Opinion The good news is, lower-income states are catching up

We explore data over the last 12 years, dividing it between the six years pre-pandemic (FY13-FY19) and the six years post-pandemic (FY19-FY25). In the pre-pandemic period, there were no signs of convergence. Lower-income states grew more slowly than higher-income ones and, based on this simple framework, this was in fact a period of divergence. Fast forward to the post-pandemic period, and the picture changes. We find evidence of lower-income states growing faster on average. In particular, Uttar Pradesh, Rajasthan and Bihar have pivoted to higher relative growth. This is recent and nascent, but the pivot is clear.

What adds to the puzzle is that this shift has occurred both during and after the pandemic, when one might have expected lower-income states to suffer more. Yet, they were able to improve their relative growth performance. What explains this outcome?

We examine a host of variables, including economic structure, human capital, infrastructure and logistics, technology adoption, and various forms of government spending. One variable stands out in explaining this convergence: Public capital expenditure by states. Several emerging states — such as Assam, UP, Rajasthan, and Bihar — have invested substantially more in infrastructure in recent years. State capex not only improves the physical backbone for economic activity but also signals a reform-oriented government. It crowds in private-sector investment. Together, these channels drive higher growth. The key question is whether this momentum can be sustained.

Strong state revenues matter for public capex. When states are fiscally comfortable, they invest more — an effect that is particularly pronounced for laggard states. In the period immediately after the pandemic, central transfers to states increased. Even as GST compensation ended, the capex loans to state programmes kicked in, keeping overall revenues elevated.

But the environment is changing again. Two developments co-exist that could potentially hurt the capex cycle.

First, we are entering a phase in which the Centre’s tax revenues are weakening, driven partly by direct and indirect tax cuts and lower-than-expected nominal GDP growth. This could reduce state revenues, given that around 41 per cent of the Centre’s divisible tax pool is shared with states under Finance Commission rules.

This is already visible in the data. After several years of increases, state revenues declined in FY25. Rather than cut capex, states chose to widen fiscal deficits. But deficits are now elevated, and further revenue pressure could eventually force a pullback in capex.

Second, pressures are not limited to revenues. There has been a wave of new or enhanced cash transfer schemes, particularly ahead of state elections. Current expenditures have risen, as have fiscal deficits. So far, several states — such as Chhattisgarh, Madhya Pradesh, Rajasthan, Odisha, Telangana, and Andhra Pradesh — have maintained their capex thrust through and after recent election cycles. But if these schemes remain expansive, pressure on capex could emerge.

So far, the capex push has been maintained. But will it last? And can anything be done to keep capex and convergence on track?

To make states more secure on the revenue front and sustain the capex drive, the Centre could step in by expanding support to states; in particular, an increase in the capex loans to states programme could help.

This loan programme is well suited to the task. It is ring-fenced for state capex and cannot be diverted to other uses. It crowds in states’ own capital spending and complements the central government’s capex. For example, while the Centre builds national highways, states can invest in urban infrastructure to complete the transport loop. Importantly, the programme is now in its sixth year, with outlays rising from Rs 120 billion in FY21 to Rs 1.5 trillion in FY26. This may be the right moment to expand its scope — by increasing its size, broadening its use, and introducing greater flexibility. Providing clarity on the programme’s size over the next few years would also allow states to plan and execute larger, multi-year capex projects.

The onus is not only on the Centre. States must also seize growth opportunities. The Centre has led a deregulation drive, highlighting about 23 ground-level reforms each of India’s states should implement. It has also eased labour laws that had become a deterrent to growth. Amongst the many changes, the new Industrial Relations Code raises the threshold below which a firm can lay off workers without permission, from 100 to 300 employees. There is a further provision in this law for states to raise the threshold from 300 employees and become magnets to large firms that are globally competitive. This is an important step for states that want to industrialise. States need to make the most of these reforms.

Finally, as global supply chains are reconfigured, opportunities have emerged to attract FDI into labour-intensive mid-tech manufacturing sectors such as textiles, footwear, furniture, and toys. Countries like Vietnam have grown quickly by seizing this opportunity over the last few years, and now the world may be looking for new manufacturers. India’s emerging states enjoy a wage advantage. If this is combined with better infrastructure, further deregulation, and easier labour laws, they can attract investment and integrate into global manufacturing supply chains.

In conclusion, India’s emerging states are showing early signs of faster growth and catch-up potential. If they can stay the course on public capex and capitalise on reform opportunities, they could become a powerful driver of India’s rising place in the world.

The writer is chief India economist, HSBC