Poverty & Inequality

Private investment and income disparity across Indian states

  • Blog Post Date 03 June, 2015
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Liberalisation reforms in India in the 1990s offered private investors the freedom to choose their investment location in the country. This column finds that income disparity across low-income states in India increased in the post-reform period, while it reduced across middle-income states. This is largely explained by private investment, which in turn depends on human capital and infrastructure of states.

One of the most important and controversial issues in economic development is the recent worldwide increase in income disparity within countries, particularly in developing countries like India that have experienced drastic and successful liberalisation. This has called into question the objectives or notions behind the processes of globalisation and liberalisation. India is the second largest developing economy in the world, which has been experiencing inter-state and intra-state imbalanced economic growth. Barro and Sala-i-Martin (1995) and others pointed out that imbalanced economic growth is a serious challenge to the development of the economy, as it creates social, economic and political tensions across regions at various levels. The issue of regional imbalance has been emphasised in all five-year plans, and various policies and programmes have been adopted to achieve balanced regional development. For instance, the 11th five-year plan (2007–2012) identified the need for the benefits of growth to flow to those sections of the population that have been ignored in the fast economic growth of the post-reform years.

Investment is identified as a crucial factor for economic growth at both the national and state levels in the Indian economy (Rao et al. 1999, Blejer and Khan 1984). The inflow of investment into a state creates employment opportunities, and generates income, output and tax revenue. Investment is sourced from both private- and public-sector institutions. The flow of public investment is discretionarily determined by the central and state governments. In contrast, the flow of private investment is determined by the rate of returns on investment in the market. In India, before 1991, the Monopoly Restrictive Trade Practices Act (MRTPA) required private players to seek permission from the central government to establish new investment projects, expand units and increase production capacity, in order to ensure fair allocation of private investment and balanced regional development. Similarly, under the Industrial Licensing Act 1951, individual investors had to petition the central government with regard to their investment proposal and the government reserved the final decision on the location of the investment. This restrictive allocation of private investment did not allow firms to operate at their optimal level of efficiency (Calberg 1981). Economic liberalisation reforms initiated in 1991 abolished several such measures and offered private investors the freedom to choose their investment location. This created competition among states to attract market-determined private investment by designing suitable policies and providing incentives. Private investment in a state pushes up economic growth, creates employment, enhances tax generation base etc. Thus, an analysis of the types of investment and disparity of economic growth at the state level is extremely relevant from a policy perspective. In a recent paper, I examine the patterns and causes of income disparity across the Indian states by focusing on the relative importance of public and private investment during the post -reform years (Mallick 2014).

Patterns and causes of income disparity across Indian states

A distinguishing feature of my research compared with related literature such as Baddeley et al. (2006), Nayar (2008), Rao et al. (1999), and Purfield (2006), is that I use better measures of state-level investment data. The measurement of investment at the sub-national levels is a challenging task in developing countries such as India. State-level investment is estimated by the directorate of economics and statistics (DES) of each state in India. Only some of them provide these estimates by private and public, separately. However, Economic and Political Weekly Research Foundation (2003) notes that these estimates are not comparable across states, due to variations in methods adopted depending upon the economic structure at a particular point of time and data availability in the individual states. Therefore, due to unavailability of data, most existing studies use loans by financial institutions (Baddeley et al. 2006, Nayar 2008, Rao et al. 1999) and credit extended by scheduled commercial banks (Purfield 2006) as a proxy for private investment. However, these proxies are poor reflections of the extent of state-level private investment, because they exclude loans by various non-financial institutions to private enterprises and foreign investors in the states. I use a comparable dataset of private and public investment at 1999-2000 constant prices for 15 major states over the period in 1993-94 to 2004-05 (Mallick 2013a). This data is estimated by using the national-level investment data of National Accounts Statistics and capital expenditure data of the Reserve bank of India (RBI) through a single framework for the 15 major states.

I examine the patterns of income disparity by classifying the 15 major states1 into low-income (LI), middle-income (MI) and high-income (HI) groups, based on their per capita income2. I find that, on average, the per capita private investment in HI group is higher than the MI group, which in turn is higher than the LI group of states. Also, I find that the variation in per capita income across states has increased during the reform years (1993-2004), when all 15 major states are considered. While the variation has decreased in MI states during this period, it has increased across the LI states in the same period3. Hence, these findings suggest that the significant increase in income disparity in LI states corresponds to increasing disparity in per capita income across all 15 major states, since economic liberalisation measures were initiated.

Further, I explore the factors that explain the rising income disparity across Indian states4. I find that there are several factors such as human capital, public investment and private investment that play a role. Additionally, I analyse the link between the evolution of income disparity and the category of investment (public/ private). Although both private investment and public investment have significant influence on income disparity, the role of private investment is more due to its higher marginal productivity than the public investment. I find that the inflow of private investment is based on physical infrastructure, human development, economic and fiscal factors, and labour productivity, along with state-specific promotional policies, incentives and strategies to attract investors (Mallick 2013b). Among these factors, the government at various levels can directly target infrastructure and human capital through the design of appropriate policies and programmes which would ensure equitable allocation of private investment, which would in turn reduce income disparity across states. Hence, public resources should be effectively utilised to develop human capital and infrastructure to reduce regional disparity across Indian states.

Lessons for policy

The distribution of public investment and resources is among the most debated and controversial matters in the Indian political economy. Public resources in India are distributed among states by the central government through both standard formulas and discretionary schemes. Finance Commission intermediates the distribution of resources between the centre and states, and among states to maintain equity, whereas, the distribution of discretionary schemes is mainly determined by the political relationship of the central government and a particular state5 Based on consultations with states, the present (14th) Finance Commission has recommended adopting a new approach of ‘cooperative federalism’ to reduce regional disparities and foster economic growth.

The recommended approach involves a significant increase in the fiscal devolution to states from 31.54% to 42%, reduction in fragmentation of fiscal transfers, and providing states with larger fiscal space to plan and spend based on their needs and priorities. Given these recommendations, the success in reducing inter-state disparities relies on the design and implementation of policies by state and local administrations.

However, my study suggests that policymakers should give relatively more consideration to the potential drivers of economic growth and development, such as human capital and infrastructure. A higher share of resources should be allocated to states that have lower quality of human capital and physical infrastructure. Better human capital and infrastructure can drive up economic growth directly by serving as inputs in production, and indirectly through promoting innovations and attracting private investment. Further, they help in reducing income inequalities across different sections of people within a state as well (Besley et al. 2013). Hence, most of the advanced countries are focusing on innovation-based growth path with improvement of human capital and infrastructure for sustainable development. However, the 14th Finance Commission has not given significant consideration to human capital and infrastructure of states in the recommendations.

Hence, the government at various levels should coordinate and design practical measures and policies that would ensure equitable allocation of private investment and distribution of public investment. The emphasis should be on equalising physical investment, human capital and infrastructure, and hence reduce regional disparities - a cherished goal of the five-year plans in India.

Notes:

  1. My analysis includes the following states: Andhra Pradesh, Assam, Bihar, Gujurat, Haryana, Karnataka, Kerala, Madhya Pradesh, Maharashtra, Odisha, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh, and West Bengal.
  2. High-income states (HI): Gujarat, Haryana, Maharashtra, and Punjab; Medium-income states (MI): Andhra Pradesh, Karnataka, Kerala, Tamil Nadu, and West Bengal; and, Low-income states (LI): Assam, Bihar, Madhya Pradesh, Odisha, Rajasthan, and Uttar Pradesh.
  3. Although the sign of the trend that captures variation in per capita income for HI states is positive, it is not statistically significant.
  4. I use dynamic panel growth models as suggested by Islam (1995) and Mankiw et al. (1992).
  5. The allocation of financial transfers across states by the central government is leading to inequity and inefficiency because it is mainly based on political considerations (Khemani 2007, Arulampalam et al. 2009, Singh and Garima 2004).

Further Reading

  • Arulampalam, Wiji, Sugato Dasgupta, Amrita Dhillon and Bhaskar Dutta  (2009), “Electoral Goals and Center-State Transfers: A Theoretical Model and Empirical Evidence from India”, Journal of Development Economics, 88: 103–119.
  • Baddeley, Michelle, McNay Kirsty and Cassen Robert  (2006), “Divergence in India: Income differential at the state level, 1970-97”, Journal of Development Studies, 42(6): 1000-1022.
  • Barro, RJ and X Sala-i-Martin (1995), Economic Growth, McGraw-Hill, New York.
  • Basely, T, M Coelho JV and Reenen (2013), ‘Investment for prosperity: Skills, infrastructure and innovation’, National Institute Economic Review No. 224 May 2013.
  • Blejer, MI and MS Khan (1984), ‘Government policy and private investment in developing countries’, IMF Staff papers, 31(2): 379-403.
  • Carlberg, M ichael (1981), “A Neoclassical model of interregional economic growth”, Regional Science and Urban Economics, Vol. 11, No. 2, pp. 191–203.
  • Economic and Political Weekly Research Foundation (2003), ‘State Domestic Products: 1960-61 to 2000-01’, Mumbai, India.
  • Islam, N azrul (1995), “Growth empirics: A panel data approach”, Quarterly Journal of Economics, 110 (4): 1127-1170. 
  • Khemani, Stuti  (2007), “Does Delegation of Fiscal Policy to an Independent Agency makes a Difference? Evidence from Intergovernmental Transfers in India”, Journal of Development Economics, 82: 464–484.
  • Mallick, Jagannath (2014), “Regional Convergence of Economic Growth during Post-Reform Period in India”, The Singapore Economic Review, 59 (2): 1450012-1-1450012-18. 
  • Mallick, Jagannath (2013a), “Public expenditure, private Investment and states income in India”, The  Journal of Developing Areas, 47(1): 181-205.
  • Mallick, Jagannath (2013b), “Private Investment in India: Regional Patterns and Determinant”, The Annals of Regional Science, 51(2): 515-536.
  • Mankiw, N. G., D. Romer and D. N. Weil (1992), A contribution to the empirics of economic growth, Quarterly Journal of Economics, 107 (2): 407-437.
  • Nayar, Gaurav  (2008), “Economic Growth and Regional Inequality in India”, Economic & Political Weekly, 43(6): 58-67.
  • Purfield, Catriona(2006), ‘Mind the gap –– Is economic growth in India leaving some states behind?,’ International Monetary Fund Working Paper No. 13.
  • Rao, M. Govinda,  Richard Tregurtha Shand and Kaliappa P Kalirajan  (1999), “Convergence of incomes across Indian states: A divergent view”, Economic and Political Weekly, 34(13): 769-778. 
  • Singh, Nirvikar and Garima Vashisth  (2004), Patterns in Centre-State Fiscal Transfers: An Illustrative Analysis, Economic and Political Weekly, 39(45): 4897-4903.
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