In the early 2000s, Gujarat and Maharashtra were locked in an economic cold war, each claiming to be India’s industrial powerhouse. The battle escalated when Maharashtra rolled out tax breaks for auto manufacturers, only for Gujarat to counter with better tax breaks, free land and other enticing benefits. This was competitive federalism at its finest.
Subnational competition for investment, talent, and economic growth is precisely how fiscal decentralization is supposed to work. However, in India, this competition often takes a Tughlakian turn — States undercut each other with reckless subsidies, bureaucratic hurdles remain firmly intact, and regulatory certainty is treated like an optional add-on.
The race to attract voters through freebies is another way competitive federalism is being distorted. Done right, competitive federalism drives efficiency and innovation. Done wrong, it becomes a reckless bidding war where States keep raising the stakes — only to realise they’ve mortgaged their future for short-term political gains.
Four benefits
Empirical research highlights four key benefits of competitive federalism.
First, it enhances economic efficiency by allowing States to tailor policies to local needs, leading to higher growth, increased investment, and job creation (Oates, 1999; Zodrow & Mieszkowski, 1986).
Second, it fosters policy innovation as States experiment with governance models, regulatory reforms, and public service delivery to gain a competitive edge (Besley & Case, 1995).
Third, it strengthens fiscal discipline, as States must balance revenue generation with responsible spending to attract businesses and maintain investor confidence (Rodden, 2006). Fourth, it improves public service quality, as competition forces States to enhance infrastructure, education, and healthcare to retain skilled workers and businesses (Gennaioli et al., 2013).
At the same time, evidence also suggests that unchecked competition can lead to negative externalities, such as a race to the bottom in tax incentives, fiscal imprudence, and an over reliance on subsidies, ultimately eroding long-term financial stability (Wilson, 1999; Gennaioli et al., 2013).
Hence, there has to be mechanism in place wherein Union can nudge States not to splurge resources on freebies. This can only happen through Finance Commission, may be through a conditional grants framework.
Investment index
Apart from the Finance Commission, the Union government has made efforts to promote competitive federalism further through a number of announcements in the Budget. The first obvious announcement was an Investment Friendliness Index of States (IFI), to be launched in 2025.
The index can function as an information mechanism that enhances transparency in State-level economic governance by establishing a quantifiable benchmark for investment attractiveness.
Drawing from institutional economics, such rankings create reputational incentives that induce subnational governments to undertake policy reforms. Theoretical models of yardstick competition (Besley & Case, 1995) suggest that when jurisdictions are publicly ranked, policymakers face electoral and economic pressures to improve performance relative to their peers.
This creates a regulatory environment where States internalise the benefits of investment facilitation as a means of achieving long-term economic growth.
Furthermore, the index serves as a commitment device, signalling policy stability and predictability to investors, which is critical in reducing transaction costs associated with uncertain regulatory environments.
Economic efficiency
Public choice theory suggests that policy competition among States can counteract bureaucratic inertia by aligning State-level incentives with broader economic efficiency. The index, if designed effectively, can also introduce fiscal incentives by linking rankings to preferential access to financial resources.
IFI can build on the success of DPIIT’s Business Reform Action Plan (BRAP), which has evolved since its launch in 2014-15 to assess and drive regulatory reforms at the sub-national level. BRAP 2024 will further streamline India’s business environment by integrating next-generation reforms, aligning with initiatives like reducing compliance burden, decriminalization, and the World Bank’s B-READY program.
Another announcement, establishment of National Manufacturing Mission, will foster both competitive and cooperative federalism by aligning Central and State efforts to strengthen India’s manufacturing ecosystem. This will provide a unified policy framework, execution roadmaps, and governance mechanisms. This initiative will encourage States to compete to improve the ease and cost of doing business, enhance infrastructure, and attract investments.
At the same time, it promotes cooperation by standardizing best practices, facilitating knowledge-sharing, and ensuring technology access across regions. The MSME focus incentivises States to tailor local support measures while adhering to national priorities, creating a balanced approach where States compete on efficiency but collaborate on systemic improvements, ultimately driving ‘Make in India’ forward.
Another area is the Budget’s commitment to mandate ministries to develop PPP project pipelines for the next three years. At the same time, the Union government is also encouraging States to carry out a similar exercise.
Simultaneously, India Infrastructure Project Development Fund’s support institutionalizes cooperative federalism by providing financial and technical assistance, ensuring States with varying fiscal capacities can participate equitably. This approach aligns with market-preserving federalism, where subnational competition drives efficiency and innovation, while a structured national framework prevents coordination failures.
All these initiatives — IFI, the National Manufacturing Mission, PPP project pipelines — are steps in the right direction, but the focus must now shift to execution. India has no shortage of well-intentioned frameworks and policy announcements; the challenge lies in implementation.
The success of competitive federalism hinges on how effectively these mechanisms translate into on-ground improvements rather than remaining theoretical constructs. The IFI must have rigorous, objective metrics to avoid becoming another bureaucratic ranking exercise.
The National Manufacturing Mission must ensure that incentives do not simply duplicate existing schemes but drive real policy shifts at the State level.
Similarly, PPP project pipelines must not become yet another box-ticking exercise but a meaningful way to bridge infrastructure gaps. The Finance Commission, too, must go beyond recommendations and establish clear accountability mechanisms to prevent States from prioritising populism over fiscal prudence.
The writer is a public policy professional
