Government

Rich State Poor State: Alternative Solutions Are Needed to Address Divergence

Progressive devolution of fiscal transfers has not helped poorer states to converge to their richer counterparts. The political party which can switch the tide will be able to ensure votebanks.

It is widely known that India suffers from both poverty and inequality; but it is important to clearly differentiate the two. Close to 21% of the population lives in abject poverty, defined by Amartya Sen as lacking the necessary resources to be able to function at a socially acceptable level. As poverty is relatively easy to identify, the eradication of poverty has been the centre of many development policies of the country.

However, as governments do not regularly assess and measure inequality, it has often taken a backseat to poverty within the policy domain. Given the current political climate with the elections around the corner, it may be worth examining why past and current governments have allowed regional economic inequality to persist between states without altering the devolution of the center’s pool of resources.

Solow’s theory on the convergence and divergence of countries has had an enormous impact on the development of economies and macroeconomics as a whole. Solow postulates that in the long run, per capita income converges to the same level in all countries. This will happen irrespective of the starting point of each country. The fundamental premise for this argument requires the factors of production and the endowment levels of the countries in comparison to being the same.

One of the ways in which poorer countries in this model catch up with richer countries is through importing improved technology and more efficient capital would provide the impetus required for poorer countries to catch up to their richer counterparts. This implies that the lower the country’s original GDP per capita, the higher is the growth rate that the country should experience over time.

Testing for the case of Indian states

We test this theory for the case of Indian states. The poorer states, in terms of GDP per capita, should be growing at a faster rate than their richer counterparts. The Centre has tried to achieve this largely through the redistribution of wealth from rich to poor states since the planning period started.

However, empirically, there has been little support for absolute convergence and studies show a trend of increasing divergence among the states. This has often given rise to resentment among states, as those that sometimes contribute more towards the country’s funds are devolved a smaller portion of the funds.

States that contribute significantly to the Centre’s pool of resources have received far less. Revenue sharing within the states in India have been called highly progressive owing to the size of fiscal transfers that each state receives based on their original contribution. Certain states such as Maharashtra and Tamil Nadu receive less than Rs 30 from the Centre through conditional and unconditional transfers for every Rs 100 they have contributed, whereas Bihar and Uttar Pradesh have received an augmented 200% and 150% of what they respectively contributed in 2016-17.

Among other things, disparities in fiscal transfers could explain political resentment among certain state governments. So, what exactly can the Centre do? Should it cut the transfers redistributed to the poorer states? Or does it continue devolving funds according to the presently prevailing formula?

Impact of progressive devolution

The reason why this creates noise within the policy domain is because progressive devolution of fiscal transfers has not provided impetus for poorer states to converge to their richer counterparts. To see the convergence and divergence of states, the diagram below plots the natural log of the initial per capita income for the year 2011-12 (X-axis) for all the states against the natural log of the average per capita income growth experienced during 2011 till 2017 (Y-axis).

From the diagram, it is evident that states such as Bihar and Uttar Pradesh, perhaps in part owing to the lack of institutional capacity available and due to various other factors, have not been able to maximise the resources devolved to them.

Data for the graph has been taken from the RBI database.
The Per Capita NSDP at constant prices for the state of West Bengal was unavailable, and therefore left out.

Although the devolution of funds through conditional and unconditional grants are to ensure minimum standards in terms of the delivery of public services, indirectly it suggests that the devolution of augmented resources has not appeared to have helped states grow at faster rates. Rather, these states continue to exhibit growth rates that are dismal.

The line of best-fit outlines where the states should lie based on their initial income levels. As the graph shows, states such as Mizoram, Tripura and Gujarat are outliers and have witnessed sustained growth in their income levels from 2011-17.

What is alarming is the situation that the states of Bihar and Uttar Pradesh find themselves in. On the one hand, if states that do not proportionally contribute to the Centre’s pool of resources do not receive augmented amounts, would this result in states becoming less “lazier” and try finding alternative measures to augment their resources. This in turn could lead to an increase in the productivity and efficiency of the state. This will create a competitive environment among the state, where those with better policies do better.

Political risks

However, there could be political risks in a Centre-state dichotomy. Suppose there was no increase in productivity of the states where transfers were cut, such a situation would lead to the progressive worsening of the states capabilities to provide the minimum basic services that people have become accustomed to. In short, the political party at the helm will face all the backlash. In the political domain, such a move would never be orchestrated as the opposing party would be able to gain votes from the residents of the states whose transfers have been cut.

The Centre needs to find alternative solutions to address the problem of divergence of the poorer states. Less economically affluent states such as Uttar Pradesh and Bihar constitute nearly 1/4th of the country’s population, a sizeable fraction of which are poor. By altering the tides of divergence, this indirectly would give rise to income levels, resulting in higher satisfaction levels among citizens.

As a result, whichever political party at the helm can find a method to help switch the tides of divergence could be able to ensure votebanks. The population residing in poorer states are happy as significant development is occurring and the richer states are ecstatic as they will be devolved a higher proportion of the transfers. But more importantly, the country would finally put divergence to bed, and ensure a situation where there is economic equality among the states.

Nikhil George is a research assistant at the department of economics at Monk Prayogshala, a not-for-profit academic research organisation based in Mumbai. He focuses on urban economics, public policy and behavioural economics.

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