Closing the Development Gap: Ensuring Fiscal Equity for Balanced Growth in Indian States

The IMF paper explores economic divergence among Indian states, highlighting how higher-income states grow faster while low-income states struggle with fiscal constraints, perpetuating disparities. It calls for targeted fiscal reforms, increased investments in infrastructure and public services, and improved resource mobilization to ensure balanced regional growth and national economic sustainability.

The International Monetary Fund's working paper authored by Rajan Govil of the IMF South Asia Regional Training and Technical Assistance Center and Khyati Chauhan, a former Research Analyst at the IMF-Singapore Regional Training Institute, explores the persistent economic divergence among Indian states. Analyzing data from 2002 to 2023, the study finds that higher-income states in India have grown faster than their lower-income counterparts, contradicting the neoclassical growth theory that predicts income convergence in the absence of restrictions on labor, capital, and technology mobility. This widening gap in per capita income presents a significant challenge to achieving balanced regional growth and improving national economic outcomes. With fiscal policy as a key differentiator among states, the paper investigates how public finances can support convergence and mitigate disparities. It emphasizes that while India’s monetary, exchange rate, and institutional frameworks remain uniform across states, fiscal strategies are largely distinct, playing a crucial role in influencing economic performance.

Stagnant Revenue and Unequal Development Spending

The study reveals that general government revenue has remained stagnant at around 20% of GDP over three decades, significantly lower than the emerging economy average of 25%. This limited revenue base constrains investment in critical areas such as infrastructure, education, and healthcare, particularly for low-income states. States account for about 60% of total public spending, with significant variations in revenue, expenditure, and debt levels. Lower-income states like Bihar and Uttar Pradesh, which also rank poorly on the multidimensional poverty index, struggle with fiscal deficits and high debt-to-GSDP ratios, limiting their ability to enhance development spending. In contrast, higher-income states such as Kerala and Haryana benefit from stronger revenue mobilization, enabling higher per capita spending on public services and infrastructure. However, these disparities perpetuate a cycle where low-income states are unable to attract private investments or improve public service delivery, further widening the economic gap.

Odisha's Fiscal Success Versus Punjab’s Challenges

Odisha offers a notable example of successful fiscal management. Leveraging mining revenues, the state has significantly increased its development and capital expenditures while maintaining a fiscal deficit below 3% of GSDP. Odisha now leads in per capita spending on public health and education among large states, highlighting how targeted investments can transform economic trajectories. On the other hand, Punjab, once one of the wealthiest states, has seen its fiscal health deteriorate due to declining own revenue and unsustainable expenditure patterns. The state’s inability to expand development spending has resulted in stagnation, with Punjab now trailing in per capita investment in public services. These contrasting cases underscore the critical role of prudent fiscal planning and effective resource utilization in driving economic growth and reducing disparities.

Subsidy Overhaul and Revenue Mobilization as Priorities

The paper emphasizes the need for central government transfers to be outcome-driven, ensuring efficiency and accountability. Currently, central schemes and fiscal awards are crucial for lower-income states but are insufficient to address structural issues. States must also improve their own tax buoyancy and reduce dependency on central transfers by enhancing revenue mobilization and addressing inefficiencies. Administered pricing mechanisms, which set prices for key commodities such as electricity and water below cost, not only reduce non-tax revenue but also lead to significant subsidies, undermining fiscal sustainability. Subsidies, accounting for 2.1% of GDP at the central level and 1.5% at the state level, need to be restructured toward growth-enhancing expenditures. The authors argue that reorienting fiscal priorities toward infrastructure, education, and healthcare is essential to create a conducive environment for private investment and long-term growth.

A Path Toward Fiscal Sustainability and Growth

India’s public debt, at 82% of GDP in FY2023, presents significant risks to fiscal sustainability, particularly given the stagnant revenue-to-GDP ratio. Interest payments, consuming over 5% of GDP and 25% of total revenue, further constrain fiscal space. Many states face similar challenges, with debt levels exceeding 20% of GSDP in most cases and reaching over 40% in states like Punjab and Bihar. While fiscal deficits have been kept under a 3% ceiling in many states, recent increases due to the pandemic and rising contingent liabilities highlight the urgency for stronger fiscal discipline. The authors suggest that reforms should include phasing out subsidies, improving tax administration, and enhancing public sector efficiency. This will not only boost revenue but also provide the necessary resources for development spending.

Addressing Disparities for Equitable Growth

The paper concludes that addressing economic divergence among Indian states is critical to achieving national growth and balanced regional development. Structural reforms at both central and state levels are essential to improve productivity and competitiveness. Investments in physical and digital infrastructure, human capital, and research and development will be pivotal in fostering economic convergence. The study calls for an integrated approach where both central and state governments work collaboratively to reduce regional disparities. Central transfers must be aligned with measurable outcomes, while states need to prioritize their spending to ensure higher growth rates over time. The contrasting trajectories of Odisha and Punjab exemplify how strategic fiscal planning can influence economic outcomes, offering valuable lessons for other states. By addressing fiscal inefficiencies and focusing on long-term growth drivers, India can unlock its economic potential and provide equitable opportunities across its diverse regions.