Yet another example of how increasing disparities might reflect the growth-enhancing role of incentives comes from considering the increasing variation in the growth performance of Indian states during the 1990s, when some states significantly accelerated their growth, while others lagged behind. Both Ahluwalia (2000) and Kohli (2006) conjecture that the increase can be attributed, at least in part, to the greater responsiveness of private investment flows to differences in the investment climate in different states. As Kohli (2006) notes, that in turn appears to have provided—subject to the constraints imposed by state-level political considerations and capacity—some incentives to state leaders to adopt measures to improve the business environment, to woo private investment. This stands in contrast to earlier periods when the share of public investment in total investment was much larger.

There is evidence that the impact of incentives was magnified by the presence of agglomeration economies in industrial activity in India. Lall and Chakravorty (2005) show that industrial diversity (which is higher in metropolitan and mixed industrial regions) has costreducing effects, through agglomeration economies. Because of this, private industrial units favored locating in existing high-density industrial areas, increasing the degree of industrial clustering. On the other hand, the location decisions of state-owned industry appeared to have been much less driven by these cost considerations and were possibly motivated by a desire for greater regional balance. The conclusion that Lall and Chakravorty draw is that the reforms and the scaling back of public investments, and the emergence of the private sector as the primary source of new industrial investments that was associated with it, contributed to higher levels of spatial inequality in industrial activity.

# **Bad inequalities**

The processes underway in India and China are almost certainly less benign and less automatic than the account above suggests. Geographic poverty traps, patterns of social exclusion, unequal opportunities for enhancing human capital, lack of access to credit and insurance, corruption and uneven influence can all conspire to simultaneously fuel rising inequality and prevent certain segments of the population from making the transition out of traditional low-productivity activities. Credit market failures often lie at the root of the problem; it is poor people who tend to be most constrained in financing lumpy investments in human and physical capital. These bad inequalities—rooted in market failures, coordination failures and governance failures—prevent individuals from connecting to markets and limit investment in human and physical capital.<sup>19</sup> We focus on two dimensions of bad inequalities. The first relates to location in the presence of externalities, impediments to mobility and heavy dependence of local states on local resources. These features can generate geographic poverty traps whereby living in a wellendowed area entails that a poor household can eventually escape poverty, while an otherwise identical household living in a poor area sees stagnation or decline. This is one possible reason why initially poorer provinces have often seen lower subsequent growth (figure 6).

19 World Bank (2005, Chapter 5) provides a useful overview of the arguments and evidence on how certain inequalities can be inefficient, notably when they entail unequal opportunities for advancement. Also see the excellent overview of the theoretical arguments in Aghion et al. (1999).

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