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Fiscal Federalism and Regional Inequality in India

Bakshi Amit Kumar Sinha (bakshi012@gmail.com) and Barna Ganguli (barnaganguli@gmail.com) are at the Centre for Economic Policy and Public Finance, a research unit of Government of Bihar at Asian Development Research Institute, Patna.

 

In all federal structures, the composing units are not self-sufficient financially. But, in India, the economic dependence of states on the centre is rather high because of widespread disparities in their levels of economic development. The federal transfers to the states through the Finance Commission, Planning Commission and centrally-sponsored schemes are investigated. The role of the union government in equitable direct investment, subsidy, and private investment policy for unbiased regional development is also underlined . The data proves that although the Finance Commission’s transfers are progressive, the share of devolution for low-income states is gradually decreasing. Unfortunately, all other transfers and efforts by the centre are regressive to address the regional inequality issues.

The authors are grateful to Tapas K Sen and EPW’s anonymous referee for their insightful comments and suggestions. They are also thankful to Shaibal Gupta for his continued motivation.
 

The spirit of cooperative federalism is asserted when the central and state governments are equal partners in development. With two major institutional transformations—implementation of the recommendations of the Fourteenth Finance Commission (FC14) and replacement of the Planning Commission by the NITI (National Institution for Transforming India) Aayog—the financial architecture of India has been redefined. The states now have more funds to spend on their priorities instead of depending on the central government. Now, the national objective is cooperative federalism which has initiated the debate for more equitable federal transfer of funds to the states. The Seventh Schedule (Article 246) of the Constitution delineates “the subject matter of laws made by the Parliament and by the Legislatures of the States” through the Union List (List I), State List (List II), and the Concurrent List (List III). In addition to the usual powers over matters related to interstate commerce, the institutions of macroeconomic policy, and defence, all residual powers are placed in the Union List. The union government has wide authority to intervene in affairs of the states and to exercise supervisory control over them. Matters related to land rights, public health and sanitation, agriculture (including agricultural education), irrigation and water use, roads, and local government are placed in the State List. Population control and family planning, education, minor ports, electricity, and trade and supply of certain basic agricultural commodities have been placed in the Concurrent List.

These lists deal with taxation too. The Union List includes, among others, taxes on income (other than agricultural income), wealth tax, estate duty, excise duties, customs duties, and corporation tax. The State List includes land revenue, excise on alcoholic liquors and narcotics, tax on agricultural income, taxes on sales or purchase of goods, taxes on vehicles, professional tax, luxury tax, entertainment tax, stamp duties, etc. The Concurrent List does not include any important taxes.

The benefit of the federal financial system is an even and equitable development of all regions of the country. But, this is lacking in the policies of Government of India. The investment of the central government is not evenly and equally distributed in the country.

Freight equalisation policy not only negated locational advantage of backward regions like united Bihar, Odisha, etc, owing to its rich mineral resource base (thereby scuttling any chances of industrialisation of this backward state), but also entailed an implicit charge on the development of industrial enterprise in Bihar by subsidising its competitors elsewhere in the country. (CEPPF 2009: 36)

The objective of this article is to diagnose the effectiveness of the fiscal federal structure to rectify regional inequality through federal transfers. Our basic assumptions are: (i) the major states of India may be categorised according to their economic well-being and revenue capacity; (ii) the federal function of the union government may be measured through the pattern of resource transfers by the Finance Commission, Planning Commission (now discontinued), and different ministries of the central government through the centrally-sponsored schemes (CSS) and subsidies; (iii) the union government may influence the geographical selection for public investments made through central public sector enterprises (CPSEs), externally aided schemes (EAS), and foreign direct investment (FDI); and (iv) the credit–deposit (CD) ratio and FDI are proxies of private investment. The first section of the article focuses on the economic base and financial structure of the states. The second section explores the mechanism and trends of federal transfers. The third section examines the regional spread of investment. The fourth section investigates the location of private investment, and the fifth section concludes.

Economic Base and Financial Structure

Economy and finances are intertwined. A large economy is able to collect more revenue to meet its financial requirements. Similarly, better and prudent financial management helps the economy to grow at a faster rate.

State structure and economic base: Backward states are facing multiple dilemmas. They are not able to attract investments due to lack of infrastructure. They are not in a position to provide these facilities on their own due to lack of investible funds (Kurian 2001). Most of these states are located in East and North India. The lack of a demand-driven market and a relatively big size of the informal economy are their other problems (Government of Bihar 2005). The more advanced coastal states were the first to take advantage of new opportunities created by economic liberalisation (Debroy et al 2013). Table 1 shows the economic base and state structure of the major Indian states. While comparing the economic base, one finds that the real per capita income (PCI) of the five states in the low-income group varies from ₹26,693 for Bihar to ₹63,674 for Odisha. Low-income states also face a high poverty ratio (36.96% in Jharkhand to 29.43% in Uttar Pradesh [UP]), and contribute a small share of the total gross domestic product (GDP; 18.9%) as compared to their high share of national population (37.3%), and have a low rating on the human development index (HDI; 0.442 of Odisha to 0.468 of UP). Almost 55% of the poor reside in these five low-income states. The PCI of the five states categorised as average-income ranged from ₹68,578 in West Bengal (wb) to ₹1,03,726 in Punjab. These average-income states have 24.6% of the population residing in 27.1% of the country’s total area and contribute to 21.6% of the GDP. Poverty in these states varies from 39.93% in Chhattisgarh to 9.2% in Andhra Pradesh (AP). The six high-income states have a PCI ranging from ₹1,18,915 in Tamil Nadu (TN) to ₹1,43,211 in Haryana. They have 30.3% of the national population residing in 27.7% of the total area and contribute to 46.1% of GDP, with a high economy base, low poverty incidence, and high HDI. Therefore, the structure of the states varies significantly across regions.

Financial structure and revenue base: For better and prudent financial management, it is important to analyse the resource base and financial structure of the economy. The resource base depends on the size of the economy, wherein a bigger economy has a large resource base while a smaller economy has a narrow resource base. As shown in Table 2 (p 42), the per capita revenue of the low revenue states ranges from ₹9,234 for Bihar to ₹12,319 of Jharkhand, with the average being only ₹10,965 (35.5% revenue for population share of 42.3%); among the average revenue states, the range is from ₹14,528 for Madhya Pradesh (MP) to ₹16,466 for Maharashtra with an average of ₹15,504 (33.4% revenue against 28.3% of population); whereas the figures for high-revenue states vary from ₹17,881 in TN to ₹20,665 in Kerala at an average of ₹19,018 (31.1% for only 21.6% population). This indicates a high degree of inequality in the resource base of different states.

Table 2 also provides data on the revenue structure. A high proportion of states’ own revenue to their total revenue receipts indicates greater financial self-reliance, while federal transfers through taxes and grants indicate the extent of their dependency. Theoretically, backward states have a limited own resource base due to a small economy and a weak market structure. Therefore, they are supposed to be in the federal structure for resources and market access. WB (4.3%) and Jharkhand (5%) have low tax–GSDP ratio, while MP (7.6%), Karnataka (7.5%), Up (7.2%), and Kerala (7%) have a higher tax–GSDP ratio as a result of the better tax administration of their state governments. In respect of own non-tax revenue, eight states of Up, Jharkhand, Rajasthan, Gujarat, Chhattisgarh, Haryana, Odisha, and Kerala (rich in mines, minerals, or industrial base) have collected more than 10% of the total revenue. In contrast, own tax revenue collection is less than 40% of total revenue in the seven states of Bihar, Odisha, Jharkhand, Up, Chhattisgarh, MP, and WB. This indicates the weak administration of revenue collectors to track the untapped potential and larger contribution of the informal economy as well. On the other hand, six high-income states have managed more than 60% of the revenue receipts from their own tax sources. This may be attributed to the lopsided nature of the union policy in central direct investment, freight equalisation, and institutional credit accessibility in these regions.

Fiscal management: Better and prudent financial management in the states may help enlarge the economic base through higher economic growth and may eventually lead to an increase in the resource base. In the light of revenue deficit grants provided by the FC14, as many as eight states have shown revenue deficit in their budgets for 2015–16. All these states are high-income or average-income states. Low-income states have been generating revenue surplus, especially after the Twelfth Finance Commission’s (FC12) recommendation for implementing the Fiscal Resources of Budgetary Management Act (FRBMA), by compromising on their social and economic needs. They should spend more on teachers, doctors, medicines, subsidies for farm inputs, law and administration, etc, for better human and economic development outcomes. Further, they should utilise their full debt potential (3.5% of GSDP) for creation of adequate infrastructure. Contrary to this, developed states utilise their debt potential and sometimes cross limit of the FRBMA (3.5%) for more and more development outcomes. Instead of rewarding them, FC14 has penalised the revenue-surplus states for maintaining the fiscal discipline achieved by its predecessor FC12. Against this backdrop, it can be seen that the states that have not followed FRBMA norms are awarded with revenue deficit grants, whereas states that have a high population pressure are being penalised since 1971 for not following the desired development trend. But, as the latter have been deprived in terms of literacy, urbanisation, and health facilities since the beginning, the implementation of population control measures were not easy for them even 50 years ago.

The ratio of interest payments to own (tax and non-tax) revenue is an important indicator of fiscal sustainability. It measures the ability of the government to meet past and present debt obligations out of its own resources. A higher ratio indicates that the state has less leverage to finance the other components of current expenditure and makes it more dependent on federal transfers or borrowings. Most of the revenue deficit states, including Bihar, are showing a high ratio (>20%). The situation of West Bengal is alarming with a high ratio of 52.1%. In addition, the ratio of debt repayment to debt receipts is an indicator of prudent and sustainable debt management. A high debt redemption ratio would indicate that debt repayments are higher than debt receipts and there is less net accrual of liabilities. If the ratio is unity, it means that debt receipts are equal to the amount of debt repayment, including interest accrued thereon, and there is no net accrual of liabilities. If the ratio exceeds unity, it means that repayment towards discharge of past obligations is more than debt receipts during the year. The ratio of six states (Ap, Gujarat, Kerala, Maharashtra, Punjab, and WB) was more than 70% while five states (Chhattisgarh, Haryana, Jharkhand, Rajasthan, and UP) managed to keep this ratio under 50% (Table 3, p 42). In recent years, this prudent fiscal management has helped these states’ economies to grow at a higher rate. Out of the five high-growth states, three are low-income states.

Mechanism of Federal Transfers

There are three sources of transfers from the union to states in the Indian federal system. The first is the statutory transfers made on the recommendation of the Finance Commission appointed by the President every five years. The second is the assistance given for plan purposes. Finally, individual central ministries provide grants for specified services in the states as desired by them. These central plan schemes (CPSs) and CSSs are in the nature of close-ended specific purpose transfers with or without matching requirements, and are included in the plan schemes. The allocation of resources in different states is also influenced by the regional policy followed by the union government, including the direct central investments (Rao and Singh 2004).

Finance Commission transfers: The Indian federal structure delineates that the centre collects more resources (69.3%) than it spends and, on the contrary, the constituent states mobilise less resources (30.7%) than they actually need (CAG 2017). Against this backdrop, under Articles 280 and 281 of the Constitution, the President appoints the Finance Commission every five years or earlier to make recommendations on devolution of shareable taxes and grants. The committee of the Constitution aimed to make the whole nation one economic space through this periodical review system and fiscal transfers to states, which are mainly guided by the principle of equalisation. All finance commissions are guided by three stated principles of equalisation, equity, and efficiency. The transfers are for equalising resources between richer and poorer states, without compromising with the efficiency and performance of any state.

According to the report of FC14, the commission has undertaken only a compositional shift in the total transfers as there was little scope for increase in the share of aggregate transfers (Finance Commission 2015). As regards vertical distribution, under the Thirteenth Finance Commission (FC13), the size of the divisible pool of resources was 32% of the net revenue receipts of the union government, but there were other transfers too through grants-in-aid (Finance Commission 2009). Under FC14, the divisible pool of resources is undoubtedly larger (42%), but all other transfers are less, as noted by the commission itself (Finance Commission 2015). Table 4 shows the criteria used by the successive finance commissions for determining the distribution of the proceeds of the central divisible pool of taxes among the states. It can be seen that the share of low-income states has reduced gradually from 48.289% during the award period of the Eleventh Finance Commission (FC11) to 42.89% in the period of the FC14, in respect of the central divisible pool of taxes. For the average-income states too, the share has declined from 26.220% during FC11 to 24.976% during FC14.

For all-India, the total transfer under FC14 increased by 149.6% compared to FC13 (from ₹17.07 lakh crore under FC13 to ₹42.60 lakh crore under FC14). But, not all states have benefited equally from that enhanced kitty. Among the major states, the increase is the highest for Chhattisgarh (211.2%) and the lowest for TN (103.7%). The figures for AP are not comparable due to the bifurcation of the state in 2014 to create the new state of Telangana. The increase for Bihar (136.8%) is the second lowest, just above TN. It is clear from Table 5 (p 44) that the most developed states like Punjab, Maharashtra, and Kerala benefited the most (with an average 186.7% hike) and poor states like Bihar, Odisha, Rajasthan, and UP benefited the least (with an average 132.2% hike) from the total central transfers. So, the data reveals that the principle of equalisation is a myth, thus supporting the argument of the augmentation of disparities.

The Comptroller and Auditor General’s report (CAG 2013–14) highlighted the deficiency of departments and the tax revenue stuck due to appeals and litigations pending before various authorities during 2011–12. The report also recorded instances of deficiencies, in scrutiny and internal audit process, ineffective call book review, and non-recovery of government dues by the departmental officers.

A staggering ₹872.7 thousand crore tax revenue remained unrealised due to appeals and litigations pending before authorities till the financial year 2016–17 (Table 6). From the estimate, on the basis of 42% as recommended by the FC14, ₹366.5 thousand crore could become distributable among the states out of ₹872.7 thousand crore. But, because of various reasons under tax administration of the union government, the states are deprived of this sizeable amount of transfers.

Planning Commission transfers: The second strategy was that of plan transfers by the Planning Commission.1 To achieve the goal of inclusive growth, one should note that the share in plan outlay should be more than the population share for backward states which can leverage economic development processes like industrialisation and infrastructure development, and relatively less than the population share for the developed states because economic forces are already active there. Table 7 (p 45) exposes the reality of the plan outlay for major Indian states from the Ninth to the Twelfth Five Year Plans. All developed states like Punjab, Haryana, Maharashtra, and Gujarat always had a higher share of the plan outlay compared to the population share, whereas poor states like Bihar, Odisha, Rajasthan, and Jharkhand received a much lower share of the plan outlay compared to their share of population.

Bihar, one should note, secured only 4.1% of the plan outlay even though it has 8.6% of the national population. So, it is proved that the richer or stronger always have more say in financial matters compared to others.

Transfers by union ministries: The transfer of funds to the states under CSS is being done through state budgets, independent societies under the control of the state governments, and at the district level with organisations under the state governments. The transfers under CSS have been focused on major areas of social and economic development. Table 8 (p 45) reveals that the per capita transfer in the health sector was the least to Bihar (₹186) among all the major states, whereas it was the highest to Odisha (₹363). Per capita transfers for water supply and sanitation were ₹43 for Bihar and ₹113 for Rajasthan. The per capita release under the Members of Parliament Local Area Development Scheme (MPLADS) was ₹215 to Rajasthan whereas it was ₹360 to Kerala. In the case of social security and the Backward Regions Grant Fund (BRGF), poor states were receiving more funds as compared to developed states. Overall, poor states like Bihar got only ₹1,324 per head under the CSS, almost one-third that received by Chhattisgarh (₹4,012).

Since 2015–16, the central government changed the CSS funding pattern for “core of the core” schemes (state 30%), “core” schemes (increase in share of state from 0% to 35%–40%), and “optional” schemes (increase in share of state from 0% to 35%–50%) (Appendix 1, p 47). So, the situation is worse than what is shown in Table 8 because now the state would contribute more funds in the CSS compared to the previous pattern. This has imposed additional financial burden on the states, especially on poor states as their resources are scarce. Thus, the principle of cooperative federalism is a myth and regressive. However, the NITI Aayog has replaced the Planning Commission following the principle of cooperative federalism. It is presumed that the NITI Aayog will address the issue of regional inequality in India.

Subsidies pattern: Subsidy, an instrument of fiscal policy, largely depends on consumption of subsidised goods and services. As such, if consumption is determined by income, it follows that high-income states will have higher consumption and so higher subsidies. Table 9 depicts the subsidy provided by the central government across the major states of India. It reflects that Bihar has received a minimum subsidy of only ₹465 per head as compared to the all-state average of ₹914 and the maximum of ₹1,715 to Punjab. Considering the per capita subsidy for all sectors in totality, Bihar has received barely half of the all-state average. The per capita subsidies for fertiliser are higher in states with more irrigated area and for LPG they are higher in urbanised states. In summary, the richer states consume a larger proportion of the subsidies. The idea of Universal Basic Income (UBI) could be a solution on this account as mentioned in the Economic Survey 2016–17 (Ministry of Finance 2017a). However, the effectiveness of targeting can be an intrinsic issue.

Central Direct Investment

Investment, the sine qua non of economic development, leads to a higher growth rate. Regarding investment in CPSE, Table 10 (p 46)shows only four rich states (Maharashtra, TN, AP, and Gujarat) had nearly 40% CPSEs while poor states had a negligible share. A low level of central sector investments in poorer states made them more poor. Therefore, poor states should build a consensus for creating an investment-friendly environment and also bargain from the union government for direct central |investment in these states. The per capita gross block investment in Maharashtra (₹21,535) is nearly seven times more than in Bihar (₹3,671).

Externally aided projects2 are important potential sources for augmenting the states’ resources and thereby external assistance plays a significant role in the development process (Table 10). A poor state like Jharkhand has got barely 0.8% of the total fund while only three southern states of TN, AP, and Karnataka received about 30% of the funds. Regarding per capita external aid in developed states, Kerala (₹2,462) is nearly seven times higher than the poor state of Jharkhand (₹363). External assistance has gained significance under the globalised economic framework for developing competitive strength in social and infrastructure sectors. One should note that externally aided schemes are routed through the ministry of external affairs, Government of India to provide assistance for state development.

Private Investment Topography

Private investment is determined by several factors. However, for this article, the influence of union government on private investment is to be assessed in respect of regional balances. Therefore, credit provided through bankers and investment made under FDI flow in different states have been examined to assess the private investment policy of the union government.

Credit–deposit gap: Relatively low CD ratio (as compared to the average) indicates the outflow of capital from the state to other relatively better off states. Inadequate infrastructure and low capital stock are the main reasons for the low CD ratio of a state. Credit management of banks is primarily guided by the central government norms, which are generally detrimental to the interests of the poor states. Table 11 lays out the bank branch statistics, deposits, and credits scenario, including sectoral credit for major Indian states.

The banking infrastructure in poor states is inadequate as 26.9% of the branches deal with 37.3% of population. The total deposits of the poor states were about 18% and credits were barely 10% of the all-India figures. The CD ratio of the poor states was only 40.5%, varying from 27.1% in Jharkhand to 60.9% in MP. The combined credit share of Bihar, Jharkhand, and Odisha was only 3% of all India. Not only is the CD ratio lower in these regions, but 15%–35% of credit also goes to the small borrowers. The deposit and credit shares of average-income states were almost same at around 15%. These states also have about 22% of the country’s total bank branches for 25% of the population. The CD ratio of these states was 65.5% varying from 50.3% in WB to 101.1% in AP. The main benefits of banking finance were harvested by the developed states. Nearly half of the deposits (46.3%) and credits (55.6%) of all states were located in the developed states. The CD ratio of the developed states was 88.6%, varying from 59.1% in Haryana to 106% in Maharashtra.

Further, a microscopic analysis of the credit situation of three major sectors—agriculture, industries, and personal loan—reveals interesting results. The share of personal loans is higher in underdeveloped states like Jharkhand (57.4%) and Bihar (54.1%). Although the share of industrial loans was the highest in an average-income state (WB), amongst developed states, Gujarat (58.7%) and Maharashtra (55.3%) had the highest shares. It is evident that banks provide a major proportion of credit for industrial development to richer states (45.3%) compared to poorer states (18.1%). The banking spread in prosperous regions was 37.2% for only 30% of the population. The major savings and investments have gone to developed states compared to their poorer counterparts. As a result, an inadequate number of bank branches and a low CD ratio create structural backwardness in these areas. However, institutional lenders and bankers are of the view that the imbalance in CD ratio is not due to the supply side of credit, but because of higher demand in richer states which is backed by good feasible investment proposals.

Foreign direct investments: The FDI inflows to India have been accompanied by strong regional concentration (Table 12). The top six developed regions (Mumbai, New Delhi, Chennai, Bengaluru, Ahmedabad, and Hyderabad) accounted for almost 75% of the FDI equity flows, out of which Mumbai and New Delhi regions together accounted for more than 50% of FDI flows during the period.

Despite impressive growth rates achieved by most of the Indian states as well as aggressive investment promotion policies pursued by various state governments, the concentration of FDI flows across a few Indian states continues to exist. There is need for provision of organised (private and/or public) advisory services relating to preparation of feasible and profitable investment plans. Most of the backward states like Bihar, Jharkhand, Odisha, Rajasthan, MP, and UP are neglected by FDI, and investment is barely 1.2%, whereas states like Maharashtra, TN, Karnataka, Gujarat, and AP account for 54.4% of the share. This reveals that the pattern and quantum of investment by foreign companies reinforce the regional inequality in the country.

Concluding Remarks

After independence, a number of policy interventions were undertaken at the national level like freight equalisation, unequal central investment, economic reforms, and uneven FDI, but these policies are also skewed towards developed states, which is a disadvantage for low-income states. Low-income states have structural complexities like high poverty incidence, low HDI, and a narrow economic and revenue base. Even after these hardships, these states have evolved as better and prudent financial managers in the recent past. In this regard, the FRBMA has played a crucial role.

The Indian federal system allows more revenue and less responsibility to the union government; the vice versa is true in the case of the states. The Finance Commission’s transfers are the only rational and formula-based transfers to deal with regional disparity to some extent, although the share of low-income states in central tax devolution is gradually decreasing over time. The pruning of CSS like BRGF and Rajiv Gandhi Panchayat Sashaktikaran Abhiyan (RGPSA) and the increased state share in CSS have put more burden on poor states. Other mechanisms (plan outlay, direct central investment, externally aided schemes, etc) of transfers are discretionary and arbitrary and widen the gap.

In the subsidies provided by the union government, the fertiliser subsidies are higher in states with more irrigated areas, LPG subsidies are higher in urbanised states, and petroleum subsidies are high in the rich states. Thus, the poor states with less irrigated area, low urbanisation, and low per capita income are doubly hit, first by denial of resources and then by the fact of unequal distribution. The pattern and attraction of FDI reinforces the regional inequality in the country. Thus, financially one can say that even after so many mechanisms of rational distribution, it is the stronger who win and the weaker who lose.

Notes

1 The plan outlay consists of normal central assistance (NCA), additional central assistance (ACA), and special central assistance (SCA). The NCA transfers were under the Gadgil–Mukherjee formula based on population (60%), per capita income (25%), efforts (7.5%) (tax, fiscal, and national objectives), and special problems (7.5%). NCA, the main assistance for state plans, was split into two parts so that special category states get 30% of the total assistance while other states share the remaining 70%. NCA was further split into 90% grants and 10% loans for special category states, while the ratio between grants and loan was 30:70 for other states. Allocation between non-special category states was determined by the Gadgil–Mukherjee formula. The ACA provides assistance for externally aided projects. Similarly, SCA provided assistance for special projects/programmes and other specific projects like Border Areas Development Programme.

2 Before 1 April 2005, the assistance from external agencies was received either as grant and loan in the ratio 70:30 or as grant only. Funds received by the Government of India from external agencies were being passed on to the states only as additional central assistance. As per the recommendations of the Twelfth Finance Commission, external loans are available to the states on the same terms and conditions as granted by the lending agencies on back to back basis with effect from 1 April 2005 (Finance Commission 2004).

References

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Ministry of Finance (2017a): Economic Survey 2016–17, Ministry of Finance, Government of India, New Delhi: Oxford University Press.

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Updated On : 6th Sep, 2019

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