Global Policy Forum

By Sadanand Dhume

Nearly a decade into an era of economic reforms designed to dismantle India's command economy, the gap between its relatively rich states and their poor cousins has grown into a gulf.

Parts of India are clocking growth rates as high as those that propelled East Asia to prosperity. But the two largest states, Uttar Pradesh and Bihar, home to one in four Indians, remain backwaters largely untouched by the economic energy rippling through other parts of the country. In 1981, Gujarat's per-capita income was about twice that of Bihar; by 1998, the average Gujarati was earning 16,250 rupees a year (about $400 at then exchange rates), roughly three and a half times as much as the average Bihari.

Not surprisingly, the strain of managing such glaring disparities is beginning to show as rich states grumble loudly about New Delhi's attempts to play Robin Hood.

On August 21, Andhra Pradesh's chief minister, Chandrababu Naidu, led seven other chief ministers and officials of rich states to New Delhi to protest at the decision of a nonpartisan government commission to reduce their shares of the federal tax pie. Naidu complained that "reforming and performing states" were being punished for reducing poverty, building infrastructure and controlling their populations. "Poor states should be given money, but not at the cost of performing states," Naidu says.

Naidu's action is the first shot in what promises to be a drawn-out battle that could jeopardize India's hard-won political consensus on economic liberalization.

Opposition from rich states is not the only problem. Uttar Pradesh and Bihar have benefited little from reform. "The consensus on economic reforms is beginning to crumble," says Yogendra Yadav, a political scientist at New Delhi's Centre for the Study of Developing Societies.

New Delhi's challenge is to maintain a balance between equity and efficiency; in the process, it must also be careful that regional grievances don't spin out of control. "If you are going to give more money for poor states, we will also become poor," Naidu says. "We have to go forward, not backward."

Dramatic changes in the economic and political landscape over the past decade make New Delhi's task even more difficult. States have more economic decision-making power than ever before. And regional political parties have grown more assertive as their voters become more demanding.

States that have seized on the end of licensing and the advent of more liberal rules on investment have profited. One star example is Naidu's Andhra Pradesh, a large state with 76 million people that has slashed red tape and attracted investment from international companies such as Oracle, Microsoft and HSBC.

INVESTORS FAVOUR JUST SIX STATES

Similarly, Maharashtra and Gujarat, with their skilled workforces and relatively high-income consumers, have been the natural destination for much new investment, both domestic and foreign. More than three-fourths of the $20 billion in foreign investment that India has approved since reforms began in 1991 has been concentrated in only six states. And as these states grow, so will lagging states find it increasingly difficult to find investors. Says Bibek Debroy, director of the Rajiv Gandhi Institute: "Who on earth is going to invest in Bihar?"

While the invisible hand of the market has rewarded better-governed states, the strong hand of government has begun to wither. Wrestling with a runaway fiscal deficit, New Delhi has been forced to cut back its commitment to the public sector. This has hurt the ability of populous states to translate their political clout into economic largesse.

The fact that many poor states are also those with runaway population growth hurts even more. India's planning commission says the population of Gujarat, Maharashtra and the four southern states is likely to stabilize by 2014. But Uttar Pradesh, at current growth rates, will continue to add to its 170 million people well past 2100.

India's fractious politics--where regional parties are becoming more and more assertive and politically powerful--only sharpens the disparity. The current BJP-led government, a patchwork of 24 parties, survives thanks to support from regional heavyweights such as Andhra Pradesh's Telugu Desam Party and Tamil Nadu's DMK. Voters, on both a national and state level, have become more demanding. Single-state parties such as Naidu's TDP aggressively articulate the demands of their state and chief ministers are willing to fight for every rupee. Naidu believes that New Delhi's financial largesse for poor states rewards economic laggards for avoiding often painful reforms. Naidu, for example, faces hunger strikers and rioting protesters opposed to his government's attempts to hike power tariffs.

For now, the spotlight is on a report by the Finance Commission, which decides on the distribution of central taxes and grants to India's 26 states. India is a federation, but the most important taxes and duties--income tax, excise and customs--are collected by the central government. States collect less important levies such as sales tax and motor-vehicle tax.

Thanks to strong GDP growth and a decision by the Finance Commission to pass on more cash to states, the total amount it disburses to states is set to grow to nearly $95 billion (at today's exchange rate) between 2002 and 2007 from about $50 billion between 1996 and 2001. The wealth of a state is determined by a formula that includes per-capita income, population, land area, level of infrastructure development, tax effort and fiscal responsibility, with income by far the most important factor. This means that states with low economic growth and high population growth will continue getting a larger slice of the pie, while the fastest-growing states see their share shrink. For example, Gujarat, one of India's best-performing states, has seen its share fall to 2.75% from nearly 4% in 1995. Poorly performing Bihar's has grown to 13% from less than 11%.

DRAG ON GROWTH

The Financial Commission justifies the changes by pointing out that poorer states need a helping hand. Poor states tend to have spotty tax collection and a hard time attracting investment.

Participants in the negotiations suggest that New Delhi will buy peace with rich states by setting up a special fund for the development of infrastructure. But this won't do anything to solve the underlying problem of balancing equity and efficiency.

Moreover, what New Delhi faces is not just the issue of equity among states, but also of accelerating national growth. According to Montek Singh Ahluwalia, a member of the Planning Commission and one of the architects of India's economic reforms, India will not be able to grow at 8%-9% a year unless laggard states improve their performance. Without accelerated growth, millions of Indians will continue to live in poverty, and the country will remain far behind China and the "miracle" economies of East Asia.

But China, which has its own regional economic disparities, is not a democratic federation. Debroy of the Rajiv Gandhi Institute says "the resentment is going to be much more palpable and difficult to handle" in India than in China. Yadav, the political scientist, adds that the first murmurs of dissent against economic reform have begun, especially in the Hindi heartland. Uttar Pradesh and Bihar control 139 of the 545 seats in India's lower house of parliament. Earlier this year the Congress Party set up a committee to review its position on economic reforms.

So far, Congress remains on board. For the most part, politicians from Hindi-heartland states have been preoccupied with caste and religion and have gone along with economic reforms. But Yadav thinks this could change. Should that happen, the divide between India's rich and poor states will only deepen.

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