When a State Loses Its Economic Core: The Fiscal Economics of Bifurcation

A State can remain constitutionally intact as a government even after its economic foundations have been fundamentally altered.

That is one of the less visible consequences of dividing a State.

A political boundary determines which government controls a territory. Fiscal capacity, however, is produced by something less orderly: where firms are located, where people earn incomes, where property changes hands, where investment accumulates and where commercial activity becomes concentrated.

When those economic assets are distributed unevenly across a new boundary, the two successor States do not begin with equivalent fiscal foundations.

The experience of Andhra Pradesh and Telangana makes this distinction particularly clear.

A boundary can divide an economy unevenly

State reorganisation is normally understood in territorial terms. A region becomes a new State; the remaining territory becomes another.

But the fiscal consequences depend on what lies inside those territories.

State governments derive their own revenue from economic activity within their jurisdiction — including business activity, consumption, property transactions, formal employment, industrial production and services. If a disproportionately large share of that activity is concentrated in one urban centre, the location of that centre becomes fiscally significant.

This was the problem created by the separation of Telangana from Andhra Pradesh.

Before 2014, Hyderabad was part of undivided Andhra Pradesh and functioned as the region’s dominant economic centre. After Telangana was created, Hyderabad became part of the new State. Andhra Pradesh therefore had to operate without the metropolitan economy that had previously formed part of its fiscal base, even as it retained the responsibilities of running a State and developing a new economic centre.

The Andhra Pradesh Reorganisation Act, 2014 created Telangana and provided for Hyderabad to function as the common capital of both States for a period not exceeding ten years, while also providing for a new capital for Andhra Pradesh.

The immediate fiscal numbers show how sharply the starting positions changed.

In the year following the division, per-capita own revenue in rump Andhra Pradesh was ₹9,007, compared with ₹11,730 for the undivided State before bifurcation — a decline of 23.2%. Telangana recorded per-capita own revenue of ₹15,623, 33.2% above the earlier level used for comparison.

These figures do not establish that every subsequent fiscal difficulty in Andhra Pradesh resulted from bifurcation. State expenditure decisions, political choices and wider economic conditions also influence fiscal outcomes.

They do establish something narrower but important:

when the territorial jurisdiction of a government changes, the economic base available to that government can change with it.

That is the central fiscal problem created by bifurcation.

The economic shock arrives faster than the replacement economy

The difficult part is not simply losing a large city.

It is losing an economic system that has accumulated over decades.

A metropolitan economy contains much more than government offices. Businesses, skilled workers, suppliers, property markets, financial services, infrastructure and investment networks reinforce one another. Once this ecosystem exists, it cannot be reproduced merely by announcing a new capital.

Administrative capacity and economic capacity therefore move at different speeds.

A government can establish departments, construct offices and designate a capital relatively quickly. Creating a comparable concentration of firms, workers, infrastructure, markets and investment requires a much longer period.

This creates a distinctive fiscal transition.

The State that loses the economic centre has to continue financing roads, schools, healthcare, administration, welfare, policing and infrastructure while simultaneously trying to create new sources of economic activity.

The initial problem is therefore not simply a shortage of revenue.

It is that the relationship between the territory being governed and the economic activity generating revenue has changed.

Four reorganisations show why the geography matters

Andhra Pradesh is not an isolated case.

Uttar Pradesh, Madhya Pradesh and Bihar were reorganised in 2000, creating Uttarakhand, Chhattisgarh and Jharkhand. The fiscal consequences were markedly different across these cases.

In the year after division, per-capita own revenue in the rump territories changed by about 4% in Uttar Pradesh, 6% in Madhya Pradesh, 31.6% in Bihar and 23.2% in Andhra Pradesh. The carved-out States recorded increases ranging from 17.6% in Chhattisgarh to 97.2% in Jharkhand.

The significance of the comparison is not simply that some States gained while others lost.

It is that the fiscal effect of creating a new State depends on what economic capacity happens to fall on either side of the new boundary.

A division that separates a resource-rich region will have different consequences from one that separates a major metropolitan economy. Industrial concentration, urbanisation, services, property markets and existing administrative structures can all change the fiscal starting point of the successor States.

The constitutional act may be similar.

The economic geography is not.

Why an economic centre carries more than its own revenue

The importance of Hyderabad cannot be understood only by counting taxes collected directly within the city.

Large economic centres generate surrounding ecosystems.

Businesses locate near other businesses. Skilled workers follow opportunities. Suppliers develop around established firms. Financial and professional services expand. Infrastructure becomes commercially viable because large numbers of firms and households use it. New investment then becomes more attractive because many of these complementary assets already exist.

Economic concentration can therefore reinforce itself.

Telangana provides a clear illustration. Hyderabad and neighbouring Ranga Reddy together accounted for about 47.5% of Telangana’s economic output in 2022-23, while covering only 8.7% of the State’s area and containing about 27.9% of its population, based on the 2011 Census.

The concentration is also closely connected to the State’s changing sectoral structure. Real estate, IT and business services, together with trade, hotels and restaurants, form a large part of Telangana’s services economy.

This matters for fiscal analysis because a relatively small geographical area can contain a disproportionately large share of the economic activity from which government revenue emerges.

The fiscal map can therefore look very different from the political map.

The asymmetry begins with inherited responsibilities

When two States emerge from one, both require governments.

Both need administrative institutions.

Both have to provide public services.

Both need infrastructure.

But the economic assets supporting those obligations may not be divided equally.

This creates an asymmetry that ordinary fiscal comparisons can miss.

If a State loses a major revenue-generating centre, its expenditure responsibilities do not automatically fall by the same proportion. It may therefore have to finance two tasks at once: maintaining the existing public system and creating a new economic base capable of supporting it.

That is different from a temporary fiscal deficit.

A cyclical downturn can reduce revenue for a period and then reverse as economic conditions improve. A territorial reorganisation can alter where the underlying revenue-generating activity lies.

The distinction matters because the remedy for a temporary shortfall need not be the same as the response to a structural change in fiscal capacity.

But the starting shock is not the final outcome

There is an important qualification.

A State that loses an economic centre does not necessarily remain economically weaker forever.

The post-bifurcation experience of Telangana itself demonstrates why the initial fiscal distribution cannot be treated as a complete explanation of subsequent development.

At the time of bifurcation, Telangana’s economic size was about 96% of Andhra Pradesh’s, compared with roughly 74% in 2004-05. Its relative per-capita income had also risen before the division and remained higher thereafter.

A successor State can build on the economic assets it inherits. A rump State can develop new cities, industries, infrastructure and economic corridors.

The initial distribution of fiscal capacity therefore creates different starting conditions without mechanically determining the destination.

A fiscal shock created by reorganisation and a State’s long-term development trajectory are not the same thing.

That distinction is important. Otherwise, bifurcation risks being treated as a complete explanation for every later difference between successor States.

What changes for fiscal federalism?

State reorganisation introduces a problem that ordinary fiscal equalisation does not capture perfectly.

India already has a system for dealing with differences in fiscal capacity and expenditure needs among States. Finance Commissions redistribute resources partly because States do not begin with identical economic bases.

But bifurcation can create another kind of difference.

A State may become fiscally weaker not because its economy suddenly deteriorates, but because a portion of the economic system that previously generated revenue now lies outside its jurisdiction.

That is a different mechanism from an ordinary growth slowdown.

The distinction becomes relevant when considering whether existing transfer arrangements adequately account for the consequences of territorial reorganisation. The current devolution framework already includes measures related to fiscal capacity and other State characteristics, but the question remains whether a one-time structural change in the territorial distribution of an economic base is sufficiently visible within those mechanisms. Andhra Pradesh’s share under the horizontal devolution formula is 4.217%.

The issue, therefore, is not whether fiscal capacity matters in India’s federal transfer system.

It is whether a constitutionally created change in fiscal capacity is visible in the same way as an ordinary difference in fiscal capacity.

The same constitutional process can produce very different fiscal outcomes

The four reorganisations since 2000 make this particularly clear.

Uttarakhand, Chhattisgarh and Jharkhand inherited economic assets that produced substantial increases in per-capita own revenue relative to their parent States. Bihar and Andhra Pradesh experienced much larger reductions in the corresponding comparison.

There is therefore no single fiscal consequence associated with creating smaller States.

The outcome depends on the economic system being divided.

Natural resources may dominate one case. A metropolitan tax base may dominate another. Industrial clusters, urbanisation, services or property markets may matter elsewhere.

This is why State reorganisation should not be analysed simply by looking at the size of the territory transferred.

The more important question is:

What economic capacity crossed the new boundary?

What happens when the map changes but the economy does not?

This raises a broader question for Indian fiscal federalism.

Suppose a State loses a major economic centre through constitutional reorganisation. The successor State that receives the centre inherits an already-developed revenue-generating ecosystem. The other State has to build a replacement.

Should that be treated in the same way as an ordinary fiscal imbalance?

There have been proposals for special assistance to States that suffer a substantial loss of fiscal capacity because of bifurcation. One such proposal has suggested a threshold of a 10% loss and a time-bound compensatory mechanism. That is a proposal rather than an established rule of India’s fiscal system.

The larger analytical question comes first.

How should a federation identify and respond to a fiscal-capacity shock that has been created by its own territorial reorganisation?

Any such mechanism would also need to avoid assuming that every bifurcation creates permanent fiscal damage. The experience of different State divisions shows that the consequences vary because their underlying economic geographies vary.

The economic system beneath the political map

A State appears on a political map as a single administrative unit.

Economically, it is something else.

It consists of cities, industrial clusters, transport networks, resource regions, labour markets, property markets and commercial relationships. Fiscal capacity emerges from the interaction among these elements.

When the boundary changes, the economic relationships do not disappear.

But the jurisdiction responsible for taxing and financing them does.

That is why two constitutionally viable successor States can nevertheless begin with very different fiscal capacities.

And that is the deeper lesson of bifurcation:

the object being divided is not only territory. It is an economic system.

When a major share of that system is concentrated on one side of the new boundary, the fiscal consequences can persist long after the political reorganisation itself has been completed.