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The growing size of state economies has not necessarily translated into economic clout because of the way fiscal rights are distributed in India. (The growing size of state economies has not necessarily translated into economic clout because of the way fiscal rights are distributed in India.)
The growing size of state economies has not necessarily translated into economic clout because of the way fiscal rights are distributed in India.
(The growing size of state economies has not necessarily translated into economic clout because of the way fiscal rights are distributed in India.)

The Indian federal paradox

The decline in the fiscal autonomy of states and their growing political clout could lead to intense political bargaining

India had a $287 billion economy in 1991, the year of economic crisis followed by big bang reforms. Maharashtra alone now has a $190 billion economy, according to the latest data available on state gross domestic product at current prices converted into dollars. So the largest state economy will soon be as big as the entire Indian economy was in 1991. Andhra Pradesh, Uttar Pradesh and Tamil Nadu are over $100 billion while Gujarat and West Bengal are approaching that mark.

A few state economies are now larger than several national economies. Only 60 of the 184 countries featured in data from the International Monetary Fund have economies larger than $100 billion. Maharashtra would be the 50th largest economy in the world if it were a separate country.

However, the growing size of state economies has not necessarily translated into economic clout because of the way fiscal rights are distributed in India.

The initial constitutional design generally allowed the Union government to collect taxes on production (taxes on income and corporate profits, for example) while taxes on distribution were meant to be collected by the states. On the spending side, New Delhi was to take care of national public goods (defence, foreign policy, communications) while the states were to provide local public goods (policing, education, health).

This design has been fundamentally changed in recent decades. Central schemes funded by New Delhi have grown in number. The proposed goods and services tax will also reduce the fiscal autonomy of the states. (This column is not an argument against either central schemes or the new tax, just a statement of facts.)

The decline in the fiscal autonomy of the states has paradoxically been accompanied by their growing political clout. What has happened in recent months is well known. Bihar chief minister Nitish Kumar has indicated that he is ready to shift allegiance to any national coalition that promises to increase central transfers to his state. Tamil Nadu politicians have managed to arm twist the Indian government into changing its position on a resolution on Sri Lanka in the United Nations Human Rights Council. West Bengal chief minister Mamata Banerjee had earlier spiked a deal with Bangladesh on sharing of the Teesta waters.

A less noticed example was at the national council meeting of the Bharatiya Janata Party in March. Other than party president Rajnath Singh and senior leader L.K. Advani, the men who had the most time in front of the mike were the star chief ministers: Narendra Modi, Raman Singh and Shivraj Singh Chouhan. Two of them even got more time than Advani. The leaders in New Delhi—Arun Jaitley, Sushma Swaraj and Nitin Gadkari—got less than half the time the regional leaders got.

Such is the emerging federal paradox in India: the states are losing financial autonomy to New Delhi but have growing political clout over the Union government. Powerful regional satraps are now in a position to leverage their political clout to demand funds from the Union government. As my colleague Manas Chakravarty pointed out on Monday, grants from the Union government account for almost a quarter of Bihar’s annual budget. In the case of Uttar Pradesh, grants are a sixth of its budget.

What we saw in the case of Nitish Kumar could thus be repeated in other contexts. Such political bargaining could exacerbate tensions between states. I have heard informal stories about how the richer states have tried to come together in National Development Council meetings to ask why they should be penalized for the underperformance of some large states. One could compare this with the question asked in Europe: how long will the Germans agree to underwrite the Greeks?

The tensions are likely to be less acute in India, because ours is a single country rather than, as is the case with Europe, a transnational federation without a common fiscal system. Yet, this is a fault line that is not given its due in public discussions.

What happens in the states will matter a lot, for two reasons. First, the political economy equilibrium in the states is more stable than that in New Delhi, which has effectively meant that decision making in state capitals in recent years has been smoother than in the national capital. Second, as World Bank president Jim Yong Kim said after his recent visit to Uttar Pradesh: “The World Bank Group’s mission of eradicating global poverty and boosting shared prosperity cannot be fulfilled if Uttar Pradesh continues to be home to 66 million of India’s poor—the highest in any state." Similarly, India cannot win the battle against poverty unless Uttar Pradesh and Bihar grow rapidly.

The states thus have an important role to play in terms of both economic growth as well as poverty reduction. It is unrealistic to pin all hopes on New Delhi, especially given what has happened over the past decade. But the attempts of the states to take the lead in policy could lead to two sorts of conflict: with the Union government as well as with other states. The result will likely be messy political bargaining.

Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at cafeeconomics@livemint.com

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

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