Savings and Investment in Indian States: Implications for Growth and Public Finances

Abstract

Regional imbalances in economic growth and development have always drawn attention of the policymakers in federal economies. Two important economic forces having implications for regional disparities are: i) market forces through interregional trade and factor flows; and ii) direct interventions through interregional fiscal transfers and channelling of investment to the poorer regions. Although impact of these forces on regional disparities has been debated in the literature; there is a broad consensus to reduce horizontal fiscal imbalances through intergovernmental transfers, to even enable functioning of common national market.

A major handicap in conducting research work and policy formulation on regional disparities in India is the absence of regional accounts, which could provide frame of reference to analyze developments in the state economies. This data gap makes it impossible to understand some of the important aspects of the state economies such as savings, capital formation, interregional trade, and capital flows. All these factors are considered crucial in the economic growth theories. However, Indian policymakers have been making their best efforts to achieve balanced regional development without having data for the underlying regional accounts. Even the role of central government’s fiscal policy, through its multiple channels of transfers and spending in the state economies, has been rarely estimated comprehensively. Without measuring the size of central government’s taxation and expenditure in the state economies, neither understanding of horizontal fiscal equalization nor consolidated analysis of government transactions in the regional accounts is feasible.

This study attempts to fill two of the important research/data gaps in the work on regional accounts and fiscal federalism in India by preparing estimates of: i) savings, investment, and interregional capital flows; and ii) consolidated fiscal accounts of the state and central government, within regional accounting framework. Estimates of regional accounts cover the period from 1993-94 to 2009-10, while consolidated fiscal accounts of the central and state governments have been prepared for 1999-00 to 2010- 11. To prepare the regional accounts at state level, we have used expenditure side approach to the economic accounting at regional level. Interregional fiscal flows by central government have been measured by analyzing interstate distribution of different components of central transfers, expenditure by central ministries, and collection of central taxes from the states. To this, state government’s budgetary transactions have been added to prepare consolidated accounts of the government at state level. Estimates of regional accounts show that changing growth trajectories of the states in the last two decades can also be explained by savings and investment patterns at the state level. Particularly, some of the poorer states have increased their saving and investment rates in the last two decades, which is reflected in their improved growth performance. Analysis of regional accounts also shows significant interstate variations in the composition of state economies, particularly for the special category states which are dominated by government expenditure and interregional trade.

Analysis of interstate allocation of the central government’s transfers and spending shows that formula based transfers, non-formula based transfers, and direct central spending benefit three different categories of the states; with distributional progressivity declining from formula based transfers to direct central spending. This differing impact of the three channels of central transfers and spending raises questions about the objectives of central government’s interventions in the state subjects. Although central transfers and spending bypassing the state budgets partly cancel out the extent of horizontal fiscal equalization achieved through Finance Commission transfers, we still found evidence for substantial horizontal fiscal equalization by consolidating central and state budgets at the state level. We also found evidence of increasing interregional central transfers to the poorer states and sizable inflows of private capital to some of the poorest states. Evidence of large and consistent interstate capital flows substantiates the need to prepare estimates of GSDP with income accruing approach rather than existing income originating approach alone. This study develops a regional accounting framework which would be useful for planning and research on regional development. Regarding the structure of fiscal federalism in India, this study establishes the need and provides an approach to broaden the concept of horizontal fiscal equalization, which would be useful for managing centre-state fiscal relations.