M Govinda Rao: Why are states rich in resources lagging?

An analysis of the transfer system shows that multiple agencies making transfers have blurred the objective of offsetting fiscal disabilities.

There has been considerable research on what factors cause differences in growth rates between regions and nations and why inequalities in the standards of living between persons, regions and nations persist and accentuate. In spite of this, much remains to be understood in the dynamics of interaction between resources, policies and institutions in determining the growth process. The endowment of resources and the volume of investments can provide only a partial explanation. The consequences of policies and institutions are equally, if not more, important, for, they impact on both the volume of investments, efficiency in resource use, and productivity growth.

Ironically, while much has been made of the natural resource endowment, history is replete with instances where the people in the regions and countries with abundant natural resources have suffered low levels of living. The phenomenon of states well-endowed in natural resources and yet lagging in economic wellbeing is true also of India. Analysis shows that Bihar, Madhya Pradesh, Orissa, Uttar Pradesh and the newly carved states of Chhattisgarh and Jharkhand have per capita income levels less than 20 per cent of the national average. These are the states richly endowed in natural resources""with rich alluvial soil, large river systems and rich deposits of coal, manganese, bauxite and copper. Madhya Pradesh, Chhattisgarh, Jharkhand and Orissa, with 14.3 per cent of country's population, have over 26 per cent of the forest cover and 78 per cent of coal deposits. Yet, these states, with 39 per cent of India's population, contribute to only 24 per cent of the NSDP and have 55 per cent of the country's poor residing in them.

Regional disparities are caused by differences in resources, policies and institutions, and the interaction between them. Institutional factors determine the nature of governance and incentive structure. They impact on both the volume of investments and their productivity. A recent study (Abhijit Banerjee and Laxmi Iyer, "History, Institutions and Economic Performance: The Legacy of Colonial Land Tenure System in India," American Economic Review, Vol 95, No. 4, 2005), mapping the economic performance of different districts with the land tenure system, showed that areas under the zamindari system grew at much slower rates. All the six lagging states were under the zamindari system and in these states land reforms were not very successful. Related to the above is the overall governance in the states and protection of property rights. Considerable efforts at creating and enhancing the capacity of market institutions, the governance system, and improving the structure of the incentives are necessary.

The policy regime relevant to these states has not been accommodating and congenial, either. The most important factor in creating an enabling environment is the creation and maintenance of physical and social infrastructure. In a federal system where the states have a predominant role in the provision of social services and co-equal role with the central government in the provision of physical infrastructure, investments in social and economic services are extremely important. Ensuring comparable levels of infrastructure is a necessary condition for the development of the lagging regions.

Ironically, despite pronouncements on balanced regional development for 55 years since the adoption of planned development strategy, why have the policy makers not succeeded in providing comparable levels of infrastructure in the lagging states (and lagging districts within states) to realise their growth potential? Analysis shows that the share of lagging states in central government investments in enterprises has been less than proportionate and what is more, the impact of these investments has been neutralised by the freight equalisation policy, the vestiges of which continue even as the policy has been abandoned. States' own investments have been constrained by their resources and central transfers.

An important instrument to ensure comparable standards of public services in the lagging states is to offset their fiscal disabilities through federal transfers. An analysis of the transfer system in India shows that multiple agencies making transfers have blurred the objective of offsetting fiscal disabilities. In addition, the methodology followed by the successive Finance Commissions""determining transfers based on projected revenue and expenditures""has involved serious disincentives and inequity. The "tyranny of the base year" has led to lower transfers to states with low base-year expenditures. The "fiscal dentistry"""filling in states' non-plan budgetary cavities""has caused the cavities to become bigger in successive years. The Planning Commission transfers as well the transfers for various central schemes have not been equalising. On the whole, the transfer system has failed to offset the fiscal disadvantages of the lagging states. Not surprisingly, per capita expenditure levels in the lagging states have been much below the average year after year. Per capita expenditure on economic and social services was about 53 per cent of the average in Bihar, and in Uttar Pradesh, it was 58 per cent. Thus, these states spend virtually one half of the average expenditures incurred by states in per capita terms and surely, they cannot be expected to provide comparable levels of services.

In addition, there are several sources of invisible transfers arising from controls on prices and outputs and the origin-based tax system, which, to a considerable extent, nullifies the equalisation done by the explicit transfer system. Even when the central government determines the procurement prices of foodgrains, there are regional resource implications. The inter-state tax exportation arising from the origin-based tax system has been an important source of inequitable resource transfer from these states.

Equally glaring is the inability of the central government to adequately compensate the states for the opportunity cost of providing minerals and ensuring forest cover for the country. The Supreme Court decision banning the felling of trees in forests has robbed the states of significant economic activity and revenue. There is no mechanism in place to compensate these states for providing these public goods. Surely, these states have to do much to improve their governance, develop markets, enhance institutional capacity, put in greater effort at raising revenue and improve efficiency in spending. At the same time, it is important to have a re-look at the policies causing resource transfers from these states and to ensure proper compensation for the opportunity cost they bear for providing minerals and forest cover for the country.

The author is director, NIPFP. Comments at mgr@nipfp.org.in