When States Bid for Capital: How Investment Is Reshaping Indian Federalism

A company deciding where to build a factory, data centre or technology facility is making a commercial decision. But in India, that decision increasingly has a federal dimension.

The question is no longer only whether an investment will come to India. It is also where within India it will be located.

That distinction has changed the economic incentives facing State governments. States now have reasons to improve infrastructure, administrative systems, labour capabilities and sector-specific policies because firms can compare one State with another. The resulting competition is changing the way economic federalism works.

But there is an important qualification: competition does not by itself create investment or growth. States enter the contest with very different economic foundations, and the form of competition matters. Competition based on institutional capability can generate pressure for reform; competition based primarily on subsidies can create fiscal costs without producing equivalent gains.

The important transformation, therefore, is not simply that States are competing for companies. It is that investment has become one mechanism through which States are encouraged to improve the conditions under which economic activity takes place.

The economic space created by liberalisation

This was not the structure of Indian economic federalism for much of the post-Independence period.

Before 1991, industrial licensing, permits and quotas gave the Union government substantial influence over investment decisions. The location and scale of industrial activity were consequently shaped within a highly centralised economic framework.

The 1991 Statement on Industrial Policy reduced this system substantially by abolishing industrial licensing for most industries, subject to specified exceptions.

The reform did not transform States overnight into autonomous economic actors. Public enterprises remained important, State administrations had to adapt gradually, and investment decisions continued to be influenced by national institutions.

But the incentive structure changed.

Once firms had greater freedom to consider different locations, the economic characteristics of States became more significant. Infrastructure, logistics, labour availability, administrative procedures and policy stability could now influence where investment was located.

This created room for States to differentiate themselves.

Federalism was therefore acquiring an economic dimension alongside its constitutional one.

The State became part of the investment decision

When several States are seeking the same investment, their governments have to demonstrate more than the availability of land.

They need to show that electricity and transport infrastructure can support production. They need administrative systems capable of processing approvals. They need workers with relevant skills. They need policies that firms can reasonably expect to remain predictable.

This is why recent contests involving Andhra Pradesh, Tamil Nadu, Karnataka, Maharashtra, Gujarat and Telangana are significant. These States have sought technology, semiconductor, electronics and electric-vehicle investments, among others.

The individual outcome matters to the State that receives the project. But the larger institutional effect lies elsewhere.

A State observing another State attract an investment because of a particular reform has an incentive to examine its own arrangements. A successful single-window system can become a model. A sector-specific policy can provoke another State to redesign its own. Administrative comparison can therefore generate pressure without requiring the Union to prescribe an identical reform everywhere.

The Department for Promotion of Industry and Internal Trade’s Business Reform Action Plan reflects part of this broader approach by comparing States and Union Territories on business reforms and regulatory procedures.

Competition can therefore produce a form of policy learning across governments.

Competition does not erase differences between States

There is, however, a danger in interpreting this process too simply.

States do not enter the investment contest from the same starting point.

A State with an established industrial cluster, major transport infrastructure, skilled labour, ports and long-standing business networks already possesses advantages that another State may take decades to build.

This matters when interpreting investment data.

Suppose an investor chooses a State with an established manufacturing ecosystem. It would be difficult to attribute that decision entirely to the latest incentive offered by the State government. Existing industrial concentration, infrastructure, geography and accumulated capabilities may be equally or more important.

The World Bank’s India Country Economic Memorandum 2024 similarly identifies the concentration of manufacturing, exports and foreign direct investment among a relatively small group of States and points to agglomeration, geography, infrastructure and complementary policies as important factors.

Competitive federalism should therefore be understood as an incentive mechanism, not as an automatic growth mechanism.

It changes what governments have reason to do.

It does not guarantee what investors will ultimately decide.

The quality of competition matters

The form that State competition takes becomes especially important when governments are trying to attract mobile capital.

There are at least two broad ways of competing.

One is to improve the underlying economic environment: faster approvals, reliable infrastructure, better logistics, skilled labour, predictable regulation and administrative capacity.

The other is to make the financial offer more attractive through subsidies, concessional utilities, cheap land or other fiscal concessions.

The two approaches are not equivalent.

A State that improves its institutional capacity may make itself more attractive to several future investors, not just one. A concession negotiated for a particular project may instead impose a fiscal cost without necessarily producing a comparable long-term improvement in the State’s economic ecosystem.

This is why the fiscal sustainability of State governments matters to competitive federalism. The Reserve Bank of India has examined State finances, expenditure and subsidies in the context of fiscal sustainability.

The central issue is therefore not whether States should compete.

It is what the competition rewards.

If investors reward reliability, infrastructure and administrative competence, competition can reinforce institutional improvement. If governments primarily compete by increasing the size of concessions, the same competitive mechanism can place pressure on public finances.

India’s global economic proposition is increasingly State-specific

The international dimension makes this transformation more visible.

A multinational company considering India does not evaluate only a country-level proposition. It ultimately has to select a physical location.

Where will the plant operate?

Where will workers be available?

Can goods move efficiently?

How predictable are approvals?

Can supporting suppliers develop around the investment?

These questions are answered at least partly at the State and local levels.

This gives India’s federal structure an increasingly important role in the country’s global economic proposition.

The China+1 strategy illustrates the point. A company may decide that India should form part of its supply-chain diversification. But the next decision is geographical: which Indian location can support the investment?

That is where differences between States become economically consequential.

An investment can also generate effects beyond the State in which it is located. Suppliers may emerge elsewhere, workers may move across State borders, infrastructure may serve neighbouring regions and successful policies may be adopted by other governments.

State competition can therefore have both a competitive and a wider national dimension.

The policy laboratory is also a learning system

The most significant consequence of competition may occur before any particular investment is secured.

Governments observe one another.

They experiment with industrial policy. They modify approval systems. They create sector-specific incentives. They attempt to develop infrastructure around emerging industries.

Some experiments will work better than others. Once their results become visible, other governments can adapt them.

This produces policy diffusion through a mechanism different from central direction.

Instead of one national instruction moving downward through the administrative hierarchy, an idea can move sideways from one State to another.

That matters in a country as economically diverse as India.

Tamil Nadu’s manufacturing ecosystem is different from Karnataka’s technology base. Gujarat’s infrastructure advantages differ from Andhra Pradesh’s emerging technology investments. States therefore cannot simply reproduce one another’s economic models. They can, however, observe particular institutional practices and adapt them to their own circumstances.

Competitive federalism thus creates a potential learning mechanism between governments.

Its value lies not merely in deciding where one factory is located, but in changing what governments believe they need to improve.

Yet the competition can become expensive

The same mechanism contains a fiscal risk.

When several governments want a highly mobile investment, the contest can escalate. Governments may offer increasingly generous incentives because the investment is seen as a prize worth securing.

This creates a difficult question: how much public support is justified by the economic activity generated?

The answer cannot be inferred simply from the announcement of an investment.

Nor can every successful investment be credited to State competition.

A company may have selected a State because of an existing industrial ecosystem. Another may have chosen a location because of geography or proximity to suppliers. A third may have been influenced by a particular policy concession.

The causal relationship between State competition and investment is therefore complicated.

This is precisely why the distinction between competition and competitiveness matters.

Competition describes the pressure States face from one another.

Competitiveness describes the underlying ability of a State to provide the conditions firms require.

The former can encourage the latter, but the two are not the same.

From redistribution of authority to comparison between States

This changes the way India’s economic federalism can be understood.

The traditional federal question is largely about who controls a particular power or resource.

Economic competition introduces another question:

How does one State perform relative to another in creating the conditions for economic activity?

That comparison can influence government behaviour even where the Constitution has not transferred a new formal power.

A State government can observe another State’s investment performance, identify an institutional difference and attempt to respond. Governments therefore become simultaneously competitors and learners.

This adds a horizontal dimension to an otherwise largely vertical understanding of economic federalism.

The Centre remains important. National taxation, infrastructure, trade policy, macroeconomic policy and the broader regulatory framework continue to shape the environment in which States operate.

But within that framework, States increasingly have incentives to differentiate themselves.

The new federal question

The deeper change is therefore not that States have become corporations competing for factories.

They have not.

States remain constitutional governments with responsibilities extending far beyond attracting investment.

Nor should every successful investment be treated as evidence that competitive federalism has succeeded.

The more defensible argument is narrower.

Economic liberalisation created greater room for States to influence the investment environment. Investment competition then created incentives for States to compare, experiment and improve.

That process can strengthen governance when competition rewards institutional capability. It can create fiscal stress when competition becomes dominated by concessions. And its effects will remain unequal because States begin with very different economic endowments.

This makes competitive federalism neither a guaranteed route to growth nor merely a contest between Chief Ministers.

It is a change in the incentive structure of India’s federal economy.

The old question was largely about where economic decisions were made.

The newer question is increasingly about which State can create the conditions under which economic activity chooses to locate there.

That shift is subtle, but it changes what federalism means in an economy where capital, technology and supply chains can move across State boundaries.