In every large and diverse country, federalism matters not just for political stability but also for economic development. The decentralisation of authority to provincial and sub-provincial levels for designing development policies and programmes can take local conditions into account and may be more effective than centrally-designed and enforced development goals and methods in a country as diverse as India.

The rapid growth of China over the past three decades provides an example. Ronald Coase, a Nobel Prize-winning economist, and his collaborator Ning Wang, have argued in a paper written a decade ago that the explanation for this growth acceleration can be found in the dilution of central authority on development matters. According to them, the emergence of decentralisation came later, after 1992 when China’s provinces, municipalities, counties, and even towns threw themselves into open competition for investment and for strategies for developing the local economy.

“China became a gigantic laboratory where many different economic experiments were tried simultaneously...Regional competition became the main transformative force in the second decade, turning China into a market economy at the end of the century.” Coase and Wang also emphasised the importance of the reform measures that created a common national market, which is a precondition for regional competition to work for national development rather than as a divisive force.

The enormous success of this decentralisation orientation in China has an important lesson that we need to consider in India where development planning and programming has been tightly controlled by the Union government for over seven decades. There is, of course, one big difference. China is a totalitarian state, and all its provinces, sub-provinces and cities are under the control of the same political party. The plus point of decentralisation is entirely economic.

India, on the other hand, is a democracy with many different ruling parties in the states. This sometimes leads to discrimination against states ruled by parties opposed to the ruling party at the Centre. The recent fiscal complaints from Karnataka are one example. A more serious one is the recently publicised allegation of blatant favouritism for ruling party MLAs when the municipal corporation in Mumbai was granting funds for developmental work in their constituencies. Hence, in India, the case for decentralisation rests not only on the promise of better development performance but also on the potential for more amicable politics.

Decentralisation in India should not lead to inter-state rivalry ending up in trade barriers between them. This is because we are moving towards an integrated national market economy after the major liberalisation of 1992, substantial development of physical infrastructure, and the rapid digital facilities for communication, internet marketing and UPI-based payments. An important example of this move towards an integrated national market is the implementation of the Goods and Services Tax system.

The promotion of state-level decentralisation needs policy adjustment in two areas. First, states must have a greater degree of flexibility to design a development strategy suitable for their conditions.

Second, the fiscal system must provide states with more unconstrained fiscal resources and better access to the capital market.

The case for flexibility in designing development strategy is very strong because there are major differences among states in land, water, mineral resources, weather conditions, human potential in numbers, age-structure and skills, entrepreneurial capacity and more. There is, of course, the fear that better endowed states will grow more rapidly, a risk that is already evident with strong central control on development strategy. In fact, the decentralisation of development strategy can reduce this widening gap among states by allowing greater differences in what crops to promote, what type of agricultural marketing to encourage, what type of industrial investments to try and attract, which areas of education and health to give priority to in governmental support and so on.

With decentralisation, the Union government's role in formulating development strategy will change with substantial focus on inter-state facilities, particularly physical and digital infrastructure, foreign trade policy considerations, and development issues intimately connected with national defence and law and order. The standing of a party in national elections should depend on its competence and effectiveness on these issues rather than the amount it is willing to dole out to farmers, poverty- stricken families and so on. This latter challenge varies from state to state and should be part of the politics at that level.

For decentralisation of development management to be effective, we also need to redesign the fiscal structure to place public funds more clearly in the hands of the authorities who will be responsible for the implementation of development policies and programmes.
In 2022-23, the states accounted for about 55 per cent of aggregate governmental expenditure but raised only 38 per cent of the aggregate governmental tax revenue, and 31 per cent of government market borrowings. The support that has to come from the share in central taxes was set by the last Finance Commission at 41 per cent of shareable taxes. However, in 2022-23, the devolution to states amounted to about 30 per cent of centrally collected taxes because a substantial part of the central direct tax collection came from cesses for specific purposes and surcharges, which are not shareable with states.

The other fiscal factor that can stand in the way of effective decentralisation of development is the continuing importance of centrally-sponsored and central-sector schemes that enforce the Union government’s view on development strategy for sectors that are within the constitutional power of states and dilutes their freedom to design locally appropriate modes of intervention. These focussed development grants, setting goals and strategies, amounted to Rs 3.8 trillion in 2022-23 Budget Estimate, roughly about half as large as the tax devolution.

Decentralisation to the states is not enough by itself. A significant stimulus for development depends on the role of the third tier of governance — municipalities and panchayats. 

Decentralisation to this third tier is implicit in the 73rd and 74th amendments to the Constitution. But their inclusion in the sharing of fiscal resources has not gone beyond the conferment of discretionary grants from the higher governmental level. These third-tier institutions need better access to fiscal resources and more flexibility in formulating their strategies for local management and development, including attracting employment.

Decentralisation for development requires that the Union government accept variations in priorities and strategies on programmatic and policy support for the sectors that are within the constitutional competence of the states. It must also limit the diversion of its tax collection away from the shareable ones. States, in turn, must apply a similar principle of flexibility in development design and a determined share in fiscal resources to panchayats and municipalities. Decentralisation of development authority will also persuade states, municipalities, and panchayats to be more aggressive in the taxes that are within their command.

Federalism in development planning and in the fiscal system is necessary both for maintaining more vigorous growth and for ensuring a higher degree of political harmony in the Union of States that is India.