In September this year, the Economic Advisory Council to the Prime Minister (EAC-PM) released a document titled: Relative economic performance of Indian states: 1960-61 to 2023-24. It shows each state’s share in the country’s income and per capita income compared to the all-India average.

The data tells us the importance of each state in the country’s economy and the average well-being of citizens of each state compared to the all-India level. The average hides inequalities. For example, Maharashtra, which contributes the most to the national economy, has a per capita income of around 150% of the national average. But these are Mumbai, which is rich, and Vidharba, which is known for farmer suicides due to poverty. Mumbai’s rich contribute the most in direct taxes and the city’s municipality is the richest in the country. But there are huge slums with uncivilized living conditions.

Regional differences

The report highlights the consistently better performance of the western and southern regions of India and the weak performance of the eastern states. The northern states are faring poorly, with the exception of Haryana and Delhi. Overall, the picture shows a growing divide in the country, which is not good for a federal and diverse nation like India.

This growing gap leads to questioning federalism. Representatives from wealthier states recently held a conclave in Kerala and argued that they were not getting their fair share of the Centre’s resources. They say they contribute much more to the national kitty than what the Center returns to them. Also in 2000, there was a “Conclave of Successes” to protest against decentralization by the Eleventh Finance Commission. Thus, little by little, the spirit of federalism weakens.

The report cites liberalization (1991) as an indicator of when southern states began to perform better. But that doesn’t address the causes. This also shows that coastal areas are faring better, especially Odisha in the east. But could it be that the poorer performance of some states is linked to the better performance of some others?

Investment is the most important determinant of production. The higher the level of investment, the larger the size of the economy. Thus, for a more comprehensive analysis, one should study the level and rate of investment in each state. Richer states generally have a higher rate of investment than poorer states and, therefore, perform better.

Investments come from the public and private sectors. The first is based on political decisions while the second is determined by profitability considerations. The government can invest in a lagging region to develop it even if no profit results in the short term. The private sector will not do this unless the government grants them concessions such as tax breaks and electricity at preferential rates.

Private investment alone goes to developed areas where a large market guarantees profits. Thus, urban conglomerates such as Mumbai, Delhi, Chennai, Bengaluru and Hyderabad are preferred destinations for investments. Haryana, which is contiguous to Delhi (with the highest per capita income), has also benefited. Calcutta is not preferred for other reasons. Coastal regions are favored because they allow cheaper access to foreign markets through exports. Additionally, cheap imported inputs may be available.

The availability of infrastructure and the quality of governance in a state are important determinants of profits. Richer states are better at both and attract more investment. Better governance is also linked to better quality education and health. This leads to the availability of a more productive workforce. But this is not critical since there is massive migration from poorer states to richer states.

Private investment represents 75% of total investment. After the launch of the New Economic Policies (NEP) in 1991, the role of the public sector as the leading sector shifted to markets. As a result, more investment has been directed to wealthier states, where profits are higher. Additionally, the financial sector that guides investment became more important after 1991. Considerable household savings were increasingly diverted from poorer states to richer states that offered higher profits. This is reflected in the low credit-to-deposit ratio of poorer states compared to richer states. This diversion of investments leads to growing disparity.

Finally, poorer states are home to a larger share of the unorganized sector working with low productivity and income. Under the NEP, the policy favored the organized sector. This has been facilitated by the construction of freight corridors and highways that allow this sector to penetrate the hinterland. Thus, the organized sector grew at the expense of the unorganized sector and fueled the faster growth of wealthier states.

In short, the NEP has played a major role in the growing divide between states since “liberalization”, as highlighted in the EAC-PM document.

West Bengal and Kerala are special cases. Both states have seen strong left-wing movements and labor activism. The private sector has therefore invested little in these States. India’s border states have received less public investment for strategic reasons. It’s also because many of them suffered from an insurgency that scared the private sector.

Opposition-ruled states have accused the Center of playing politics with public investments. The often displayed slogan “Double Engine ki Sarkar” reflects this idea. Furthermore, growing cronyism in India impacts investment decisions as political signals are important. This spoils the investment climate by reducing risk for cronies while increasing it for others. This results in a drop in the overall investment rate which has a greater impact on the poorest states.

The underground economy is also proportionately more prevalent in poorer states. This vitiates the investment climate due to policy failure and poor governance and reduces investments received. This therefore reduces their growth potential.

Threat to federalism

Persistent differences in the economic performance of different states threaten federalism. Policy must therefore reverse this trend. Even maintaining spreads at current levels is no longer an option. This requires a reversal of the trend of private investment, weak governance and poor infrastructure in lagging states.

The Center and states must act. States must improve governance and reduce levels of corruption within their territories. Public spending in social sectors must be significantly increased. Private investment in poorer states cannot be increased by fiat in a market economy. This requires a change in the Centre’s strategy to favor the organized sector over the unorganized sector. If the focus shifts to the unorganized sector, incomes of the marginalized will increase, boosting demand and production in poorer states. As demand increases in these states, it would attract more private investment.

The organized sector, constrained by lack of demand, would also benefit. They do not need more concessions from the government since they have enough resources to increase their investments. These policy changes will not mean that wealthier states will not experience growth; only the disparities would decrease. This would be a development from below which would strengthen federalism and help preserve the unity of the nation.

Arun Kumar is a retired professor of economics from Jawaharlal Nehru University and author of the book, The biggest crisis in the Indian economy: the impact of coronavirus and the road ahead (2020)