The impact of fiscal deficit on economic growth is one of the highly debated issues in economics. According to budget estimates, the ratio of fiscal deficit to GDP (centre and states but excluding off-budget bonds) in India would be 10.2% for the year 2009-10. It has drastically increased from 4.2% in 2007-08 to 8.9% in 2008-09. This reversed all the fiscal gains made since 2003-04. Fiscal deficit can be financed through domestic borrowing, external borrowing or by printing money. Excessive domestic borrowing may put upward pressure on interest rates and external borrowing may result in external debt crisis. Printing money may lead to high inflation. The excessive fiscal deficits seem to be the major concern of academicians and policy makers in India given economic slowdown and week recovery. Now, the question of interest is whether chronic fiscal deficit hurts economic growth?
Apparently there is no consensus among economists on this issue either theoretically or empirically. One argument, following Keynes, is that high fiscal deficits accelerate capital accumulation and growth (Krishnamurty 1984, Chandrasekhar 2000, Shetty 2001, Murty and Soumya 2007). High fiscal deficit crowds-out private investment through an increase in the interest rate, if the government borrowing is used only to finance revenue deficit. Otherwise, increase in fiscal deficit due to public sector investment, especially in infrastructure (which consists of highways, airports, mass transit, etc.) stimulates growth in the private sector. Increasing public investment in an appropriate policy framework, gives the private sector adequate poise and incentives to invest on a massive scale leading to overall economic growth.
On the other hand, the efficacy of fiscal expansion has been questioned given large fiscal deficits and accumulation of high debt-GDP ratio (Acharya 2001, Sinivasan 2001). The argument is higher fiscal deficit may crowd-out private investment. This impact works through interest rate. In an open economy, higher public expenditure leads to higher capital flows and a real appreciation which results in lower net exports and again a reduction in the economic activity.
In this context, it is important to understand the pass through of rising fiscal deficit to the macro economy. Here, an attempt to understand the effect of high fiscal deficits on savings and investment behavior of public and private sectors is made as economic growth is mainly driven by these two factors. High levels of debt-GDP due to increase in fiscal deficits may increase interest payments and thereby crowds-out public investment. There is also another argument that overall saving rate will reduce due to increase in revenue deficit caused by increase in interest payments. Here, we empirically test whether increase in interest payments affects capital expenditure or not. Consequently is there any reduction in aggregate savings. Before that it is also interesting to test the crowding-in or crowding-out effect between public and private investments.
The equation below shows the relationship between aggregate private and public investments. It is postulated that real private investment depends on real output, real public investment and real interest rate. Since all three variables are stationary in levels the equation has been estimated by using least-squares method. The values given in the brackets are t-statistics. ‘EL’ indicates elasticity.
Relationship between private and public investments:
Data: 1981-2007. Source: NAS, RBI
1. PITOTR = -272.58 + 0.22 YR+ 1.76 PCFTOTR – 2.16 (PLR-INFL)
(-8.82) (9.62) (4.92) (-0.78)
EL: 1.19 0.86 -0.06
`R2 = 0.98 DW = 1.1
Variables:
PITOTR: Real total private investment
PCFTOTR: Real total public investment
PLR: Prime lending rate
INFL: Rate of inflation
YR: Real output
Real output seems to have a positive effect on private investment following accelerator phenomenon. Interestingly public investment seems to effect private investment positively indicating crowding-in effect. However interest rate has a negative effect on private investment with an elasticity of 0.06. Therefore if interest rate increases as a result
of large fiscal deficits, private investment will fall moderately.
Crowding-out within the public sector:
As stated above, high debt-GDP ratios would increase the expenditure on interest payments. As result, there will be a process of adjustment towards capital expenditure. This might lead to a contraction in public investment thereby reduction in capital accumulation and economic growth. Here public investment is estimated as a function of total revenues and interest payments on debt. All three variables are in nominal terms. The variables in the equation below are stationary in levels. Therefore the equation is estimated in levels only. Auto regressive term (AR) is used in the equation to correct for serial correlation.
Data: 1981-2007. Source: NAS, RBI.
2. PCFTOT = 16.53 + 0.52 TR - 0.45 IPD – 0.47 AR (1)
(3.44) (9.22) (-2.34) (-2.24)
`R2 = 0.99 DW = 1.96
Variables:
PCFTOT: Nominal public investment
TR: Total nominal revenues
IPD: Interest payments on debt (Nominal)
The total revenues seems to have a positive effect on public investment with an elasticity of 1.1. As expected, interest payments seems to effect nominal public investment negatively with an elasticity of 0.32. Therefore, it is important to control the debt/GDP to avoid a reduction in the public investment.
Relation between private and public savings:
As specified above, the responsiveness of private savings to changes in public savings is tested below. It is postulated that real private savings depends on real personal disposable income and real public savings. Real private savings and real personal disposable income are stationary in levels, but real public investment is non-stationary in level but stationary in first difference (indicated by D). Therefore the equation is estimated both in levels as well as in first differences by using data from 1981 to 2007. A dummy variable is used for the years from 1998-2007 as a multiplication dummy to represent the random fluctuations in real public savings. The values given in the brackets are t-statistics. ‘EL’ indicates elasticity.
Data: 1981-2007. Source: NAS, RBI
3.1 GDSPVTR = -103.01 + 0.38 PDYR - 1.42 GDSPUBR – 3.04 GDSPUBR*D9807
(-3.36) (23.05) (-2.69) (-5.09)
EL: 1.28 -0.11
`R2 = 0.99 DW = 1.5
3.2 D(GDSPVTR)= 0.30+0.43 D(PDYR)–0.16 D(GDSPUBR)–1.19(GDSPUBR*D9807)
(0.04) (4.06) (-0.28) (-1.6)
EL: 0.84 -0.01
`R2 = 0.67 DW = 2.19
Variables:
GDSPVTR: Real gross domestic savings in private sector
GDSPUBR: Real gross domestic savings in public sector
PDYR: Real personal disposable income
- In both 3.1 (long-run) and 3.2 (short-run), private savings respond positively to disposable income as expected. Interestingly, this empirical exercise shows that public savings has a negative effect on private savings. If public savings falls, then private savings will increase implying compensation effect though partial. Therefore overall savings may not reduce to the extent of decrease in public savings.
The above results reveal that there is a strong crowding-in effect associated with public and private investments in India. Also, a fall in public savings, implying rise in revenue deficit, would be compensated by increase in private savings and therefore overall savings may not reduce to the full extent of rise in revenue deficit. However, a higher fiscal deficit and debt/GDP ratio would increase interest payments on debt and thereby reduce public investment. Therefore the fear about high fiscal deficit is justified if the government incur deficit to finance its current expenditure rather than capital expenditure. Public investment particularly in infrastructure can support private investment which will ultimately improve economic growth. Since, taxes respond positively to income, consequent economic growth would increase taxes, which will strengthen the revenue receipts of the government and thereby reduce the revenue deficit. Therefore government should consider capital spending rather than current spending to avoid ill effects of high fiscal deficit. |
