Making a better Indian Union

The idea that the southern states are being penalised for better performance overlooks the full costs and benefits of being part of the Union

There is a growing clamour among some prominent politicians and commentators from South India, now labelled “The South Tax Movement”, who argue that they are not receiving a fair deal as part of the Indian Union. They contend that their relative prosperity has resulted in them transferring resources to poorer northern states. They submit that Karnataka gets only 15 paisa for every rupee of tax paid, and Tamil Nadu gets 29 paisa, whereas Uttar Pradesh gets Rs 2.73, and Bihar gets Rs 7.06. They assert that they are being penalised for better economic management, while the poorer northern states are being rewarded through fiscal transfers for not performing as well.

This resentment may increase as incomes across states diverge further. But it’s not just a North-South issue,  it’s a rich vs poor state issue. States like Maharashtra, Gujarat, Haryana, and Delhi also contribute more than they get back, and net beneficiaries also include eastern states like Assam, Odisha, and West Bengal. 

Similar complaints are also heard in other economic unions such as the the European Union (EU), where richer northern countries such as Germany, the Netherlands, Sweden, and Denmark feel they are overcontributing compared to, until recently, less well-managed countries in Southern Europe, such as Greece, Portugal, and Spain, and poorer East European countries that are converging but still need help.  The large net fiscal contribution required by the UK may have been a factor, though not the only one, in its decision, which it now regrets, to leave the EU.

But fiscal transfers alone do not capture the full costs and benefits of a Union. The more industrialised, richer countries get a huge captive market in the EU in which they can sell their products.  Those that have adopted the euro as their currency also get a huge competitive advantage as their labour becomes cheaper (relative to labour productivity), while that of the relatively poor countries in the euro — such as Spain, Greece, and Portugal — more expensive. The Bertelsmann Stiftung Foundation showed that German growth was 0.5 per cent per year higher due to the euro — largely because its national currency the D-Mark would have been stronger, and, as a result, exports were lower. Similar benefits also accrue to Austria and the Netherlands, and even to Denmark, which is not in the EU but keeps its krone pegged to it.  So, while the richer parts of the EU subsidise the poorer parts through fiscal transfers, they also gain by having a captive market and an undervalued currency that improves their competitiveness across the world.

Similar benefits accrue to richer states in the Indian Union. And they are not just those in the south, but also include states like Gujarat, Maharashtra, as well as the PHD states Punjab, Haryana, Delhi, and the hill states of Himachal, Uttarakhand, and Sikkim. Labour productivity in these states is three-four times higher than in poorer states like Bihar, UP, Jharkhand, Rajasthan and Madhya Pradesh, giving them a competitive advantage. This attracts more new investments and even faster growth. All this makes convergence between richer and poorer states more difficult. Businesses in these states also get a captive internal market — further enhanced by the introduction of the goods and services tax. Companies from Coimbatore, Bengaluru and Chennai with higher productivity can sell products in a large protected internal pan-India market. 

Free internal migration is another benefit in the EU — estimated to increase EU income by €100-230 billion over 10 years. Just as in the EU, in India as well, growing labour migration from the poorer states to richer ones benefits both the workers from poorer states, who obtain relatively high-paying jobs in construction and as farm labour, and the recipient states. Migrants fill jobs that the richer local population is not willing to do anymore, and allows them to move into more skilled, better-paid work.  Restricting jobs to locals — proposed by some states — will reduce, not enhance, overall welfare.

Of course, economics alone does not drive tensions within a Union. The UK’s exit from the EU was driven by factors that were largely non-economic. One ticking time bomb for the Indian Union — with a pronounced North vs South cleavage — is that India has not adjusted the state-wise allocation of parliamentary seats since the 1991 census. The constitutional requirement to adjust the seats after 2026 means that the disparity between the actual seats and those that would be allocated, if based on population, will be huge. Milan Vaishnav has shown that due to much faster population growth in the North than in the South, Bihar and UP, which already dominate Parliament, as well as Madhya Pradesh, Jharkhand and Rajasthan, would gain over 30 seats. The losers would be the southern states, Odisha and West Bengal.  Some solutions to this can be found, such as increasing the seats in Parliament, dividing the larger states, or giving smaller states more seats in the Rajya Sabha to balance out the Lok Sabha. India will need to confront this time bomb between 2026 and the census of 2031.

In the meantime, the issue of fiscal allocations confronting the 16th Finance Commission is imminent. But in debating the costs and benefits of belonging to the Indian Union, the richer states —including the ones from the South — must realise that they gain enormous other economic benefits from the Union, while they subsidise the poorer states through net fiscal transfers. The real issue that India must confront is that the gap between the richer and poorer states is widening despite more funds going to the poorer states. Improving the gap in education, health, and economic infrastructure is key to getting more investment to the poorer states. Ensuring that the net fiscal transfers are directed at addressing these gaps in the poorer (Bihar, MP, Jharkhand, UP and Rajasthan) and lagging states (West Bengal) is key to having a more convergent growth process across the country, leading to a better Indian Union by 2047.

 

The writer is a former distinguished visiting professor at NIPFP, New Delhi, and co-author of Unshackling India, published by HarperCollins India, named Financial Times Best New Book in Economics 2022