Fiscal Deficit and Economic Growth Relationship in India: A Time Series Econometric Analysis

Abstract

High and persistent level of fiscal deficit is one of the major macroeconomic problems in India ever since mid-1980s. Fiscal consolidation is on the forefront of policy discussion since early 1990s to present day context. However, the actual administrative measure to control fiscal deficits in India took place in the year 2003 with enactment of Fiscal Responsibility and Budget Management (FRBM) Act and it brought into force in April 2004. The rationale behind keeping fiscal deficits under control is its adverse effect on macroeconomy and particularly the economic growth. On the one hand, the monetary policy makers in India (Reserve Bank of India) argue that higher fiscal deficits will impede the economic growth and hence requires a control. On the other hand, the fiscal policy makers (Ministry of Finance) argue that deficit spending is indispensable to augment the economic growth. Hence, there exists a puzzle that how fiscal deficit is affecting GDP in India. This paper tries to answer the puzzle by taking up a long-term time series analysis starting from the period 1980–1981 to 2015–2016. By adopting a vector error correction method (VECM), this paper proves that fiscal deficit is adversely affecting the GDP growth and therefore requires a strict control. Based on very few existing literature, paper also argues that if fiscal deficit money spent on capital formation purpose, it promotes growth and hence supports ‘Golden Rule’ of public finance.