Fiscal Deficit-Economic Growth Nexus in India: A Cointegration analysis

Ranjan Kumar Mohanty 1

Abstract The basic aim of the study is to examine both the short run and long run relationship between fiscal deficit and economic growth in India by covering the time period from 1970-71 to 2011-12. Johansen Cointegration test, Granger Causality test, And Vector Error correction Model (VECM) technique are adopted in order to examine the objectives of this study. The Johansen methodology confirms the existence of long run relationship between GDP and the selected variables. The findings of the paper indicate that there is negative and significant relationship between fiscal deficit and economic growth in the long run. One percent increase in Fiscal deficit is likely to significantly decrease gross domestic product by 0.216537. But the Vector Error Correction model and Granger Causality test discards the short run relationship between fiscal deficit and economic growth. The findings of study also reveal that the negative impact of post- reform fiscal deficit on economic growth is more than the impact of pre-reform’s fiscal deficit. This is contrary to Keynesian theory, but in conformity with Neo-classical theory, which holds that fiscal deficits lead to a fall in the Gross Domestic Product. The study suggests the reduction of subsidies and invests this money in health, education, infrastructure sectors such as power and roads etc., so that it will enhance the productivity of both human capital and physical capital, which will go a long way in increasing the percapita income of the people.

Key Words: - Fiscal deficit, Economic Growth, Johansen Cointegration, Granger Causality, Vector Error Correction. JEL Codes: H62, O40, C32.

I. Introduction

The impact of fiscal deficit on economic growth is one of the highly debated issues in all world economies. The target of achieving sustained growth and maintaining macroeconomic stability is the dream among many developed, developing and underdeveloped economies. The economic growth and stability of developing countries in recent times has brought the issues of fiscal deficit into sharp focus. Continuing high levels of fiscal deficit, even if adoption of fiscal Responsibility and Budget Management Act (FRBM), pose a serious danger to macroeconomic stability in India. The excessive fiscal deficits seem to be the major concern of academicians and policy makers in India. The annual growth rate of GDP is 6.5 percent in 2011-12, whereas gross fiscal deficit is 5.8 percentage of GDP in same period in India. Now, the question of interest is whether this persistent fiscal deficit hampers economic growth in India? How has increase in fiscal deficits impacted India’s economic growth over the last four decades?

In India, gross fiscal deficit is defined as the excess of the sum total of revenue expenditure, capital outlay and net lending over revenue receipts and non-debt capital receipts including the proceeds from disinvestment. The government has to incur deficits to finance its revenue and

1Mohanty is a Ph.D scholar at the Centre for Economic Studies & Planning, School of Social Sciences, Jawaharlal

Nehru University, New Delhi-110067, India. Mail- ranjanmohanty85@gmail.com, phone- +91 9013673174

expenditure mismatches and also to finance investments. The problem arises when the deficit level becomes too high and chronic. The ill-effects of high deficits are linked to the way they are financed and how it is used. The fiscal deficits can be financed through domestic borrowing, foreign borrowing or by printing money. Excess use of any particular mode of financing of the fiscal deficit has adverse macroeconomic consequences, viz, seigniorage financing of fiscal deficit can create inflationary pressures in the economy, bond financing of fiscal deficit can lead to rise in interest rates and in turn can crowd out private investment and the external financing of fiscal deficit can spill over to balance of payment crisis and appreciation of exchange rates and in turn debt spiraling.

Sometime large fiscal deficit can affect the country’s economic growth adversely. A higher fiscal deficit implies high government borrowing and high debt servicing which forces the government to cut back in spending on relevant sectors like health, education and infrastructure. This reduces growth in human and physical capital, both of which have a long-term impact on economic growth. Large public borrowing can also lead to crowding out of private investment, inflation and exchange rate fluctuations. However, if productive public investments increase and if public and private investments are complementary, then the negative impact of high public borrowings on private investments and economic growth may be offset. Fiscal deficit used for creating infrastructure and human capital will have a different impact than if it is used for financing ill-targeted subsidies and wasteful recurrent expenditure. Therefore the fear about high fiscal deficit is justified if the government incur deficit to finance its current expenditure rather than capital expenditure.

In this context, it is important to understand the consequences of rising fiscal deficit on the economic growth of Indian economy. There have been concerns about the high fiscal deficit. The literature, in particular the empirical part, on the relationship between fiscal deficit and economic growth is scarce. Recent empirical studies investigate the impact of budget deficit on growth in advanced and emerging countries by using cross country data and only few of them; attention is devoted to the country specific. This study has examined the empirical relationship between fiscal deficit and economic growth in India by using time series data from 1970-71 to 2011-12. This study has also estimated the relationship by using two sub periods such as one for 1970-1991, and another for 1992-2011 for more clarification. Both short run and long run relationship testing is being carried out in this study through Granger Causality test, Johansen Cointegration and Vector Error Correction Model (VECM).

I.1 Trends in Deficit of Central Government in India

The following figure-1 traces the trends in deficits of central government over the past four decades. The gross fiscal deficit as a percent of Gross Domestic Product (GDP) increased from 3.04 percent of GDP in 1970-71 to the peak of 8.37 percent in 1986-87 and then declined to 4.84 percent in 1996-97. It was around 7 percent of GDP during 1987-88 to 1990-91. During the 1990s the average fiscal deficit as a percent of GDP was 5.67 percent. However, after 2003-04 central governments contained the fiscal deficit from 4.48 percent of GDP to its all time minimum of 2.54 percent in the year 2007-08. Then it increased to 6.48 percent in 2009-10 and declined to 5.89 percent. Similarly primary deficit, which is fiscal deficit excluding interest payment has increased from 1.74 percent in 1970-71 to a peak of 5.43 percent in 1986-87 and declined to 0.53 percent of GDP in 1996-97. Primary deficit was dissolved from the year 2003-04 to the year 2007-08 except the year 2005-06. It was 2.78 percent during the year 2011-12.

After 1991-92, primary deficit has declined much due to the rising interest payment and to some extent a decline in fiscal deficit. Revenue deficit was incurred in the period 1971-72 and 1972-73. It was 0.57 percent in 1979-80, after that it increased to 3.26 percent in 1990-91. It reached maximum of 5.25 percent of GDP in 2009-10. The average of revenue deficit as a percentage of GDP in 1980s, 1990s and 2000s has been 1.72 percent, 3.02 percent and 3.40 percent respectively. It was 4.46 percent of GDP during the period 2011-12.

Figure-1

I.2 Gross Fiscal Deficit and Growth Rate of Gross Domestic product:-

As it is clear from the figure-2, India’s economic growth rate has been plotted against this GFD to GDP ratio for the period 1970-71 to 2011-12. It is seen that the rate of growth is lower when the GFD-GDP ratio of the Central government is high. This implies higher fiscal deficit may be detrimental for the Indian economy. This simple trend analysis is not sufficient for any valid inference. Therefore the study has used the advanced econometric technique.

Figure-2

In this paper, Section I is the introduction, while Section II discusses the theoretical issues and empirical literature on fiscal deficit and economic growth. Section III presents the research questions, objectives, data source and the methodology used in this study. Section IV analyses the empirical results and interpretations and Section V concludes with a summary of the study and recommendations. II. Review of literature: II.1 Theoretical Perspectives

There is no agreement among economists either on analytical grounds or on the basis of empirical results whether financing government expenditure by incurring a fiscal deficit is good, bad, or neutral in terms of its real effects, particularly on investment and growth. Generally speaking, there are three schools of thought concerning the economic effects of budget deficits: Neoclassical, Keynesian and Ricardian. Among the mainstream analytical perspectives, the neo-classical view considers fiscal deficits detrimental to investment and growth, while in the Keynesian paradigm, it constitutes a key policy prescription. Theorists persuaded by Ricardian equivalence assert that fiscal deficits do not really matter except for smoothening the adjustment to expenditure or revenue shocks. While the neo-classical and Ricardian schools focus on the long run, the Keynesian view emphasizes the short run effects. II.1.1The Neo-Classical View The component of revenue deficit in fiscal deficits implies a reduction in government saving or an increase in government dis-saving. In the neoclassical perspective, this will have a detrimental effect on growth if the reduction in government saving is not fully offset by a rise in private saving, thereby resulting in a fall in the overall saving rate. This, apart from putting pressure on the interest rate, will adversely affect growth. The neo-classical economists assume that markets clear so that full employment of resources is attained. In this paradigm, fiscal deficits raise lifetime consumption by shifting taxes to the future generations. If economic resources are fully employed, increased consumption necessarily implies decreased savings in a closed economy. In an open economy, real interest rates and investment may remain unaffected, but the fall in national saving is financed by higher external borrowing accompanied by an appreciation of the domestic currency and fall in exports. In both cases, net national saving falls and consumption rises accompanied by some combination of fall in investment and exports. The neo-classical paradigm assumes that the consumption of each individual is determined as the solution to an intertemporal optimisation problem where both borrowing and lending are permitted at the market rate of interest. It also assumes that individuals have finite life spans where each consumer belongs to a specific generation and the life spans of successive generations overlap. II.1.2 Keynesian View of Fiscal Deficits The Keynesian view in the context of the existence of some unemployed resources, envisages that an increase in autonomous government expenditure, whether investment or consumption, financed by borrowing would cause output to expand through a multiplier process. The traditional Keynesian framework does not distinguish between alternative uses of the fiscal deficit as between government consumption or investment expenditure, nor does it distinguish between alternative sources of financing the fiscal deficit through monetisation or external or internal borrowing. In fact, there is no explicit budget constraint in the analysis. Subsequent elaborations of the Keynesian paradigm envisage that the multiplier-based expansion of output leads to a rise in the demand for money, and if money supply is fixed and deficit is bond financed, interest rates would rise partially offsetting the multiplier effect. However, the Keynesians argue that increased aggregate demand enhances the profitability of private investment and leads to higher investment at any given rate of interest. The effect of a rise in interest rate may thus be more than neutralised by the increased profitability of investment. Keynesians argue that deficits may stimulate savings and investment even if interest rate rises, primarily because of the employment of hitherto unutilised resources. However, at full employment, deficits would lead to crowding out even in the Keynesian paradigm. In the standard Keynesian analysis, if everyone thinks that a budget deficit makes them wealthier, it would raise the output and employment, and thereby actually make people wealthier. Unlike the

loanable funds theory, the Keynesian paradigm rules out any direct effect on interest rate of borrowing by the government. II.1.3 Ricardian Equivalence Perspective In the perspective of Ricardian, fiscal deficits are viewed as neutral in terms of their impact on growth. The financing of budgets by deficits amounts only to postponement of taxes. The deficit in any current period is exactly equal to the present value of future taxation that is required to pay off the increment to debt resulting from the deficit. In other words, government spending must be paid for, whether now or later, and the present value of spending must be equal to the present value of tax and non-tax revenues. Fiscal deficits are a useful device for smoothening the impact of revenue shocks or for meeting the requirements of lumpy expenditures, the financing of which through taxes may be spread over a period of time. However, such fiscal deficits do not have an impact on aggregate demand if household spending decisions are based on the present value of their incomes that takes into account the present value of their future tax liabilities. Alternatively, a decrease in current government saving that is implied by the fiscal deficit may be accompanied by an offsetting increase in private saving, leaving the national saving and, therefore, investment unchanged. Then, there is no impact on the real interest rate. Ricardian equivalence requires the assumption that individuals in the economy are foresighted, they have discount rates that are equal to governments’ discount rates on spending and they have extremely long time horizons for evaluating the present value of future taxes. In particular, such a time horizon may well extend beyond their own lives in which case they save with a view to making altruistic transfers to take care of the tax liabilities of their future generations2. II.2 Empirical Studies: The study has reviewed some important empirical studies on fiscal deficit and economic growth. Christopher S. Adam and David L. Bevan (2002) examined the relation between fiscal deficits and growth for a panel of 45 developing countries and found a possible non-linearity in the relation between growth and the fiscal deficit for a sample of developing countries. Yaya Keho (2010) examined the causal relationship between budget deficits and economic growth for seven West African countries over the period 1980-2005. The empirical evidence showed mixed results. In three countries, it did not find any causality between budget deficit and growth. In the remaining four countries, deficits had adverse effects on economic growth. Nelson and Singh (1994) used data on a cross section of 70 developing countries during two time periods, 1970-1979 and 1980-1989, to investigate the effect of budget deficits on GDP growth rates. This study concludes that the budget deficit had little or no significant effect on the economic growth of these nations in the 1970s and 1980s. Jorge C. Avila (2011) analyzed the relationship between fiscal deficit, macroeconomic uncertainty and growth of Argentina for the period 1915-2006, and concluded that the deficit hampered on per-capita income growth in Argentina through the volatility in relative prices. Lance Taylor et al. (2012) examined the interactions between the ‘primary’ fiscal deficit, economic growth and debt for the period 1961-20 of USA. It found a strong positive effect on growth of a higher primary deficit, even when possible increases in the interest rate are taken into account. Osinubi et al. (2006) synthesized a relationship between budget deficits and external debt in Nigeria between 1970 and 2003. The results of the econometric analysis confirmed the existence of the debt Laffer curve and the nonlinear effects of external debt on growth in Nigeria.

2 C. Rangarajan, and Srivastava, D ,(2005), “Fiscal deficits and government debt in India: implications for growth

and stabilization”, National Institute of Public Finance and Policy (NIPFP),Working Paper no 35.

Goher Fatima et al. (2011) aimed at verifying the impact of government fiscal deficit on investment and economic growth using time series of thirty years stretching between 1980 and 2009 and believed that fiscal profligacy has seriously undermined the growth objectives thereby adversely impacting physical and social infrastructure in the country. Niloy Bose, M Emranul Haque, and Denise R Osborn (2003) examined the growth effects of government expenditure for a panel of thirty developing countries over the decades of the 1970s and 1980s and found that the share of government capital expenditure in GDP is positively and significantly correlated with economic growth, but current expenditure is insignificant.

Alfredo Schclarek (2004) empirically explored the relationship between debt and growth for a number of developing and industrial economies. For developing countries, the study found that lower total public external debt levels associated with higher growth rates and for industrial countries, it did not find any significant relationship between gross government debt and economic growth. Gadong T. Dalyop (2010) examined the effectiveness of fiscal deficits on the growth rate of the Real Gross Domestic Product and found that fiscal deficit in the Nigerian economy is Ricardian. Fiscal deficits therefore had little effect on the level of economic activity. Khalifa H. Ghali (1997) built an endogenous growth model to untangle the nature of the relationship between government expenditure and economic growth in Saudi Arabia by examining the intertemporal interactions among the growth rate in per capita real GDP and the share of government spending in GDP. The empirical analysis found no consistent evidence that government spending can increase Saudi Arabia’s per capita output growth. Nur Hayati Abd Rahman (2012) investigated the relationship between budget deficit and economic growth from Malaysia’s perspective by using quarterly data from 2000 to 2011. It was found that there is no long-run relationship between budget deficit and economic growth of Malaysia, consistent with the Ricardian equivalence hypothesis. L.A.V. Catao and M. E. Terrones (2005) showed a strong positive association between deficits and inflation among high-inflation and developing country groups, but not among low-inflation advanced economies by using the data from 107 countries over 1960–2001. Sanjeev Gupta et al. (2005) assessed the effects of fiscal consolidation and expenditure composition on economic growth in a sample of 39 low-income countries during the 1990s. The paper found that strong budgetary positions are generally associated with higher economic growth in both the short and long terms. Richard J. Cebula (1995) examined the impact on per capita real economic growth in the United States of federal budget deficits with quarterly data over the 1955-1992 periods. The empirical findings indicated that federal budget deficits, over time, reduce the rate of economic growth. Brender and Drazen(2008) found that high budget deficit recorded by a country will give negative signals to the citizens that the government authorities did not perform well in managing the funds of a country . As a result, there is a probability of re-election process to be conducted in order to replace the authorities. Indirectly, the authorities who did not perform well may not be able to bring the country to the upper level. Hence, it will not contribute to high economic growth due to lack of confidence among citizens, investors and other neighboring countries. Tan (2006) examined both the long and short run relationship between fiscal deficit, inflation and economic growth in Malaysian economy during 1966-2003. They found the absence of long run relationship among these variables and also found that fiscal deficits appeared to have neither long nor short run links with income. Eisner and Pieper (1987) reported a positive impact of cyclically and inflation-adjusted budget deficits on economic growth in the United States and other Organization for Economic Cooperation and development (OECD) countries. The negative impact of fiscal deficits on long-run growth has been empirically documented in several studies,

such as Fischer (1993), Easterly and Rebelo (1993), Easterly, Rodriguez, and Schmidt-Hebbel (1994), Bleaney, Gemmell, and Kneller (2001). Fisher (1993) found that larger budget surpluses were strongly associated with more rapid growth through greater capital accumulation and greater productivity. Easterly and Rebelo (1992) also found a consistent negative relation. III. Research Questions

� Does fiscal deficit affect gross domestic product (GDP) of the Indian economy?

� Does it significantly affect the growth of Indian economy in the long run?

� Is there any short run relationship between fiscal deficit and GDP in India?

III.1 Objectives � To investigate the long run relationship between fiscal deficit and economic growth in

Indian economy � To examine the short run relationship between fiscal deficit and economic growth in

Indian economy III.2 Data Source and Methodology The study is entirely based on secondary data. The objectives of the study are examined by using time series data covering period from 1970-71 to 2011-12. Relevant data for the study are obtained from Data Base on Indian Economy from Reserve Bank of India. All variables are in 2004-05 bases and measured in real terms by using GDP deflator. All variables are converted to natural log. This study has examined the empirical relationship between fiscal deficit and economic growth in India by using three periods i.e. 1970-71 to 2011-12, 1970-1991 and 1992-2011 for more clarification.

The objectives of the study are being examined by using Unit root test (ADF and PP test), Johansen Cointegration Test, Granger Causality test, And Vector Error correction Model technique.

III.3 Econometric Specification The study has used the following specifications in order to evaluate the effects of fiscal deficit on economic growth. The following mathematical models are used for analysis. GDP = ƒ (FISDEF, GDCF, EMPLM) -------------------------------------------------- eqn -1 The estimated Long run model is of the following form ∆LGDP = β1 + β2 LFISDEFt + β3 LGDCFt + β4 LEMPLMt + µ1 …………………..eqn-2 The estimated Vector Error Correction Model (VECM) is of the following form ∆LGDPt = α1 + α2 ∆LFISDEFt-1+ α3 ∆LGDCFt-1 + α4 ∆ LEMPLMt-1 + ECMt-1+ εt ..eqn-3 Where, LGDP = Log of gross domestic product at factor cost proxy for economic growth LFISDEF = Log of fiscal deficit held by the central government LGDCF= Log of gross domestic capital formation LEMPLM= Log of employment in the public and organized private sectors µ and ε = Error term ∆= the first difference operator α1, and β1 are intercepts, α2, α3, α4, β2, β3 and β4 are coefficients and µ and ε are error terms of the estimated equations.

IV. Empirical Analysis: IV.1 Testing for Unit Roots (ADF and PP) In order to investigate the order of integration among the variables such as LGDP, LFISDEF, LGDCF and LEMPLM, the study has used the Augmented Dickey Fuller (ADF) and Phillips Perron (PP) tests. As per the above methodology, the tools of unit root tests ADF and PP tests are tested for all the variables by taking null hypothesis as ‘presence of unit root’ (i.e. presence of non-sationarity) against the alternative hypothesis ‘series is stationary’. If the absolute computed value exceeds the absolute critical value, then we reject the null hypothesis and conclude that series is stationary and vice-versa. It is clear from Table-1 and Table-2 that the null hypothesis of no unit roots for all the time series are rejected at their first differences since the ADF and PP test statistic values are less than the critical values at one percent levels of significances. Thus, these variables are stationary and integrated of same order, i.e., I (1). Thus it is cleared that all the variables have unit root in their level form but at first difference the variables became stationary.

Table -1 (ADF Test) Variables

Level First Difference Constant Constant&

trend Constant Constant&

trend LGDP 3.6527

(1.0000) -1.3720 (0.8549)

-5.8904 (0.0000)

-8.0161 (0.0000)

LFISDEF -0.9248 (0.7702)

-2.8393 (0.1926)

-6.7666 (0.0000)

-6.6726 (0.0000)

LGDCF 1.1169 (0.9970)

-1.7428 (0.7137)

-7.4584 (0.0000)

-7.9657 (0.0000)

LEMPLM -2.7165 (0.0801)

-2.2685 (0.4401)

-4.4364 (0.0010)

-4.9184 (0.0015)

Note- Brackets show MacKinnon (1996) one-sided p- values.

Table - 2 (PP Test) Variables

Level First Difference Constant Constant&

trend Constant Constant&

trend LGDP 4.8045

(1.0000) -1.3720 (0.8544)

-5.9294 (0.0000)

-10.5432 (0.0000)

LFISDEF -0.7090 (0.8332)

-2.7293 (0.2309)

-7.5895 (0.0000)

-7.4585 (0.0000)

LGDCF -3.2241 (1.0000)

-1.4849 (0.8187)

-7.4549 (0.0000)

-11.5130 (0.0000)

LEMPLM -4.0767 (0.0028)

-2.4745 (0.3384)

-4.5275 (0.0008)

-5.0583 (0.0010)

Note- Brackets show MacKinnon (1996) one-sided p- values.

IV.2 Johansen Cointegration Test

In case of non stationary data it is quite possible that there is a linear combination of integrated variables that is stationary; such variables are said to be cointegrated. To understand the cointegrating relationship across these variables the study uses Johansen (1991) Cointegration Test. The Akaike information criterion (AIC), Schwarz information criterion (SBC), Final prediction error (FPE), Hannan-Quinn information criterion (HQ) and the likelihood ratio (LR) test collectively suggest an optimal lag length of one and the cointegration results are provided in Table-3.

Table - 3 (Cointegration tests based on Johansen’s Maximum Likelihood Method) LGDP = f(LFISDEF LGDCF LEMPLM )

No. of CE(s)

Eigen value Trace

statistics

0.05 Critical Value

Max-Eigen Statistics

0.05 Critical value

None* 0.562798 61.27835 47.85613 33.09440 27.58434 At most 1 0.357844 28.18395 29.79707 17.71699 21.13162 At most 2 0.181469 10.46696 15.49471 8.009774 14.26460 At most 3 0.059581 2.457187 3.841466 2.457187 3.841466

Trace test and Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level Both the trace statistics and max- eigen statistics rejected the null hypothesis of no cointegration at the 0.05 level (61.27835 > 47.85613 and 33.09440 > 27.58434). But the null hypothesis of one cointegration among the variables is not rejected at the 0.05 level (28.18395 < 29.79707 and 17.71699 < 21.13162) by both the trace statistics and max- eigen statistics respectievely. Hence, the johansen methodology concludes there exist one cointegrating relationship among lGDP, lfisdef, lgfcf and lemplm. So, estimation of VECM model is required in this context. IV.3 Estimated long run relationship The presence of cointegration between variables suggests a long run relationship among the variables under consideration. The long run relationship between GDP, FISDEF, GDCF and EMPLM for one cointegrating vector for the India in the period 1970-71 to 2011-12 is shown in the Table no-4. For better understanding the relationship between GDP and FISDEF the study has estimated the VEC model for the period of 1970-2011, 1970-1991 and 1992- 2011 separately. The justification for this is to examine whether pre-reform period fiscal deficit or post- reform period fiscal deficit has more impact on GDP. When the variables are in logarithms and one cointegrating vector is estimated, the coefficients can be interpreted as long run elasticities. The Table no-4 shows all the coefficients are highly significant at 1% level for whole period and sub-period (1992-2011).

Table -4 Result for the Estimated Long Run Coefficient Dependent Variable LGDP

Whole Period (1970-2011)

Sub Period (1970-1991)

Sub Period (1992-2011)

Regressor Coefficient Coefficient Coefficient LFISDEF -0.216537*

(0.08299) [-2.60922]

-0.014488 (0.15620) [-0.09275]

-0.415029* (0.05101) [-8.13650]

LGDCF -0.565562* (0.04042) [-13.9934]

-0.862909* (0.20960) [-4.11694]

-0.424624* (0.03356) [-12.6530]

LEMPLM 1.098850* (0.36084) [ 3.04527]

0.724290 (0.77714) [ 0.93199]

1.464168* (0.41613) [ 3.51850]

C 0.569570 0.290997 1.918147 Note : Standard errors in ( ) & t-statistics in [ ], * indicates 1% level of significance During the long run period (1970-2011), one percent increase in Fiscal deficit is likely to decrease gross domestic product by 0.216537 percent and this estimate is significant at 1% level. Thus, it shows there is negative and significant relationship between fiscal deficit and gross domestic product. In india, high fiscal deficit is detrimental for the growth of the economy. Similarly, there is positive and significant relationship exist between employment in the public and organsied private sector and GDP (1.098%) and gross domestic capital formation has negative and significant effect on GDP. Between periods 1970-1991 there is negative relationship between fiscal deficit and GDP but it is insignificant. But GDCF is highly significant and negatively affect GDP. In case of employment the impact is insignificant. But one interesting result has come out, when the study examined the periods of 1992-2011 particularly after reform of the economy. At that time the negative impact of fiscal deficit is more on GDP than the previous period. It reflects one percent increase in Fiscal deficit is likely to decrease gross domestic product by 0.415209 percent and is highly significant. For 1% increase in employment in the public and organsied private sector, GDP is increased by 1.46416% and for 1% increase in gross domestic capital formation; it reduces GDP by 0.4246%. These coefficients are significant at 1% level. So the cointegartion result shows there is long run relationship among these variables and fiscal deficit has negative impact on economic growth of the economy. IV.4 Estimated Short run Co-efficient Results Based on Error Correction Model The estimates of the error correction model based on the associated long-run estimates are shown in Table-5.

Table-5 Error Correction Representation Dependent Variable LGDP Whole Period

(1970-2011) Sub Period (1970-1991)

Sub Period (1992-2011)

Regressor Coefficient Coefficient Coefficient C 0.066486

(0.0000) 0.072648 (0.0001)

0.055206 (0.0047)

D(LGDP) -0.161164 (0.4764)

-0.265224 (0.3505)

0.041720 (0.8916)

D(LFISDEF) -0.001185 (0.9551)

-0.060987 (0.2097)

0.010631 (0.5169)

D(LGDCF) 0.022668 (0.6691)

-0.000272 (0.9976)

0.076441 (0.1408)

D(LEMPLM) -0.433276 (0.2633)

-0.722577 (0.2230)

0.509278 (0.1293)

ECM t-1 0.076875 (0.1189)

0.135976 (0.2053)

-0.029381 (0.6613)

Normality Test: 3.106209 (0.211590)

1.278019 (0.527815)

0.737010 (0.691768)

Serial Correlation LM Test: 0.788124 (0.6743)

5.282286 (0.0713)

0.220909 (0.6383)

Heteroskedasticity Test: 12.65802 (0.1242)

10.57262 (0.2271)

4.822454 (0.7764)

Note : p values in ( ) All the variables are statistically insignificant. Apart from that, the coefficient of the error correction term is insignificant. So it does not respond to the previous period disequilibrium in the model. However, the result of this error correction model is reliable since it passes all diagnostic tests. Statistically, the model itself is highly significant based on the probability of the F-statistic. Only for the period 1992-2011 the coefficient of the error correction term has correct sign, but it is insignificant. This implies the absence of short run relationship among the variables. IV.5 Granger Causality Tests: It is evident from the Table no-6 that fiscal deficit doesn’t granger cause GDP and also GDP doesnot granger cause fiscal deficit because it cannot reject null hypothesis in both the context. So it shows the absence of any short run relationship between these two variables.

Table-6 Granger Causality Tests result Null Hypothesis F-Stat Prob. conclusion

DLGDP does not Granger Cause DLEMPLM 0.23879 0.6280 Do not reject DLEMPLM does not Granger Cause DLGDP 10.2165 0.0028 Reject DLFISDEF does not Granger Cause DLEMPLM 0.77192 0.3853 Do not reject DLEMPLM does not Granger Cause DLFISDEF 0.73799 0.3958 Do not reject

DLGDCF does not Granger Cause DLEMPLM 0.02745 0.8693 Do not reject DLEMPLM does not Granger Cause DLGDCF 2.70721 0.1084 Do not reject

DLFISDEF does not Granger Cause DLGDP 0.60361 0.4421 Do not reject DLGDP does not Granger Cause DLFISDEF 0.73920 0.3955 Do not reject

DLGDCF does not Granger Cause DLGDP 0.00042 0.9837 Do not reject DLGDP does not Granger Cause DLGDCF 1.58784 0.2155 Do not reject

DLGDCF does not Granger Cause DLFISDEF 0.06277 0.8036 Do not reject DLFISDEF does not Granger Cause DLGDCF 0.00530 0.9423 Do not reject

5. Conclusion and Policy Implications The Johansen methodology concludes there exist one cointegrating relationship among LGDP, LFISDEF, LGDCF and LEMPLM. Hence, it reflects there is long run relationship between GDP and the selected variables. The finding of the paper indicates that there is negative and significant relationship between fiscal deficit and economic growth in the long run. One percent increase in Fiscal deficit is likely to decrease gross domestic product by 0.216537 percent and this estimate is significant at 1% level. But the Vector Error Correction model and Granger Causality test discards the short run relationship between fiscal deficit and economic growth. The findings of study also reveal that the negative impact of post- reform fiscal deficit on economic growth is more than the impact of pre-reform’s fiscal deficit. One percent increase in Fiscal deficit is likely to decrease gross domestic product by 0.415209 percent and is highly significant in period 1992-2011, whereas during 1970-1991 it is likely to reduce 0.014488, but it is insignificant. In India, high fiscal deficit is detrimental for the growth of the economy. This is contrary to Keynesian theory, but in conformity with Neo-classical theory, which holds that fiscal deficits lead to a fall in the Gross Domestic Product.

The resources so acquired should be invested in self-liquidating and profitable ventures. The study suggests the reduction of subsidies and invests this money in health, education, infrastructure sectors such as power and roads etc., so that it will enhance the productivity of both human capital and physical capital, which will go a long way in increasing the percapita income of the people.

References

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Appendix Table 7 VEC model estimates (1970-2011) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM)

Error Correction: D(LGDP) D(LFISDEF) D(LGDCF) D(LEMPLM) CointEq1 0.076875 0.345915 0.107785 -0.068481 (0.04806) (0.39690) (0.17187) (0.02219) [ 1.59961] [ 0.87155] [ 0.62712] [-3.08633]

D(LGDP(-1)) -0.161164 0.252735 0.390752 0.178710 (0.22383) (1.84848) (0.80047) (0.10334) [-0.72004] [ 0.13673] [ 0.48816] [ 1.72934]

D(LFISDEF(-1)) -0.001185 -0.213133 0.019091 -0.010300 (0.02091) (0.17271) (0.07479) (0.00966) [-0.05669] [-1.23408] [ 0.25527] [-1.06683]

D(LGDCF(-1)) 0.022668 -0.191571 -0.246715 -0.015943 (0.05259) (0.43428) (0.18806) (0.02428) [ 0.43108] [-0.44112] [-1.31189] [-0.65666]

D(LEMPLM(-1)) -0.433276 3.801064 -1.087861 0.057397 (0.38091) (3.14575) (1.36223) (0.17586) [-1.13748] [ 1.20832] [-0.79859] [ 0.32637]

C 0.066486 0.035407 0.079967 0.002967 (0.00999) (0.08248) (0.03572) (0.00461) [ 6.65684] [ 0.42926] [ 2.23881] [ 0.64332] Standard errors in ( ) & t-statistics in [ ]

Table-8 VEC model estimates (1970-1991) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM) Error Correction: D(LGDP) D(LFISDEF) D(LGDCF) D(LEMPLM)

CointEq1 0.135976 0.237359 0.797706 -0.035007 (0.10235) (0.68217) (0.34489) (0.04950) [ 1.32848] [ 0.34795] [ 2.31291] [-0.70719]

D(LGDP(-1)) -0.265224 1.104059 -0.774053 0.095728 (0.27460) (1.83011) (0.92527) (0.13280) [-0.96587] [ 0.60327] [-0.83657] [ 0.72083]

D(LFISDEF(-1)) -0.060987 -0.426067 -0.187227 -0.023505 (0.04638) (0.30911) (0.15628) (0.02243) [-1.31492] [-1.37835] [-1.19799] [-1.04787]

D(LGDCF(-1)) -0.000272 -0.576292 -0.144962 -0.046036 (0.08700) (0.57982) (0.29315) (0.04207) [-0.00313] [-0.99391] [-0.49450] [-1.09415]

D(LEMPLM(-1)) -0.722577 2.120709 1.320524 -0.018593 (0.56662) (3.77637) (1.90927) (0.27403) [-1.27524] [ 0.56157] [ 0.69164] [-0.06785]

C 0.072648 0.049779 0.077459 0.019838 (0.01286) (0.08570) (0.04333) (0.00622) [ 5.64975] [ 0.58086] [ 1.78773] [ 3.18999]

Standard errors in ( ) & t-statistics in [ ]

Table-9 VEC model estimates (1992-2011) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM) Error Correction: D(LGDP) D(LFISDEF) D(LGDCF) D(LEMPLM)

CointEq1 -0.029381 3.602680 -0.471595 -0.003013 (0.06564) (0.76507) (0.36808) (0.03973) [-0.44760] [ 4.70898] [-1.28123] [-0.07584]

D(LGDP(-1)) 0.041720 -9.113820 2.465831 0.048531 (0.30050) (3.50245) (1.68506) (0.18188) [ 0.13883] [-2.60213] [ 1.46335] [ 0.26683]

D(LFISDEF(-1)) 0.010631 0.319830 -0.008592 -0.000499 (0.01599) (0.18634) (0.08965) (0.00968) [ 0.66495] [ 1.71638] [-0.09584] [-0.05159]

D(LGDCF(-1)) 0.076441 0.986645 -0.397739 0.049365 (0.04896) (0.57065) (0.27455) (0.02963) [ 1.56127] [ 1.72897] [-1.44872] [ 1.66584]

D(LEMPLM(-1)) 0.509278 4.515538 -1.954957 0.664023 (0.31592) (3.68219) (1.77153) (0.19121) [ 1.61203] [ 1.22632] [-1.10354] [ 3.47270]

C 0.055206 0.543301 -0.022039 -0.005960 (0.01646) (0.19181) (0.09228) (0.00996) [ 3.35458] [ 2.83249] [-0.23883] [-0.59837]

Standard errors in ( ) & t-statistics in [ ]