Research Article

Decentralization and Journal of South Asian Development

16(1) 130–151, 2021
Its Impact on Growth © The Author(s) 2021
Sage Publications India Private Limited
in India Reprints and permissions:
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DOI: 10.1177/09731741211013210
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Fernanda Andrade de Xavier1,

Aparna P. Lolayekar2 and
Pranab Mukhopadhyay1

Abstract
We study the effect of revenue decentralization (RD) and expenditure decen-
tralization (ED) on sub-national growth in India from 1981–1982 to 2015–2016
for 14 large (non-special-category) states. Our study provides evidence that
both RD and ED play a defining role in India’s sub-national growth in this three-
and-a-half-decade period. We use a panel data model with fixed effects (FE) and
Driscoll and Kraay standard errors that control for heteroscedasticity, autocor-
relation and cross-sectional dependence. To test for causality between growth
and decentralization, we use the Granger non-causality test.The regression analy-
sis is supplemented with the distribution dynamics approach. We find that: (a)
While decentralization Granger-caused economic growth, the reverse causality
effect of growth on decentralization was not significant; (b) Economic growth
increased significantly after liberalization; (c) Decentralization, capital expenditure
and social expenditure had significant positive impacts on economic growth; and
(d) States that had high levels of decentralization also had high levels of per capita
income, while states that had low decentralization also exhibited low per capita
income.

Keywords
Decentralization in India, economic growth, sub-national government, distribu-
tion dynamics, Granger Causality

1
Goa Business School, Goa University, Taleigao Plateau, Goa, India.
2
Manohar Parrikar School of Law, Governance and Public Policy, Goa University, Goa, India.

Corresponding author:
Pranab Mukhopadhyay, Goa Business School, Goa University, Taleigao Plateau, Goa 403206, India.
E-mail: pm@unigoa.ac.in
Xavier et al. 131

Introduction
Growth economics has identified several factors, such as technology (Arrow, 1962;
Romer, 1990; Solow, 1956), innovation (Grossman & Helpman, 1991), human
capital (Barro, 1991; Becker, 1993), capital deepening (Kuznets, 1973), regional
policies (Krugman, 1991), social and political institutions (Asher & Novosad, 2017;
Deshpande, 2011; North, 1987), inequality (Alesina & Perotti, 1996; Deaton &
Drèze, 2002) and public policy (Easterly, 2019), which impact income dynamics.
A different strand of literature explaining regional growth has pointed out that
in a federal structure, it is possible to influence sub-national growth by reallocat-
ing expenditure and revenue responsibilities between different tiers of government
(Davoodi & Zou, 1998). It has been argued in the same vein that greater democra-
tization and devolution of powers could positively impact both the efficiency and
effectiveness of economic policies (Feruglio, 2007). Therefore, an identical set of
policies in a country may differ in effectiveness across different states due to the
variations in institutional and organizational factors across states (Sala-i-Martin,
1996). Allocation of fiscal functions among different government tiers, depending
on their comparative advantage, leads to better governance and economic efficiency
(Oommen, 2006). The reason this may occur is that fiscal decentralization could
improve the delivery of public services, as well as revenue collection (Kalirajan
& Otsuka, 2012). Therefore, a better understanding of the extent and process of
decentralization in a country may be vital to enhancing regional growth.
Decentralization is defined as the devolution of revenue, expenditure and deci-
sion-making authority to democratically elected lower-level governments, mostly
independent of the central government (World Bank, 2000). Theoretically, three
necessary conditions are required for decentralized provision of public goods and
services to be Pareto-superior: heterogeneity, externalities and economies of scale.
Welfare is maximized in a decentralized set-up when regions are heterogeneous
in their preferences for public goods and services. Decentralization is considered
beneficial when regions do not show evidence of interregional spillovers of the
benefits of their expenditure to other regions and when there is no cost saving
through uniform, centralized provision of public goods and services (Oates, 1972).
Fiscal decentralization enhances efficiency in usage of local resources for sev-
eral reasons, as local governments are directly associated with the beneficiaries
of these policies (Ebel & Yilmaz, 2002; RBI, 2006). Sub-national governments
may be subject to greater scrutiny by the public, since they are closer to them in a
decentralized set-up. Public scrutiny forces authorities to appoint competent staff
and to undertake efficient expenditure. Decentralization can reduce moral-hazard
and agency problems and reduce the number of bureaucracy layers (Boadway &
Shah, 2007).
With fiscal decentralization, regional governments can provide public services
based on the preferences of their respective constituencies in contrast to the central
government (Weingast, 2014). Besides, these regional and local governments face
competition from their counterparts, leading to the efficient provision of public
services (Oates, 1999). These policies could impact not only growth but also
inequality (Clements et al., 2015).
132 Journal of South Asian Development

There are some potential risks associated with decentralization as well. Some
economists have associated decentralization with slower growth, leading to mac-
roeconomic instability (Prud’homme, 1995). Fiscal decentralization, if not done
correctly, can widen regional inequalities, can have an adverse effect on the fiscal
balances and can lead to coordination failures among sub-national governments
and the centre (Hindricks et al., 2008; Rodden et al., 2003; World Bank, 2002).
In order to realize the benefits of fiscal decentralization, it is essential that sub-
national governments be able to undertake autonomous expenditure decisions and
be accountable for them. Similarly, governments should have adequate revenue to
undertake their spending responsibilities either through sufficient taxation autonomy
or steady unconditional transfers (Hankla, 2008).
The jury is out on the impact of decentralization on economic growth. While
some studies show that decentralization had a positive impact on economic growth
(Akai & Sakata, 2002; Justin & Zhiqiang, 2000; Qiao et al., 2008), others have found
that fiscal decentralization had a negative impact on economic growth (Davoodi &
Zou, 1998; Jin, 2009; Zhang & Zou, 1998). The impact of fiscal decentralization
differs from country to country and over time and would depend on the institutional
economic structure of the economy.

The Indian Context

The Indian Constitution is federal in its set-up. However, from the 1950s till the
1980s, the fiscal power was mainly concentrated with the central government. It
was only in 1991 that the states were given greater powers to follow their economic
and social policies (Bagchi, 2003). In 1992, constitutional recognition was given
to the third-tier level of government in India. Our study is restricted to the analy-
sis of decentralization at the sub-national (state) level due to the unavailability of
data at the local (third-tier) level for the time period of our study. While India has
undertaken expenditure decentralization (ED) to the sub-national governments, it
has still not achieved much in terms of tax devolution (Panda et al., 2019).
Multiple types of explanations have been used to understand India’s sub-national
growth trajectory (Ahluwalia, 2000; Lolayekar & Mukhopadhyay, 2020; Raju,
2012; Sachs et al., 2002). However, data limitations have restricted the covariates
that similar international studies have employed (Maiti & Marjit, 2015; Nayyar,
2008). For example, disaggregated data on investments and savings, interstate trade
data, research and development expenditure are not available at the state level. While
literacy rates could serve as a proxy to human capital, they are available only with
decadal periodicity after the population census (Census, 2011).
There has been a varying degree of decentralization across regions in India.
Concerning delivery of public services and mobilization of resources, both physi-
cal and human, some states have been more successful than others (Rao, 2008).
With decentralization, it has been argued, the local elites have been in a position to
have greater control over a larger share of public resources than the poor, which
has implications for inequality (Drèze & Sen, 1995). Others have found that
decentralization has fostered development equitably across states through health and
Xavier et al. 133

education expenditures (Kalirajan & Otsuka, 2012). Therefore, apart from growth,
decentralization also has a distributional impact.
We examine these issues in our study that spans the last three and a half decade
(from 1981–1982 to 2015–2016). During this period, the Indian economy saw
significant institutional changes, with increased open market policies from the
early 1990s (Kotwal et al., 2011) and the 73rd and 74th constitutional amendments
devolving more powers to lower tiers of government (Rao, 2002). In India, an
increase in capital expenditure simultaneous with a decrease in revenue expendi-
ture (without affecting the fiscal deficit) was found to have a positive influence on
the economic growth (RBI, 2016). The capital outlay of state governments was
considered growth-inducing and had a more prolonged effect on the economy than
revenue expenditure (Jain & Kumar, 2013). Social sector expenditures (including
expenditures on education and health) are also significant for India’s growth and
development (Mittal, 2016). These expenditures enhance economic growth by
positively influencing the competitiveness, productivity and efficiency of labour
and reducing absolute poverty. Further, sustainable economic growth requires
social sustainability, and social expenditures could help achieve that (Kaur et al.,
2013). Ganaie et al. (2018) found a positive impact of ED but a negative impact
of revenue decentralization (RD) on economic growth.
We contribute to this literature by using a twofold strategy. First, we use a
regression model to establish the impact of decentralization on growth. We use
a panel fixed effects (FE) model with both ED and RD as covariates, along with
social and capital expenditures (Devarajan et al. 1996). We also use the Dumitrescu
and Hurlin (2012) Granger non-causality test to confirm causality between growth
and decentralization. Second, we complement the regression-based approach
with a distribution dynamics approach proposed by Quah (1997). This approach
overcomes problems that could arise from the non-fulfilment of the normality
assumption in regression-based approaches. More importantly, it can help better
identify the presence of convergence clubs and polarization among states (Kar
et al., 2011; Lolayekar & Mukhopadhyay, 2017).
We find that RD and ED had a positive impact on growth. Similarly, capital
expenditure and social expenditure had a significant positive impact on economic
growth, which was higher after liberalization. This has significant implications for
public policy relating to the devolution of powers among different tiers of govern-
ment in India. These findings also add to the growth and public finance literature.
The rest of the article is organized as follows. In the second section, we present
the materials and methods. In the third section, we present the results, followed by
the analysis in the fourth section. We conclude the article in the fifth section with
a discussion of our findings and their policy implications.

Materials and Methods

The theoretical framework used to analyse the influence of fiscal decentralization
on economic growth is the commonly used production–function approach (Davoodi
& Zou, 1998).
134 Journal of South Asian Development

As a first step, we define the quantitative measure of decentralization used in

this study to measure the effects on income. Many cross-country studies in the
past have measured fiscal decentralization as the ratio of sub-national government
expenditure/revenue to total government expenditure/revenue (Ebel & Yilmaz,
2002). This measure may overestimate the extent of decentralization and can mis-
represent the impact of fiscal decentralization on major economic indicators. The
more recent trend is to construct measures of fiscal decentralization which reflect
the sub-national governments’ autonomy in terms of both expenditure and revenue
decisions (Akai & Sakata, 2002). Hence, it is necessary to subtract that expenditure
from the sub-national-government share mandated by the central government or
undertaken on behalf of the central government. Expenditure financed through
conditional transfers whose use is predetermined by the centre is deducted from the
sub-national expenditure. Again, in terms of revenue, it is necessary to distinguish
between own revenue, shared taxes and transfers. In terms of the RD measure, only
those resources over which the sub-national government has authority in terms of
either the tax rate or the tax base are included.
We have constructed two measures of decentralization: expenditure and
revenue. The ED variable measures the extent of autonomy a state enjoys in its
expenditure vis-à-vis the centre. ED is measured by estimating the ratio of the ‘i-th’
state’s expenditure as a proportion of its total expenditure (centre plus state). This
measure is adopted from Qiao et al. (2008) and modified suitably to measure the
decentralization level of Indian states. We use per capita measures to control for
heterogeneity in population across states. The state’s own expenditure does not
include the central grants, and the formula used is as follows:

State’s own expenditure pc it

  ED =  (1)
_State’s own expenditure pc it + Central expenditure pc it i

where
State’s own expenditure pcit = state’s aggregate expenditure minus central grants
to the state in per capita terms;
Central expenditure pcit = central grants per capita, including grants under the central
plan schemes, centrally sponsored schemes, state plan schemes and non-plan grants;
i = ith state; and
t = time period.

Although the state government undertakes state plan schemes, we excluded the
grants to states under these schemes, as state governments do not have autonomy
in their spending decisions. One of the reasons cited for terminating the Planning
Commission in 2014 through which these grants to state plan schemes were pro-
vided was to increase the autonomy of states and promote cooperative federalism
among states (Rao, 2016).
The RD variable measures the extent of autonomy a state enjoys in its revenues
vis-à-vis the centre. This represents the ability of the ‘ith’ state to raise its own
revenues through taxes. We measure this by estimating the ratio of the ‘ith’ state’s
tax revenue as a proportion of its total revenue (centre plus state). Therefore, the
Xavier et al. 135

state’s own tax revenue excludes the state’s share in central taxes, as the state has
no control over the tax rate or base in terms of revenue collection. This measure is
adopted from Oommen (2006) and modified suitably to measure decentralization
at the sub-national level. The formula used is as follows:
RD = state’s own tax revenue per capita (pc) of state ‘i’ divided by the sum of
aggregate central tax revenue per capita and state’s own tax revenue per capita.

State’s own revenue pc it

 
RD =  (2)
_State’s own revenue pc it + Central revenue pc iti

where
State’s own revenue pcit = states’ own tax revenue in per capita terms.
Central revenue pcit = contribution of the central funds to the ‘ith’ state.
Here, central revenue per capita is the state’s share in central taxes of the ‘ith’ state
in per capita terms, i = ith state, and t = time period.

Regression-based Approach
We examine the impact of ED and RD on state-level growth using the commonly
used regression method with a formal econometric model. We anticipate that growth
is subject to many influences apart from fiscal decentralization, such as population,
human capital, initial per capita GDP, the real investment share in GDP, total labour
force, the degree of openness of economy/volume of trade, the inflation rate and
policy reforms (Feltenstein & Iwata, 2005; Lin & Liu, 2000; Zhang & Zou, 1998).
The tax rate has also been used as an explanatory variable (Davoodi & Zou, 1998;
Zhang & Zou, 1998). Expenditures on health, economic development, administra-
tion and education (as a ratio of total state-government spending) have been used as
control variables while determining the impact of decentralization on GDP growth
(Zhang & Zou 2001). As a substitute for investment expenditure (for which data
is not available at the sub-national level), we have used the government capital
expenditure. In India, the crowding-out hypothesis and Ricardian-equivalence
hypothesis have received mixed responses (Ghatak & Ghatak, 1996; Mitra, 2006;
Pradhan et al., 1990), but there has been evidence of a positive correlation between
private capital investment and public capital expenditure at the national level during
certain phases (Bahal et al., 2018).
India undertook significant market reforms in the 1990s. The empirical growth
literature often distinguishes economic policies between two periods: before 1990
and after 1990. We, therefore, wish to account for this structural change before and
after the liberalization process. The conceptual model we propose predicts growth
as an outcome of these factors (see Equation [3]).

Growth = f (capital expenditure, social expenditure,

   (3)
economic policy, decentralization)
136 Journal of South Asian Development

The specific linear model used for estimation is stated in Equation (4):
ln PCI it = b 1 + b 2 SocialExp it + b 3 CapitalExp it + b 4 Lib it + b 5 Dec it +
    (4)
b 6 (sq_Dec it) + a i + e it
where
i is the ith state;
t is the time period;
lnPCI is the natural log of gross state domestic product (GSDP) per capita at cur-
rent prices;
CapitalExp is the proportion of capital outlay to the aggregate expenditure of state
i at current prices;
SocialExp is the proportion of social expenditure to the aggregate expenditure of
state i at current prices;
Lib is a dummy variable separating the post-liberalization period from the pre-
liberalization period. It takes the value ‘0’ for pre-liberalization years (up to 1990)
and ‘1’ after that (1991 onwards);
Dec is a measure of decentralization (ED for expenditure and RD for revenue);
sq_Dec is the square of the measure of decentralization (ED for expenditure and
RD for revenue);
a is an entity-specific intercept (used in the FE model); and
e is the stochastic error term.

Panel data models enable researchers to analyse economic processes while con-
sidering the heterogeneity of units and accounting for dynamic effects that are not
included in cross-sectional data (Greene, 2010). One advantage also is that they
are more informative and provide greater variability in terms of the data collected
and are thus more efficient in the estimation of parameters. These models enable
researchers to analyse complex behavioural models that are subject to less restric-
tive assumptions (Ullah & Giles, 1998).
A basic method applied to panel data is the pooled ordinary least squares (POLS)
model, also known as the population-averaged model (see Equation [4], where ai =
0). POLS provide efficient estimates only when the classical model’s assumptions
are satisfied, including zero conditional mean of error term, homoscedasticity,
independence across units and strict exogeneity of independent variables. Such
conditions are hard to fulfil, and if data is available, then researchers prefer panel
data models, choosing between the random effects (RE) and FE models depending
on the nature of the data. An RE model is resorted to when unobserved effects are
not correlated with the explanatory variables. If this assumption is violated, the
RE estimator will produce biased and inconsistent estimates (Greene, 2010). To
solve this problem the within estimator or FE estimator is used. In this method,
deviations from individual means are computed. Thus, even if a correlation between
unobserved factors and some explanatory variables exists, the within estima-
tor will produce unbiased and consistent estimates (Hausman & Taylor, 1981).
Accordingly, in Equation (4), we would anticipate that bi = 0 and ai ≠ 0. We also
use the Dumitrescu and Hurlin (2012) Granger non-causality test to analyse the
two-way causality between growth and decentralization.
Xavier et al. 137

Testing for Causality

The popular test to analyse the causal relationship between time series variables
was first proposed by Granger (1969). This was extended by Dumitrescu and Hurlin
(2012) to analyse heterogenous, balanced panels and to test bidirectional causality.
We tested whether decentralization causes growth (Equation [5]) and whether the
causality runs from growth to decentralization (Equation [6]) using the following
regression equations:

  D ln PCI it = a i + | k = 1 b ik D ln PCI i, t - k + | k = 1 c ik DDec i, t - k + E it

K K
(5)

   DDec it = a i + | k = 1 b ik DDec i, t - k + | k = 1 c ik D ln PCI i, t - k + E it

K K
(6)

where:
Lag order k is assumed to be identical for all panels;
coefficients (β , c) are allowed to differ across individuals but are assumed to be
time-invariant; and
D stands for the first difference of the stationary variables.

A precondition to running the Granger causality test is that the variables be sta-
tionary. We used the Hadri Lagrange multiplier (LM) test to test for unit roots in
our panel data. This test is suitable for data with a large T and a moderate N and
balanced panel models, like the one we use for our study. While the variables were
not stationary at level, they were found to be stationary when we used their first
difference. For all the three variables (lnPCI, ED and RD), we could not reject the
null hypothesis, meaning that all the panels were stationary at the first difference
(Table 3).
Next, we undertook the Dumitrescu and Hurlin (2012) Granger non-causality
test using the first difference of the lnPCI and decentralization variables. We used
the Z-bar test for interpreting the results, as according to Hurlin and Dumitrescu
(2012), it is suitable for our data with large time periods and few panels.
We ran two separate regressions for decentralization: model 1 for ED and model
2 for RD (see Table 2). In keeping with earlier contributions (Akai & Sakata, 2002;
Hanif et al., 2020; Yushkov, 2015), we decided to run separate models with ED and
RD, as the covariates had a significant correlation between them (the correlation
coefficient value was 0.72). The correlation between the fiscal variables CapitalExp
and SocialExp, on the other hand, was found to be low (correlation coefficient
value was 0.11). We, therefore, did not anticipate the problem of multicollinearity
arising if we kept both the fiscal variables in the regression estimation. Since our
data took the form of a balanced panel, we could use either a POLS or a panel
data model (FE or RE).
In the model with ED as a predictor (model 1), we used the Breusch–Pagan LM
(BP-LM) test to choose between the RE and POLS models. The results (Prob. >
chi-square = 0.000) suggested that the RE model would be preferred over the POLS.
We next chose between the RE model and the FE model. Usually, we would have
used the Hausman test to determine this. Since we used robust standard errors to
138 Journal of South Asian Development

avoid problems of heteroscedasticity, the preferred test then was the Sargan–Hansen
test as a substitute for the Hausman test (Baum et al., 2014). The post-estimation
test rejected the null hypothesis of RE, implying that the RE model would provide
inconsistent estimates. The FE model was, therefore, the preferred option. In RD
(model 2), the BP-LM test suggested that the POLS model was preferred to the
RE model. Hence, we used the F-test to choose between the POLS and FE models.
The results indicated that the FE model would be preferred over the POLS model
(Prob. > F = 0.000). Therefore, in both the ED and RD models, the FE model was
the preferred choice. Also, in both these models, the post-estimation tests indicated:
(a) the presence of heteroscedasticity among the variables (modified Wald test in
the FE model); (b) the presence of serial correlation—first-order autocorrelation
(Wooldridge test); and (c) the presence of cross-sectional correlation between
panels (BP-LM test for independence).
Three popular methods address the problem of heteroscedasticity, autocorrelation
and cross-sectional dependence for long panel data (large T and small N) (Hoechle,
2007). The first method is the Parks-Kmenta method. This method is applied to
panel data using a feasible generalized least square (FGLS)-based algorithm, but it
produces unacceptably small standard errors. To overcome this problem, Beck and
Katz (1995) proposed the estimation of POLS with panel-corrected standard errors.
The third method produces the Driscoll and Kraay (DK) standard errors, which can
be applied to POLS/weighted least squares (WLS) and FE (within) estimations. The
DK standard errors are not only consistent in the presence of heteroscedasticity and
auto-correlation but are also robust to general levels of cross-sectional correlation
(Fofanah, 2020; Fuinhas et al., 2019; Hartwell, 2014; Simionescu et al., 2016).

Distribution Dynamics Approach

This approach encompasses both time series and cross-section properties of the
data simultaneously. The density of distribution ϕt evolves as per Equation (7):
     z t = M · z t - 1 (7)

where M maps the transition between the income distributions for two consecutive
periods, ‘t’ and ‘t – 1’. This is a first-order Markov process, as the density distribu-
tion ϕ for the period ‘t’ only depends on the density ϕ for the immediately preceding
period ‘t – 1’. In our estimates below, we have assumed that the distribution ϕ has
a finite number of states.
In estimating the dynamics of income distribution, there are three possibilities
for an economy’s behaviour over a given period of time:

1. It may move ahead;

2. It may stay where it was; or
3. It may even fall behind.

The distribution dynamics information is encoded in a transition probability matrix

(TPM). This is a square matrix that describes the probabilities of moving from
Xavier et al. 139

one state to another in a dynamic system. Each row represents the probability of
moving from the state represented by that row to the other states. All entries have
a value between 0 and 1, which represents probability, and the sum of the entries’
values in a row adds up to 1. Here, the evolution of income is modelled as a Markov
process governed by a transition probability. The current state (in a first-order
Markov chain) only depends on the immediate previous state (Kemeny, 2003). The
advantage of this methodology is that it formulates a law of motion for the entire
distribution of incomes between the periods under analysis, allowing us to model
the existence of convergence clubs in the data. In the case of transition probability
matrix, it is assumed that an economy or region over a given time period (say, 1
year or 5 years) either remains in the same position or changes its relative position
in the income distribution (Bandyopadhyay, 2012; Quah, 1996).
For the Markov transition matrices, we assume that the probability of variable
st taking a particular value depends only on its previous value st-1 according to the
first-order Markov chain:

    P {s t = j | s t - 1 = i} = Pij (8)

where Pij indicates the probability that state i will be followed by state j and the
sum of values in each row will add up to 1:
   Pi1 + Pi2 + g + Pin = 1 (9)
The transition matrix constructed is as follows:
RS V
SSP11 P12 ...P1nWWW
SSP W
SS 12 P22 ...P2nWWW
     P = SS... . ... . ... ... WW (10)
SS... . ... . ... ... WW
SS W
SSPn1 Pn2 ...PnnWWW
S W
T X
where row i and column j indicate the probability that state i will be followed by
state j.
The Markov chains model the evolution of relative income distribution. We
thus identify the position of the economy in the starting period. This is done by
dividing the income distribution into ‘income states’ over a range of income lev-
els. We then observe how many of the economies that are in an income state, say
between 0.75 and 1 in the initial period, remain in that same state (persistence) or
shift elsewhere in the next period (mobility). The TPM measures the probability
of the income level in a country or region rising, falling or remaining unchanged
between two periods (Magrini, 2007).

Data
We use data for 14 large general-category (also called non-special-category) states
of India. The special- and general-category states differ significantly in terms of
140 Journal of South Asian Development

their own revenue generation, cost disabilities and central financial assistance and
hence cannot be compared in terms of fiscal decentralization (FC, 2009; Rao, 2017).
Hence, the special-category states have been left out of this study. We have also
not included the states like Goa and Delhi in the analysis, because these are outliers
in per capita income terms and have a comparatively small population. The period
for the study is 1981–1982 to 2015–2016, which is the largest time span for which
data is currently available for all variables under consideration.
We combine data from multiple sources. GSDP per capita data is taken from
MOSPI (various years). GSDP data from 1980–1981 to 1992–1993 is based on
the 1981 series, data from 1993–1994 to 1998–1999 is based on the 1993–1994
series, data from 1999–2000 to 2003–2004 is based on the 1999–2000 series, data
from 2004–2005 to 2010–2011 is based on the 2004–2005 series, and finally data
from 2011–2012 to 2015–2016 is based on the 2011–2012 series. Data on all types
of state expenditures, state revenues and central transfers to states are taken from
the (EPWRF various years). All the data used in our study are at current prices.
The state-level year-wise population estimates are obtained by interpolating
decadal census estimates to obtain the states’ annual population from 1981–1982
to 2015–2016 (PC, 2014). The newly formed states (Jharkhand, Uttarakhand,
Chhattisgarh and Telangana) have been merged with their respective original
states (Bihar, Uttar Pradesh, Madhya Pradesh and Andhra Pradesh) for analytical
comparability.

Results
We first present the summary statistics of the variables used in the regression analy-
sis (Table 1). The 35-year period with 14 states generates 490 observations. LnPCI
has a mean of 9.58 (overall) and has a standard deviation of 1.26 (overall). While
ED has a mean of 0.9, RD has a mean of 0.69, confirming that India is much more
decentralized in expenditure than in revenue. However, RD has a higher variation
as compared to ED. The capital expenditure ratio has a mean of 0.11, and the social
expenditure ratio has a mean of 0.31.
We present the regression results (including those of the Granger causality
regression), followed by the analysis of the distribution dynamics approach.
The results of the regression Equation (4) are presented in Table 2. ED and RD
both were found to have a significant and positive influence on lnPCI, confirming
that a reallocation of expenditure shares and revenue collection responsibilities to
the states will enhance growth. Moreover, this could be achieved without altering
the aggregate government spending/revenue. A unit increase in RD will lead to a
4.81% increase in lnPCI. ED, on the other hand, was found to have a non-linear
relationship with lnPCI, and therefore the extent of the impact of ED would depend
on the value of ED at which change is being contemplated.
Social expenditure, as expected, was found to have a significant and positive
influence on lnPCI in both regressions, confirming its importance for economic
growth. Similarly, capital expenditure was also found to have a significant and
positive influence on lnPCI. The liberalization variable was highly significant and
Xavier et al. 141

Table 1.  Summary Statistics of Variables of 14 States (from 1981–1982 to 2015–2016)

Variable Mean Std. Dev. Min. Max.

LnPCI Overall 9.58 1.259 7.110 12.12
Between 0.363 8.824 10.02
Within 1.209 7.348 11.90
ED Overall 0.90 0.042 0.726 0.97
Between 0.034 0.827 0.94
Within 0.026 0.800 0.98
RD Overall 0.69 0.151 0.286 0.93
Between 0.153 0.376 0.87
Within 0.031 0.593 0.78
CapitalExp Overall 0.11 0.047 –0.032 0.22
Between 0.028 0.056 0.14
Within 0.038 0.005 0.20
SocialExp Overall 0.31 0.046 0.165 0.43
Between 0.030 0.234 0.35
Within 0.036 0.186 0.42
Source: Data on all types of state expenditures, revenues and transfers: (EPWRF, various years). Data
on PCI: (MOSPI, various years).
Note: Observations—N = 490, n = 14, T = 35.

Table 2.  Fixed Effects Regression Using Driscoll–Kraay Standard Errors, with
Dependent Variable LnPCI

Variable 1 (ED) 2 (RD)

ED 53.15**
Sq_ED –31.28*
RD 4.81**
CapitalExp 5.32*** 5.71***
SocialExp 5.01* 5.65**
Lib 2.18*** 2.115***
Constant –16.56* 2.34
Within R-squared 0.688 0.698
F-statistic F(5, 34) = 16.19 F(4, 34) = 22.50
F-statistic (p-value) 0.000 0.000
Sargan–Hansen statistic (p-value) 0.000
Breusch–Pagan Lagrange multiplier (LM) test 0.000 1.00
F-test that all u_i = 0 Prob. > F = 0.000
Modified Wald test (p-value) 0.000 0.000
Wooldridge test (p-value) 0.000 0.000
Breusch–Pagan LM test of independence (p-value) 0.000 0.000
No. of observations (maximum lag length 3) 490 490
Source: Authors’ calculations.
Note: ***, ** and * Significant at the 1%, 5% and 10% levels, respectively.
142 Journal of South Asian Development

Table 3.  Hadri Lagrange Multiplier Test for Unit Root in Panel Data

Test DED DRD DlnPCI

Statistic Statistic p-Value Statistic p-Value Statistic p-Value
z –0.8238 0.795 –0.0484 0.5193 –0.7724 0.795
Ho All panels are stationary.
Ha Some panels contain unit roots.
Source: Authors’ calculations.
Note: Number of panels (N) = 14; number of periods (T) = 34.
LR variance: Bartlett kernel, 5 lags.
Cross-sectional means removed.
Asymptotics: N, T → infinity sequentially.

positive, confirming the higher income growth in the post-liberalization phase

in both the models. The R-squared (within) was around 0.69 for both the regres-
sion models and demonstrated the significance of estimates in the joint test of
the hypothesis. Next, we discuss the results of the Dumitrescu and Hurlin (2012)
Granger non-causality test. We find that in the case of ED and RD, we can reject
the null hypothesis which states that ED/RD does not Granger-cause lnPCI and
accept the alternative hypothesis that ED/RD does Granger-cause lnPCI for at least
one of the states (Table 4 ).
We also examined the bidirectional causality between lnPCI and decentraliza-
tion. We found that while lnPCI does not Granger-cause decentralization, RD and
ED do (Table 5).

Analysis
We now examine how decentralization has affected the distribution of growth in
incomes across states (see Table 6)—how many states remain in the same state
and how many move elsewhere during this period. If they have moved above the
diagonal, then the relative performance has been good, and if they have moved

Table 4.  Dumitrescu and Hurlin (2012) Granger Non-causality Test (decentralization →
DlnPCI)

DED DRD
Test Statistic p-Value Statistic p-Value
Z-bar statistic 2.4606 0.0139 3.4618 0.0005
H0 DED does not Granger-cause DRD does not Granger-cause
DlnPCI. DlnPCI.
H1 DDED does Granger-cause DRD does Granger-cause
DlnPCI for at least one panel DlnPCI for at least one panel
variable (states). variable (states).
Source: Authors’ calculations.
Note: Optimal number of lags (AIC) = 8 (lags tested = 1–8)
Xavier et al. 143

Table 5.  Dumitrescu and Hurlin (2012) Granger Non-causality Test (DlnPCI →
decentralization)

DED DRD
Test Statistic p-Value Statistic p-Value
Z-bar statistic –0.566 0.5714 –0.4842 0.6283
H0 DlnPCI does not Granger-cause DlnPCI does not Granger-cause
DED. DRD.
H1 DlnPCI does Granger-cause DED DlnPCI does Granger-cause DRD
for at least one panel variable for at least one panel variable
(states). (states).
Source: Authors’ calculations.
Note: Optimal number of lags (AIC) = 1 (lags tested = 1–7).

Table 6.  Relative Per Capita Income Transition Dynamics, 1981–2015

2015
1981 States with an States with an Number of
ending level less ending level greater states
than 1.00 than 1.00
States with a Bihar, Madhya Andhra Pradesh, 10
starting level less Pradesh, Odisha, Karnataka, Uttar
than 1.00 Rajasthan, West Pradesh, Kerala, Tamil
Bengal Nadu
States with a starting Gujarat, Maharashtra, 4
level greater than 1.00 Haryana, Punjab
Source: Authors’ calculations.

below the diagonal, the relative performance has been lacking. This allows us to
create a distribution of states based on their performance during the two periods.
We use a 2 × 2 matrix to examine the mobility of states in PCI from 1981–1982
to 2015–2016. Five states (Andhra Pradesh, Karnataka, Uttar Pradesh, Kerala and
Tamil Nadu) started with a PCI less than the national average but by 2015–2016
had moved above the national average (above the diagonal). Five states (Bihar,
Madhya Pradesh, including Chhattisgarh, Odisha, Rajasthan and West Bengal)
began with a PCI below the national average and ended in 2015–2016 below the
national average. Four states (Gujarat, Maharashtra, Haryana and Punjab) began
and ended with a PCI higher than the national average.
We now examine the degree of decentralization (expenditure and revenue).
The transition matrices indicate heterogeneity in the degree of decentralization
(see Table 7). Six states began the period with an RD lower than the average
(Bihar, Madhya Pradesh, Odisha, Rajasthan, Uttar Pradesh and West Bengal), and
eight states began with an RD higher than the average (Andhra Pradesh, Gujarat,
Haryana, Karnataka, Kerala, Maharashtra, Punjab and Tamil Nadu). All these states
maintained their relative positions, and there was no transition in RD during this
period.
144 Journal of South Asian Development

Table 7.  Relative Revenue Decentralization Transition Dynamics, 1981–2015

2015
1981 States with an ending States with an ending Number of
level less than 1.00 level greater than 1.00 states
States with a Bihar, Madhya Pradesh, 6
starting level Odisha, Rajasthan, Uttar
less than 1.00 Pradesh, West Bengal
States with a Andhra Pradesh, Gujarat, 8
starting level Haryana, Karnataka,
greater than Kerala, Maharashtra,
1.00 Punjab, Tamil Nadu
Source: Authors’ calculations.

We find a higher transition among states in ED (see Table 8). Two states
(Rajasthan and Uttar Pradesh) began with an ED lower than the national average
and ended with an ED greater than the average. West Bengal was the only state
that started with an ED greater than the average but ended with an ED lower than
the average. Four states (Andhra Pradesh, Bihar, Madhya Pradesh and Odisha)
began with an ED lower than the average and ended with an ED lower than the
average. Seven states (Gujarat, Haryana, Karnataka, Kerala, Maharashtra, Punjab
and Tamil Nadu) began with an ED greater than the average and ended with an
ED greater than the average.
Four states (Gujarat, Maharashtra, Haryana and Punjab) began with a high
PCI and ended with a high PCI. These four states exhibited high RD and ED in
both the beginning and the end. Kerala and Tamil Nadu also had high ED and RD
like the above four states and transitioned from an initial low PCI to a high PCI.
Andhra Pradesh, Rajasthan and Uttar Pradesh are exceptions in different ways.
Andhra Pradesh had a high RD but had a low ED (beginning and end) and could
transition from a low PCI to a high PCI. Uttar Pradesh, on the other hand, had a
low RD (beginning and end) but transitioned from a low ED to a high ED and was
able to transition from a low PCI to a high PCI. Rajasthan shared the same status

Table 8.  Relative Expenditure Decentralization Transition Dynamics, 1981–2015

2015
1981 States with an States with an ending Number of
ending level less level greater than states
than
States with a Andhra Pradesh, Bihar, Rajasthan, Uttar 6
starting level less Madhya Pradesh, Pradesh + Uttarakhand
than 1.00 Odisha
States with a West Bengal Gujarat, Haryana, 8
starting level Karnataka, Kerala,
greater than Maharashtra, Punjab,
1.00 Tamil Nadu
Source: Authors’ calculations.
Xavier et al. 145

as Uttar Pradesh but could not make PCI gains as Uttar Pradesh did. West Bengal
became part of those states that began and ended with a low PCI. It had a low RD
(beginning and end), and its ED reduced between the two periods. All the states
(Bihar, Madhya Pradesh and Odisha) that had a low ED and RD (beginning and
end) also had a low PCI (beginning and end).

Figure 1.  Spatial Distribution of Decentralization (in ED and RD) and PCI (1981–1982
and 2015–2016)
Source: Github (2020) and Authors’ calculations.
146 Journal of South Asian Development

We visualize the association between decentralization and PCI spatially by

creating four categories—corresponding to the four cells of the 2 × 2 matrix. If
the ED, RD and PCI of a state are all in the first cell (less than average), then the
state takes a value of ‘1’. If the ED, RD and PCI are in the fourth cell (all above the
average), then the state takes a value of ‘4’. If PCI is higher than the average but
either RD or ED is less than the average, then the state takes a value of 3. Similarly,
if either RD or ED is less than the average but PCI is also below the national aver-
age, the state takes a value of 2. In Figure 1, the dark-blue areas have the lowest
decentralization level and growth, while the red areas have high decentralization
and a high PCI. The orange areas have one aspect of high decentralization (either
ED or RD) but a high PCI. The light-blue areas have a low PCI and one aspect
of high decentralization (either ED or RD). As we can see, in 2015–2016, the red
areas have spread along the west coast and the orange areas in the south-east. The
western segment, which was deep blue, has changed to light blue, but eastern India
has remained blue and, in one case, has receded.

Conclusion and Discussion

Our results show a positive impact of ED, as well as RD, on economic growth.
Additionally, we find that: (a) ED has a non-linear relationship with economic
growth; and (b) RD has a linear relationship with growth. This contrasts with some
earlier studies that found a positive impact of ED but a negative impact of RD on
economic growth (Ganaie et al., 2018). We also find that social sector expenditure
and capital expenditure by the government have a positive impact on growth.
We used a twofold strategy to examine the research questions. A regression-
based approach confirmed the direction of causality, as well as the significance
of each of the covariates. We also used an alternative to the regression-based
approach—the distributional dynamics approach—that did not capture causality but:
(a) overcame the normality requirement for regression analysis; and (b) displayed
the income distribution change using the Markov chain analysis.
Our results imply that by increasing the efficiency of resource allocation between
the levels of government, it is possible to increase growth. Sub-national governments
are better aware of the local needs and thus are in a better position to match local
demand with the available resources. This can be achieved by increased devolution
of expenditure and revenue raising responsibilities among the sub-national govern-
ments. Therefore, fiscal autonomy enhances growth. Besides this, the liberalization
dummy variable, which was used to capture the structural change in the Indian
economy, was found to have a significant and positive influence on growth.

Policy Implications
The findings of our study have important policy implications. The constitutional
bodies of the central and state finance commissions, apart from their primary
objective of fixing state shares, must also look at their role as being catalytic to
economic growth. State governments that wish to expand their growth prospects
Xavier et al. 147

should consider enhancing their decentralization efforts, infrastructure and social

sector involvement. Our results also reiterate what is already well known in the
growth literature: human capital enhances growth—thus, social expenditures have
a positive influence on sub-national growth (Kalirajan & Otsuka, 2012).
In India, there has been wide diversity in the extent of decentralization, especially
between third-tier governments. Many states have made very limited devolution of
fiscal powers despite the constitutional provisions being available since the 73rd
and 74th constitutional amendments in 1992. While our article has not looked at
the third-tier level of government, we anticipate that further decentralization would
not only strengthen local governance but may also enhance growth (Panagariya
et al., 2014; Rao, 2008).

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, author-
ship and/or publication of this article.

Funding
The authors received no financial support for the research, authorship and/or publication
of this article.

ORCID iDs
Aparna P. Lolayekar https://orcid.org/0000-0001-6652-4673
Pranab Mukhopadhyay https://orcid.org/0000-0001-9999-4938

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