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Backdoor Effects of Decentralization on State Investment Spendings through Central Grants in India

RSA Blog
RSA Blog India

In India, the 1993-94 constitutional amendments extended the state’s and local government’s role in the investment-related decision-making powers to improve their economic performance. A significant reason behind such an unprecedented rise of decentralization reforms is associated with the long-term outcome of regional economic growth. This transition towards market-oriented resource allocation from centralized planning has enhanced the responsibility of subnational governments in delivering infrastructure.


Conditional granting

The central government also funds a part of the investment expenditure in state-planned size in the form of conditional grants. These conditions are imposed to influence the investment related spending preferences of state governments, either by defining where and how the state may use the grant money or by using conditions to nudge subnational governments to spend in a certain manner.

However, states believe that these conditional grants are growing too big and therefore take away their fiscal autonomy in much of the expenditure field. Thus, as a policy and general approach, these conditional grants should be wound down. There might also be the possibility that the same ruling party at the state and center level (political considerations) influences the size of the investment of state economy by not taking away their fiscal autonomy.

Given this background, we examine whether the investment in infrastructure in Indian states increases as the autonomy power of the states in financing these investment spending on infrastructure in the form of revenue decentralization increases or not. Also, how does central government intervention through transfers in the form of conditional grants given for state-planned schemes affect this relationship?

To address these questions we use investment spending on infrastructure by the states, revenue decentralization and central conditional grants from State Finances Reports, Reserve Bank of India for eighteen major non-special category states of India from 2005-2016 along with other controls ( per capita state real GDP  at 2011-12 constant prices, outstanding liabilities of the state government (debt), the budget deficit (-surplus), population growth rate, governance effectiveness, political considerations such as election year and center-state political party alignment and political ideology (from left to right of the state government) and combine them in an econometric analysis in a panel setting.


Undermine the state’s decision on productive infrastructure investment

Our results indicate that a greater degree of decentralization in terms of revenue powers to the states is boosting up the investment levels in states. The central grants are significantly increasing state government spending on infrastructure both in economic and social services. That means revenue decentralization and central grants if taken alone, act as a monetary incentive for regions to invest. But, the cofounding effect i.e. the interaction term between revenue decentralization and central grants is negative and significant showing that central transfers weaken the positive link between revenue decentralization and state investment in infrastructure This implies that, as the prospects of the state depend more on the decisions taken at central level in the form of grants, the resources of the state government might shift away from utilizing the funds to improve the state economy.

Outstanding liabilities and budget deficits are reducing infrastructural investment by the state government. As the population grows, investment also increases to cater to the needs of the growing population. Center-state party alignment and election year have a positive impact on the state infrastructure. But the center-state political alignment coefficient becomes insignificant while considering the interaction effect of central grants and revenue decentralization which signifies that the party alignment does not favor the states while devolving central grants. Political ideology from left to right is reducing investment. Left-wing political parties favor increasing government intervention and do not subscribe to the view that market mechanisms can take care of most of a country’s economic problems Also, better governance in states is not a significant driver of state spending.

Further, there might be the possibility that the states have higher autonomy in terms of spending decentralization that might affect the investment spending decisions of the state government. To check the validity of the results, we extend our baseline model by controlling for spending decentralization to capture the pure effects of revenue decentralization on state investment decisions that go beyond the transfer of spending powers to the states in the form of higher expenditure decentralization. We found that even after controlling for spending decentralization, the results hold consistent, i.e., the significance of the variables of interest (revenue decentralization, central grants, and their interaction) remains unchanged.


Benefits to decentralization?

The analysis gives new evidence but also raises new questions about the increasing beneficial effects of decentralization by providing more autonomy to states for boosting up the regional investment to increase the economic growth that has been slowed down in many states in recent times. Decentralization in terms of revenue share or higher regional autonomy gives more room for the states to spend on investment purposes in economic and social services. The impact of revenue decentralization on regional investment spending decreases with increasing receipts of grants from the central government. Hence, this study can aid as a potential guiding factor in the area of fiscal federalism of a developing country like India, which has a relatively higher degree of decentralization. From the policy perspective, undermining the autonomy of regions by higher central grant transfers offsets the positive effect of revenue decentralization. Thus, higher autonomy should be granted to the state government in investment decision-making, which would ultimately foster growth-inducing development policies of the economy.




Dr. Nupur Nirola, ( Assistant Professor at the Jindal School of International Affairs, O.P. Jindal Global University, India, OP Jindal Global University, India. She is an applied macroeconomist with research interests in regional growth economics, institutional economics and fiscal federalism framework.


Atrayee Choudhury, ( Doctoral Candidate at the Department of Economic Sciences, Indian Institute of Technology Kanpur, India. She currently works in the broad area of applied macroeconomics with particular interests in public economics, economics of geography and institutional economics and has works published in international journals like European Journal of Political Economy and Annals of Regional Science. 


Dr. Rohith Jyothish, ( Assistant Professor at the Jindal School of International Affairs, O.P. Jindal Global University, India. He is a political economist with research interests in democracy, development, and labour in South Asia. He is an Assistant Editor at the scholarly journal, Big Data & Society. Prior to academics, he worked in public policy and civic media.



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