanks to falling trade barriers. It is perhaps no surprise that regionalism has grown in Europe as its economy has been integrated.

That raises a fascinating question: Will the creation of a single Indian market thanks to GST encourage not just the demand for greater political rights by existing states but also embolden local elites to push for the creation of new states?

The possibility cannot be dismissed. The first round of states’ reorganization was based on cultural identity, specifically language. There could be another round that is driven not by language but by economic reasons.

It is interesting that the Rashtriya Swayamsevak Sangh has revived a principle suggested by B.R. Ambedkar when Indian states were being reorganized on the basis of language in the first decade after Independence.

Ambedkar had said that while each state should have one language, each linguistic group need not be consolidated into one state. Large linguistic states could be broken into smaller units of around 25 million in the interests of efficient administration. Andhra Pradesh has recently been bifurcated. And there are persistent debates about the need to divide large states such as Uttar Pradesh and Maharashtra.

It is now increasingly clear that a lot of action has shifted to the states—though this is not necessarily reflected in the media because of its concentration in a handful of cities. The states account for more than half of total government spending in India. They have done better at capital investment than New Delhi has. The states have always been at the forefront of policy innovations—and this could continue in the coming years. Gone are the days when elected chief ministers had to seek meetings in the Planning Commission to get funding.

But there is a challenge as well. The states will have to build capacity to spend more, design policies and provide public goods. The largest states will soon have economies that are bigger than what the Indian economy as a whole was in 1991. Managing these large economies will require skill.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com.

To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics

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