The Empirical Analysis Of Relation Between Fiscal Deficit

Published Date: 02 Nov 2017

A project submitted in the partial fulfillment of requirement for award of the degree in Master of Business Administration

Under the guidance of:

Dr. MONICA SINGHANIA

Submitted by:

Rachit Kwatra

MBA (FT) | F – 39

Area Code: FIN

FACULTY OF MANAGEMENT STUDIES

UNIVERSITY OF DELHI

MARCH 2013

Certificate

This is to certify that the project titled "Empirical analysis of relation between fiscal deficit and inflation, government expenditure and money flow in the Indian economy", submitted in the partial fulfillment of requirement for award of the degree in Master of Business Administration at the Faculty of Management Studies, University of Delhi is the student’s bona-fide work. Any material borrowed or referred to is duly acknowledged.

Signed & Dated

Signed & Dated

Name of Student

Name of Supervisor

Acknowledgement

I would hereby like to thank my guide Dr. Monica Singhania for her constant help and support in completing this project. Pursuing a project in such a vast and dynamic field would not have been possible without her encouragement and guidance.

Apart from the project work, I also owe my gratitude to Dr. Monica Singhania for being a faculty member who has always laid strong emphasis on creative thinking and always been there for her students whenever they needed her support and guidance.

I would also like to thanks the entire faculty at FMS, Delhi for providing me with a very enriching and fruitful stint which has gone a long way in making me realize my potential and interests. Last but not the least, I would also like to thanks my colleagues and staff at the library and the computer center for extending full support and cooperation at every stage of the project.

I have learnt from several articles, research studies and papers from national and international entities. I acknowledge the value I have received from these bodies of knowledge.

Rachit Kwatra

Roll number – 39

MBA (FT) | 2011-2013

Faculty of Management Studies

University of Delhi

March 2013

Contents

Executive Summary

There has been widespread debate about the relation between fiscal deficit and inflation in the past and researches have been conducted on the same. However, while researches have differed on the results that have been obtained, it has been generally agreed that research on the topic needs to continue primarily because of the importance factors like inflation and particularly gross fiscal deficit hold for the national economy.

Though a large fiscal deficit by itself is not bad, it can affect the country’s economic growth adversely. A large fiscal deficit implies high government borrowing and high debt servicing which in turn could mean a cut back in spending on critical 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 (impacting exports). 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. The present disquiet in India about the rising fiscal deficit is justified. Given that high deficits have an adverse impact on India’s growth, it is imperative that the government draw up a clear roadmap to reduce fiscal deficits if it wants the economy to return to 9 per cent growth path as it says it does. What needs to be done is restructuring of public expenditure. Merely meeting targets stipulated in the FRBM Act through clever accounting practices such as the transfer of massive subsidies to oil marketing and fertilizer companies as off budget items will not do. Neither will measures like divestment to finance the fiscal deficit.

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.

The basic gap in understanding till date has been the fact that most research papers prefer to focus solely on inflation without giving a thought to other factors like government expenditure and money flow in the economy before finding a dependency relationship. Hence, while a relation between inflation and gross fiscal deficit, which is already proved theoretically, becomes obvious via empirical analysis, what is not considered is whether inflation in the first place is a very big determinant of the gross fiscal deficit.

This dissertation tries to bridge that gap by including two more important factors namely money flow in the economy and the government expenditure. The paper analyzes the relationship via a simple regression model and subsequent improvements on that model to minimize the error term and improve the accuracy. At the same time, tests are conducted as to the validity of the improvements made via some augmented unit root tests.

Introduction

Aim of the Research

The main aim of this research is to conduct an empirical analysis of the relationship between fiscal deficit and inflation, government expenditure and money flow in the Indian economy.

Structure of the Report:

The entire report would be spread across the following headers:

Introduction

Historical Background

Literature Review

Research Design

Analysis & Findings

Summary & Recommendations

\

Historical Background

Inflation in India: An Overview

TABLE 240: CONSUMER PRICE INDEX - ANNUAL VARIATION

 

 

(Per cent)

 

 

 

 

 

 

 

 

 

 

 

 

Industrial Worker

 

 

(Base 1982=100)

 

 

 

 

Year/ Month

Apr.

May

Jun.

Jul.

Aug.

Sep.

Oct.

Nov.

Dec.

Jan.

Feb.

Mar.

1990-91

7.8

7.7

8.8

9.9

9.2

8.5

10.8

12.5

13.7

16.1

15.4

13.6

1991-92

12.2

12.1

13.0

13.2

14.2

15.7

14.4

13.6

13.1

12.9

13.4

13.9

1992-93

14.4

14.7

12.9

13.1

11.5

10.0

9.4

8.4

8.0

5.7

5.7

6.1

1993-94

6.1

5.1

5.9

4.5

5.8

6.6

7.4

8.6

8.6

9.1

9.5

9.9

1994-95

9.8

10.6

10.8

11.1

10.9

11.2

10.3

9.8

9.5

9.9

9.8

9.7

1995-96

9.7

10.3

10.5

11.4

10.9

10.1

10.4

10.3

9.7

9.0

8.6

8.9

1996-97

9.8

9.3

8.8

8.3

8.9

8.5

8.5

8.7

10.4

11.1

10.8

10.0

1997-98

9.3

7.3

6.6

5.6

4.7

4.9

5.5

4.9

6.3

9.7

9.1

8.3

1998-99

8.2

10.5

12.4

14.8

15.0

16.3

18.6

19.7

15.3

9.4

8.6

8.9

1999-00

8.4

7.7

5.3

3.2

3.1

2.1

0.9

0.0

0.5

2.6

3.6

4.8

2000-01

5.5

5.0

5.2

5.0

4.0

3.5

2.7

2.7

3.5

3.2

3.0

2.5

2001-02

2.3

2.5

3.4

4.0

5.2

4.7

4.2

4.9

5.2

4.9

5.2

5.2

2002-03

4.7

4.7

4.2

3.9

3.9

4.3

4.1

3.6

3.2

3.4

3.9

4.1

2003-04

5.1

4.7

4.4

4.2

3.1

2.9

3.3

3.1

3.7

4.3

4.1

3.5

2004-05

2.2

2.8

3.0

3.2

4.6

4.8

4.6

4.2

3.8

4.4

4.2

4.2

2005-06

5.0

3.7

3.3

4.1

3.4

3.6

4.2

5.3

5.6

 

 

 

Industrial Worker

 

 

(Base 2001=100)

 

 

 

 

Year/ Month

Apr.

May

Jun.

Jul.

Aug.

Sep.

Oct.

Nov.

Dec.

Jan.

Feb.

Mar.

2005-06

 

 

 

 

 

 

 

 

 

4.7

4.9

4.9

2006-07

5.0

6.3

7.7

6.7

6.3

6.8

7.3

6.3

6.9

6.7

7.6

6.7

2007-08

6.7

6.6

5.7

6.5

7.3

6.4

5.5

5.5

5.5

5.5

5.5

7.9

2008-09

7.8

7.8

7.7

8.3

9.0

9.8

10.4

10.4

9.7

10.4

9.6

8.0

2009-10

8.7

8.6

9.3

11.9

11.7

11.6

11.5

13.5

15.0

16.2

14.9

14.9

2010-11

13.3

13.9

13.7

11.3

9.9

9.8

9.7

8.3

9.5

9.3

8.8

8.8

2011-12

9.4

8.7

8.6

8.4

9.0

10.1

9.4

9.3

6.5

5.3

7.6

8.6

Evolution of India’s fiscal policy

India commenced on the path of planned development with the setting up of the Planning Commission in 1950. That was also the year when the country adopted a federal Constitution with strong unitary features giving the central government primacy in terms of planning for economic development. The subsequent planning process laid emphasis on strengthening public sector enterprises as a means to achieve economic growth and industrial development. The resulting economic framework imposed administrative controls on various industries and a system of licensing and quotas for private industries. Consequently, the main role of fiscal policy was to transfer private savings to cater to the growing consumption and investment needs of the public sector. Other goals included the reduction of income and wealth inequalities through taxes and transfers, encouraging balanced regional development, fostering small scale industries and sometimes influencing the trends in economic activities towards desired goals. The government authorized a comprehensive review of the tax system culminating in the Taxation Enquiry Commission Report of 1953. However, the government then invited the British economist Nicholas Kaldor to examine the possibility of reforming the tax system. Kaldor found the system inefficient and inequitable given the narrow tax base and inadequate reporting of property income and taxation. He also found the maximum marginal income tax rate at 92 percent to be too high and suggested it be reduced to 45 percent. In view of his recommendations, the government revived capital gains taxation, brought in a gift tax, a wealth tax and an expenditure tax (which was not continued due to administrative complexities). Despite Kaldor’s recommendations income and corporate taxes at the highest marginal rate continued to be extraordinarily high. In indirect taxes, a major component was the central excise duty. This was initially used to tax raw materials and intermediate goods and not final consumer goods. The tax also had a major cascading effect‟ since it was imposed not just on final consumer goods but also on inputs and capital goods. In effect, the tax on the input was again taxed at the next point of manufacture resulting in double taxation of the input. Considering that the states were separately imposing sales tax at the post-manufacturing wholesale and retail levels, this cascading impact was considerable.

The other main central indirect tax is the customs duty. Given that imports into India were restricted, this was not a very large source of revenue. The tariffs were high and differentiated. Items at later stages of production like finished goods were taxed at higher rates than those at earlier stages, like raw materials. Rates also differed on the basis of perceived income elasticities with necessities taxed at lower rates than luxury goods. In 1985-86 the government presented its Long-Term Fiscal Policy stressing on the need to reduce tariffs, have fewer rates and eventually remove quantitative limits on imports. While India’s external debt and expenditure patterns were heading for unsustainable levels, the proximate causes of the balance of payments crisis came from certain unforeseen external and domestic political events. The First Gulf War caused a spike in oil prices leading to a sharp increase in the government’s fuel subsidy burden. Furthermore, the assassination of former Prime Minister Rajiv Gandhi increased political uncertainties leading to the withdrawal of some foreign funds. The subsequent economic reforms changed the Indian economy forever.

Following the balance of payments crisis of 1991, the government commenced on a path of economic liberalization whereby the economy was opened up to foreign investment and trade, the private sector was encouraged and the system of quotas and licenses was dismantled. Fiscal policy was re-oriented to cohere with these changes. The Tax Reforms Committee provided a blue print for reforming both direct and indirect taxes. Its main strategy was to reduce the proportion of trade taxes in total tax revenue, increase the share of domestic consumption taxes by converting the excise into a VAT and enhance the contribution of direct taxes to total revenue. It recommended reducing the rates of all major taxes, minimizing exemptions and deductions, simplifying laws and procedures, improving tax administration and increasing computerization and information system modernization. As a part of the subsequent direct tax reforms, the personal income tax brackets were reduced to three with rates of 20, 30 and 40 percent in 1992-93. Financial assets were removed from the imposition of wealth tax and the maximum rate of wealth tax was reduced to 1 percent. Personal income tax rates were reduced again to 10, 20, and 30 percent in 1997-98. The rates have largely remained the same since with the exemption limit being increased and slab structure raised from time to time. A subsequent 2 percent surcharge to fund education was later made applicable to all taxes. The basic corporate tax rate was reduced to 50 percent and the rates for different closely held companies made uniform at 55 percent. In 1993-94, the distinction between the closely held and the widely held companies was removed and the uniform tax rate was brought down to 40 percent. The rate was further reduced to 35 percent with a 10 percent tax on distributed dividends in 1997-98. The global financial crisis that erupted around September 2008 saw Indian fiscal policy being tested to its limits. The policymakers had to grapple with the impact of the crisis that was affecting the Indian economy through three channels; contagion risks to the financial sector; the negative impact on exports; and the effect on exchange rates. Somewhat serendipitously, the government already had an expansionary fiscal stance in view of a rural farm loan waiver scheme, the expansion of social security schemes under the National Rural Employment Guarantee Act (NREGA) and the implementation of revised salaries and compensations for the central public servants as per the recommendations of the Sixth Pay Commission. Furthermore, the parliamentary elections of 2008 also resulted in further government expenditures.

Looking ahead, the government would probably focus on reforms on both the tax and expenditure fronts. With regard to tax policy, changes can be expected in terms of legislation as well as administrative reforms to improve efficiency. The main legislative proposals are the DTC and the GST both of which are in various stages of legislative consultation. The DTC seeks to simplify the tax code, revamp the system of tax deductions and remove ambiguities of law. The GST aims at bringing a fairly unified system of input tax credits across the value chain and at an interstate level. Currently the central excise and service taxes have limited credit facilities up to the manufacturing stage. The state VAT is not geared to provide interstate input tax credits. It is proposed to institute a dual GST structure with separate central and state GSTs. This would require a constitutional amendment to allow both the central and state governments to have concurrent jurisdiction over the entire value chain. Interstate GST credit and full credit for the central GST is envisaged. This would also require an advanced information technology (IT) infrastructure (Empowered Committee, 2009). IT is also likely to be further leveraged for improving the direct tax administration. Moves in this direction include increasing the number of Centralized Processing Centers (CPCs) that carry out bulk processing functions from one to four. The number of taxpayer help centers and web-based taxpayer interface facilities are also to be increased substantially.

CENTRE’S GROSS FISCAL DEFICIT AND ITS FINANCING

(Rupees Billion)

 

 

 

Year

GFD receipts

GFD expenditure

Gross fiscal deficit

1980-81

123.73

206.72

82.99

1981-82

150.16

236.82

86.66

1982-83

174.34

280.61

106.27

1983-84

197.11

327.41

130.30

1984-85

234.66

408.82

174.16

1985-86

280.35

498.93

218.58

1986-87

330.83

594.25

263.42

1987-88

370.37

640.81

270.44

1988-89

435.91

745.14

309.23

1989-90

522.96

879.28

356.32

1990-91

549.54

995.86

446.32

1991-92

690.69

1053.94

363.25

1992-93

760.89

1162.62

401.73

1993-94

754.05

1356.62

602.57

1994-95

966.91

1543.94

577.03

1995-96

1115.27

1717.70

602.43

1996-97

1267.34

1934.68

667.33

1997-98

1347.98

2237.35

889.37

1998-99

1553.59

2687.07

1133.49

1999-00

1832.06

2879.22

1047.16

2000-01

1947.30

3135.46

1188.16

2001-02

2049.52

3459.07

1409.55

2002-03

2339.85

3790.57

1450.72

2003-04

2807.65

4040.38

1232.73

2004-05

3104.15

4362.09

1257.94

2005-06

3486.58

4950.93

1464.35

2006-07

4349.21

5774.94

1425.73

2007-08

5806.59

7075.71

1269.12

2008-09

5408.25

8778.17

3369.92

2009-10

5973.92

10158.74

4184.82

2010-11

8113.17

11849.08

3735.91

2011-12

7824.82

13044.62

5219.80

2012-13

9656.85

14792.75

5135.90

Notes : 1) Data for 2011-12 are Revised Estimates and data for 2012-13 are Budget Estimates.

2) GFD Receipts includes revenue receipts and disinvestments proceeds from 1991-92 onwards and only revenue receipts for all other years.

3) GFD Expenditure includes revenue expenditure, capital outlay and loans and advances net of recoveries.

4) Drawdown of Cash Balances represent variation in ad hoc treasury bills issued net of changes in cash balances with RBI up to March 31,1997.

5) Market Borrowing include dated securities and 364-day treasury bills.

6) Other borrowings comprise small savings, state provident fund, special deposits, reserve funds, treasury bills excluding 364-day treasury bills, etc.

7) Market Borrowings from year 2004 - 05 to 2010-11 is exclusive of amount raised under Market Stabilisation Scheme.

Source: Budget documents of the Government of India.

Literature Review

Govt. deficit and the inflationary process in Nigeria, 1986-88, Usman Moses Okpanachi

The basic purpose of this paper was to investigate the relationship between government deficit and inflation in Nigeria. The objectives include determining the nature and direction of the causality, inherent factors involved in inflation, how deficit plays a role in those factors and affects inflation as a whole, etc. The techniques that have been used in this paper are both qualitative and quantitative in nature. The statistical analysis has been carried out with the help of tools like macro econometric model, charts, ratios, growth rates, etc. The creation of the model was done with the help of the Two-Stage Least Squares Method (2SLS). The causality found with this method was found to be two-way in nature.

There is a very strong relation between fiscal operations and the macro-economy in Nigeria. The major reason if the central control of the govt. in all economic activities. The process of deregulation only began in 1986 with the introduction of the Structural Adjustment Programme. Before that, most of the sectors were under the control of the Nigerian government. A few sectors, like energy and communication, were under the total control of the government. This ensured that the government was the major driver of all economic growth in the country. As a result, the fiscal actions of the government determined to a large extent the movement of the rest of the economy. The private sector, albeit limited, did exist and based most of its activities on the consequences of the budget. While the central control has had its positive effects, it has also been a bugbear, so to say. Using siegniorage to finance domestic deficits and unchecked monetization of oil wells has made the economy susceptible to monetary imbalance. This has led to a self-perpetuating inflation with deficits providing the buffers.

The association between the deficits and the changes in money supply due to the over-reliance on the banking system by the government for financing forms the crux of the relation between deficit and inflation in Nigeria. Inflation was directly influenced by deficits because of the reliance on the banks by the government to create money to bridge the deficits.

The paper was divided into 6 sections. The first section provided a historical background to the relation, basis of the study, research problem that was encountered and the objectives that the paper hoped to achieve. There was also a brief explanation about the methodology involved in the process. The next section was focused on reviewing the existing literature in the field. It tried to explore a wide variety of papers to explore all the different theories and hypothesis put forward over time and finds a relation which could be used to its advantage. There was also an emphasis on reviewing papers across all levels of relation between inflation and fiscal deficit, moderate, heavy and light. The salient features of this section were:

Any kind of financing to cover deficit will eventually lead to a rise in the monetary supply in the market without any consideration of the sources of financing

Rise in money supply is directly linked to high inflation, which is a characteristic of the situation in Nigeria

There is no simple relationship between deficit and any of the macroeconomic variables like balance of payments, consumption, etc. In a similar way, the effect of continuous fiscal deficits on economic variables varies across countries and no uniform trend is observed ever. Even if consequences may tend to be same somewhere, the magnitude and severity may vary.

Deficits have very high tendency of crowding out private expenditures directly, or indirectly through higher interest rates.

Money supply and prices sometimes display a bilateral (two way) relationship with government deficits providing the link between the two, a situation that triggers a self generating inflation process.

Section 3 presents a detailed description of the model and the estimation technique. The model of the study is a simultaneous equation model including four behavioral equations explaining respectively, the domestic price, government expenditure, government revenue and money supply; and two identities, namely government domestic deficit and the condition of budget balance. This model brings out the interrelationships between macroeconomic variables, and captures the relevant transmission mechanism of a bilateral relationship between money and prices.

Section 4 provides a descriptive examination of the relationship between deficit and inflation using percentages, ratios and charts. It is evident from this section that the deficits of the government were partly responsible for the inflationary pressures on the economy through their effects on money supply. Causality between the two variables was examined. It was found that there existed a feedback relationship running from money to prices during the period under consideration, a situation that predisposed the economy to a self-generating inflationary process. Inflation resulted in a widening of government deficits, which when financed by money creation (as was predominantly the case) caused further expansion of money supply and further inflation. This chapter also examines the deficit financing options that were available to the government, and noted the preference (dominance) for money financing as against debt financing during the period under study.

The paper concluded that as a first step, the government needs to reassert control over expenditures. This is particularly necessary in view of the constraints on alternative sources of financing deficits in Nigeria. Given the magnitude of the deficits in recent years, to bring the budget into balance, government might have to cut expenditure by nearly a half. This may not be practically feasible. The way out is that revenue generation must improve as well. Tax laws are supposed to be reviewed from time to time in order to bring them in line with changing macroeconomic and social conditions. In a democratic setting, the national assembly is usually responsible for such reviews. Delays in reviewing tax laws result in revenue loss. Equally crucial is the issue of prompt collection of revenues. Real tax revenues tend to fall due to collection lags especially at times of rising prices.

2. An empirical analysis of fiscal imbalances and inflation in Pakistan, Asif Idrees Agha and Muhammad Saleem Khan

This research looks at the relationship between fiscal indicators and inflation in Pakistan using annual data from 1973 to 2003. In the long-run inflation is not only related to fiscal imbalances but also to the sources of financing fiscal deficit. This has been arrived at via the results of the Johansen co-integration test.

There is a well established relationship between inflation and monetary expansion. This relationship applies to Pakistan as much as to other countries. In fact, growth of money supply can be used to map can be used to map rise in general price level. Fiscal deficit is also supposed to have played a major role in price variations in Pakistan. Particularly, developments in the real sector, creation of money and the fiscal and external sector are the drivers of the price fluctuations in Pakistan. This paper tries to determine that relation. It also propounds that even in countries where fiscal policy is not so dominant; the relation between deficit and inflation can be easily established.

There has been a great deal of discussion in the macroeconomic literature about the effects that a country’s rate of long-run economic growth may have on inflation and vice versa. One can say on the basis of the famous Philips Curve relationship that countries that on average have higher rates of economic growth or lower unemployment have higher rates of inflation. A first look at the data suggests that it may be very difficult to find empirical evidence that growth does impact inflation. On this basis, it would be difficult to argue that there exists any systematic relationship between inflation and growth, either positive or negative.

It has been established by this paper that in Pakistan, inflation is mainly attributable to very high fiscal deficit. The general price level is affected by financing of deficit through the banks from printing of new money and creating interest-bearing debt. This holds a number of implications for the conduct of monetary as well as fiscal policy. Fiscal issues would generally make more problematic the conduct of monetary policy because there will always be a pressure to finance government deficits on the central banks. A discretionary policy of financing deficit creates problems for the implementation of monetary policy. For government financing of its fiscal deficit, rule based policy should be defined. It is evident that higher output growth is positively related to the increase in general price level. Since, the first and the foremost objective of monetary policy is to achieve price stability, there is potential for conflict between the monetary and fiscal policy. Whereas, current fiscal policy stance has been explicitly tilted towards achieving higher economic growth, therefore, it is expected that expansionary fiscal policy stance would result in higher interest rates, crowding out of private investment, which would likely promote inflationary pressures. Inflationary financing of the deficit is likely to pose a threat in conducting monetary policy. In this scenario, a better management of fiscal sector would be helpful in achieving apparently divergent objectives. The objective of government financing of fiscal deficit takes into account elements of cost and risk. Typically, government debt management aims primarily at minimizing the financial burden. However, choosing between various options to meet the government’s borrowing requirements, it is suggested that macroeconomic and monetary implications should also be considered and close coordination between fiscal and monetary authorities is required to achieve their objectives.

3. Budget deficit, inflation and debt sustainability: Evidence from Turkey, A. Cevdet, E.C. Alpher and S. Ozmucur

Turkey had embarked yet another disinflation and structural reform program in December 1999 that failed drastically after the two crises in November 2000 and February 2001. Prior to the crises, the government had been sending very dim fiscal signals, and even counter effective ones in the form of lack of commitment for durable fiscal measures and increased transparency in public accounts. These weak signals had led to the contention by the domestic and foreign holders of the government debt that the government would not be able to reduce real interest rates and hence the interest burden, and the fiscal credibility stood at an all time low since the initiation of the program in December 1999. Lackadaisical fiscal performance had prevailed for an extended time period, and the tolerance limits of the markets were being tested presumably without being too aware of it.

The empirical link from budget deficits to monetary expansion and then to inflation is usually weak, leading some people to hastily jump to the conclusion that deficits may indeed be less crucial than one may think in determining the course of inflation. These very same advocates of "inflationary processes detached from budget deficits" point to declining or intact seigniorage revenues, i.e., lack of monetization in the face of increasing budget deficits and provide that as further empirical support for their position.

The real sector will suffer the consequences of higher deficit policies financed by the issuing of bonds in the form of crowded out investment in plant and equipment, culminating in reduced output growth. With money supply intact and output falling, prices will start to increase. In the financial sector, on the other hand, innovations

in the form of new financial instruments are encouraged through high interest rates, and repos are typical examples of such innovations in chronic and high inflation countries. People are thus able to hold interest bearing assets that are almost as liquid as money, and monetization is effectively done by the private financial sector instead of the government. The final transmission mechanism leading to higher inflation now is based on expectations of higher future inflation. The impact of reduced seigniorage and increased borrowing increases the debt, implying that either the deficit will have to increase or that government will have to print money to keep the deficit/GDP ratio intact. If future deficits are to be avoided at some stage to ensure sustainability of the debt/GDP ratio, then monetization will have to be resorted to, and hence the expectation of higher future inflation. Thus the link between budget deficits and inflation is not very straightforward and high inflation equilibrium may very well be one of the equilibria corresponding to the same fundamentals. A proper analysis of the budget deficit money growth inflation link will have crucial policy implications. If inflation is found to be a "nominal" problem with a strong inertial component, then the costs of disinflation are presumably being overemphasized. An overwhelmingly nominal nature for inflation would legitimize the choice of a nominal anchor, inevitably the exchange rate in the case of Turkey. It goes without saying that the very same nature of inflation would make credibility an indispensable ingredient of any disinflation program.

Macroeconomic effects of budget deficits, their financing, and the ensuing debt dynamics have enjoyed substantial attention in macro theory recently, particularly in the light of different growth performances displayed by developing countries. The link from sound fiscal policies to macroeconomic stability and ultimately to sustainable growth is now fully recognized and a group of countries, most of which constitute the emerging markets segment of the world economy, spend all their efforts to put themselves on the sustainable growth path. The size of the budget deficit a country registers and the means of financing it determine the debt dynamics and the fiscal constraints the country will be subject to in the medium to long term.

Unstable debt dynamics have dire implications for budgetary policy. When the public perceives the unsustainability of fiscal policy, it will relinquish its holdings of government debt and necessitate a change in policy. The intention of the governments should be to pre-empt this and conduct a change of policy before the holders of debt impose the change on them. The Turkish Government has been taking fairly drastic measures in the first half of 2001 following the devaluation in February 2001, but how and if these will lead to a change in public’s expectations, still remains as a question. An inference of unsustainability would shift the market sentiment drastically towards a pessimistic outlook, and throw the economy into the bad equilibrium it tried to avoid in the first place. Intuitively, sustainability of a given fiscal policy will be determined by projections of the future path of debt/GNP ratio. It is ultimately the willingness and appetite of the creditors that will determine the sustainability of the ratio.

In this study, the authors have have looked at the conditions from which we could be drawing inferences regarding sustainability of fiscal stance on the one hand and a long-run relationship between inflation and budget deficits on the other. These issues have assumed even greater importance in the aftermath of the collapse of the stabilization program that had been designed to achieve sustainability in debt dynamics and produce a permanent reduction in inflation rates. The latter of these two goals would conceivably be achieved by dislodging the inertial component in the inflationary process, which was strictly conditional on success on the former goal.

The analysis of empirical findings indicates that the discounted debt to GNP ratio process during 1970-2000 is inherently non-stationary, implying an unsustainable fiscal outlook. Our findings do not point to insolvency at this point in time, but point to the necessity of a policy change towards fiscal austerity if insolvency is to be avoided in the medium to long term.

The second set of findings pertaining to the long-run relationship between the inflation rate, budget deficit, and real output growth suggests two important results. The first of these is that the consolidated budget deficit does not have a long-run component unlike the inflation rate, suggesting that changes in the consolidated budget deficit have no permanent effect on the inflation rate. On the other hand, the PSBR does have a long-run component and is co-integrated with the inflation rate. In non-technical terms, changes in the PSBR lead to permanent effects on the inflation rate. Hence, the PSBR should be deemed a better indicator of fiscal deficits in comparison to the consolidated budget deficit. Lack of accountability and transparency regarding that portion of the PSBR in excess of the consolidated budget deficit has been frequently referred to as endangering the medium to long-term fiscal sustainability. However, supportive empirical work has been lacking, and our intention was to contribute to the filling of this gap.

Research Design

The data to be used has been sourced from the RBI database, the Handbook of Statistics published by the Reserve Bank of India. The various entities that have been used for building the relations include – gross fiscal deficit as a measure of deficit, inflation via the use of the consumer price index, broad money (M3) to measure money supply and govt. expenditure through the total expenditure of the central government. The period under study begins from 1980-81 and continues till 2010-11, which amounts to a total of 32 observations in all. All the variables have been converted to their natural logarithms so that series become of less order and hence the fluctuations in the raw data are minimized to the maximum extent possible.

To perform the empirical analysis, a multiple regression model has been created with the help of Eviews software. The model is as follows:

C:\Users\Toshiba\Desktop\1.jpg

The regression equation so generated will be testing the following hypothesis:

Inflation increases gross fiscal deficit, i.e., beta(1) > 0

By a general observation, an increasing inflation will lead to a higher budget deficit due to the increase in the nominal interest rate. Nominal rate was postulated to be divided into real interest rate and expected interest rate by the Fischer effect. Nominal interest rate rises with rising inflation expectation. This in turn leads to an increase in the public debt. As is common, a big part of the expenditure of the govt. is the interest rate payments. If inflation leads to an increase in the interest rate, this consequently causes a rise in the interest payments as well as budget deficit by leading to an increase in the Debt/GDP ratio and thereby an increase in the fiscal deficit. There have been many other postulates regarding how inflation affects real budget deficit. Olivera-Tanzi effect is the most common one which uses lags in tax revenue collection to deteriorate real budget revenues.

Money supply decreases fiscal deficit i.e., beta(2)<0

The credibility of the monetary policy is an important determinant of the fiscal position in an economy. Any monetary policy which is credible enough is a sure indication of the independence of the central bank. This ensures, at least to a certain extent, that there is no monetization of the government debt. The first effect of the monetary policy on the fiscal situation is the revenue effect. If we consider the short run, a tight clenched monetary policy would lead to a lowering in the output and subsequently a reduction in the tax revenue collection. This would lead to a rise in the budget deficit. The second effect is the effect on the public debt. If the monetary policy is tight, it will lead to an increase in the interest rates therefore making it tougher to repay the debt. Overall, there are two main possibilities that can arise:

The public expects that the tight policy will be abandoned eventually because the monetary authority will fail to reach its inflation target.

Once the tight policy is announced, it will bring down inflation and inflation expectations

In the first case, a tight policy may lead to higher inflation and higher nominal rates. In the second case, the nominal interest rate is decreased by the expected reaction in inflation and the debt effect thus is not clear. The debt effect is a positive if the government is a net borrower and negative if the government is a net lender. The level of the public debt, maturity of government bonds, share of flexible interest rate on bonds and the sensitivity of various interest rates determines the magnitude of the debt effect.

The effect due to seigniorage is the third effect. A deceleration in the rate of money creation (through open market operations) leads to an increase in debt creation, resulting in higher budget deficits in subsequent periods.

Government expenditure increases fiscal deficit, i.e., beta(3)>0

In general, fiscal deficit will increase with increase in government expenditure (either because of operation of Wagner’s law or otherwise) if revenue is not generated in the same proportion. However, there are other reasons also due to which government expenditure can increase fiscal deficit even after raise in tax revenue. It has been found that in Latin American countries, due to deficient and inefficient social programs, budget deficit and public deficit increase even after rise in the tax revenue. Şen (2003) found that high inflation cause to decrease in tax revenue in crisis time and low level of tax revenue cause to tax loss which leads to high budget deficit. Egeli (2000) also stated that increasing public spending leads to increase in budget deficit. Egeli (2000) concluded that this disequilibrium results from governments’ wrong policies such as using borrowing in order to finance the deficit.

Data Analysis and Findings

We start off by taking a look at the descriptive statistics for each of the variables (in terms of Mean, Median, Standard Deviation, Coefficient of Variation, Skewness, Kurtosis, Jarque-Bera Statistics, etc.

Broad Money (M3)

CPI

Govt. Expenditure

Gross Fiscal Deficit

Mean

8.758669

7.25538

7.523147

7.471346

Median

8.773059

7.371545

7.545919

7.508219

Maximum

11.20609

8.386595

9.487002

9.476131

Minimum

6.323893

5.993961

5.427941

5.331365

Std. Dev.

1.486738

0.705531

1.174226

1.189971

Skewness

-0.002179

-0.212242

-0.102327

-0.09627

Kurtosis

1.81733

1.81564

1.98059

2.013989

Jarque-Bera

1.864971

2.110526

1.441441

1.345721

Probability

0.393574

0.348101

0.486402

0.510247

C.V.

0.169744741

0.0972425

0.156081757

0.159271301

Sum

280.2774

232.1721

240.7407

239.0831

Sum Sq. Dev.

68.52207

15.43099

42.74301

43.89694

Observations

32

32

32

32

From the above table it can be seen that the standard deviation of the money supply is highest at 1.486 while that of inflation is lowest at 0.705. Since Standard Deviation is not a good measure to measure fluctuations in the series therefore C.V. has been calculated which shows that the C.V. of money supply is highest (0.169) and that of fiscal deficit is second highest at 0.159. The lowest C.V. is found to be of inflation (Consumer Price Index) at 0.097.

Jarque-Bera statistics show that all variables have a lognormal distribution as data do not support to reject the null hypothesis that variables under consideration have followed normal distribution.

All the variables under consideration have a negative skew indicating that the mass of the distribution is concentrated on the right of the figure.

Now we will have a look at the results from the least square regression analysis.

Dependent Variable: GFD

 

 

 

 

Method: Least Squares

 

Date: 03/12/13 Time: 02:36

 

Sample: 1 32

 

Included observations: 32

 

 

 

 

 

 

 

 

Variable

Coefficient

Std. Error

t-Statistic

Prob.

 

 

 

 

 

C

-0.115608

0.254331

-0.454558

0.6529

BM

0.018867

0.059256

0.318402

0.7525

CPI

-0.007418

0.086329

-0.085922

0.9321

GEX

0.993669

0.081088

12.25419

0

 

 

 

 

 

 

 

 

 

 

R-squared

0.99933

Mean dependent var

 

7.471346

Adjusted R-squared

0.999258

S.D. dependent var

 

1.189971

S.E. of regression

0.032421

Akaike info criterion

 

-3.903565

Sum squared resid

0.029431

Schwarz criterion

 

-3.720348

Log likelihood

66.45705

Hannan-Quinn criter.

 

-3.842834

F-statistic

13911.52

Durbin-Watson stat

 

0.724169

Prob(F-statistic)

0

 

 

 

 

 

 

 

The results of the regression analysis presented above indicate that money supply (coefficient = 0.018) affects fiscal deficit positively, albeit in a weak manner. Inflation has an even weaker effect (coefficient = -0.007418) and a negative one at that. Contrary to the other two, fiscal deficit seems to be entirely driven by government expenditure with a coefficient of 0.993 in the regression equation. This indicates that fiscal deficit almost entirely moves along the lines of the government expenditure.

We now take a look at the actual, fitted and residual graphs and the fitted regression equation that has been generated

However, all of these results obtained above suffer from the problem of multi-co-linearity. To resolve this issue, various approaches were tried and eventually it was found out that the best results could be obtained by taking first difference of all variables and then performing regression, once with a constant and the next time without a constant.

We will now have a look at the regression results performed with taking first difference of variables but without using a constant

Dependent Variable: GFD_TD

 

 

 

 

Method: Least Squares

 

Sample: 1 31

 

Included observations: 31

 

 

 

 

 

 

 

 

Variable

Coefficient

Std. Error

t-Statistic

Prob.

 

 

 

 

 

GEX_TD

0.711123

0.097257

7.311821

0

BM_TD

0.254411

0.102909

2.472201

0.0198

CPI_TD

0.015289

0.147321

0.103784

0.9181

 

 

 

 

 

 

 

 

 

 

R-squared

0.742575

Mean dependent var

 

0.133702

Adjusted R-squared

0.724187

S.D. dependent var

 

0.045875

S.E. of regression

0.024092

Akaike info criterion

 

-4.522075

Sum squared resid

0.016252

Schwarz criterion

 

-4.383302

Log likelihood

73.09215

Hannan-Quinn criter.

 

-4.476838

Durbin-Watson stat

1.399262

 

 

 

 

 

 

 

 

Analyzing these results on the same parameters, we now find a considerable change in the results. All the three variables now affect the gross fiscal deficit positively. Government expenditure still continues to be a major driver of gross fiscal deficit with a coefficient of 0.711. However, the money flow is also a significant determinant of the fiscal deficit now with a coefficient of 0.254. Inflation continues to occupy a comparatively weaker position in determining fiscal deficit.

We now take a look at the graphs and the equation generated for regression with first difference of variables without a constant

Estimation Command:

=========================

LS GFD_TD GEX_TD BM_TD CPI_TD

Estimation Equation:

=========================

GFD_TD = C(1)*GEX_TD + C(2)*BM_TD + C(3)*CPI_TD

Substituted Coefficients:

=========================

GFD_TD = 0.711123337404*GEX_TD + 0.25441101141*BM_TD + 0.0152894877582*CPI_TD

However, not including a constant will lead to neglecting the time effect. Hence we include a constant to take that into account and again analyze the new obtained results. Here are the results obtained by using first difference of variables with a constant included.

Dependent Variable: GFD_TD

 

 

 

 

Method: Least Squares

 

Sample: 1 31

 

Included observations: 31

 

 

 

Variable

Coefficient

Std. Error

t-Statistic

Prob.

 

 

 

 

 

 

 

 

C

-0.034926

0.031395

-1.112478

0.2757

CPI_TD

0.068293

0.154243

0.442766

0.6615

BM_TD

0.445063

0.199677

2.228918

0.0343

GEX_TD

0.712281

0.096852

7.354305

0

 

 

 

 

 

 

 

 

R-squared

0.753857

Mean dependent var

 

0.133702

Adjusted R-squared

0.726508

S.D. dependent var

 

0.045875

S.E. of regression

0.023991

Akaike info criterion

 

-4.502376

Sum squared resid

0.01554

Schwarz criterion

 

-4.317346

Log likelihood

73.78683

Hannan-Quinn criter.

 

-4.442061

F-statistic

27.56415

Durbin-Watson stat

 

1.598654

Prob(F-statistic)

0

 

 

 

 

 

 

 

We again analyze the results obtained in this way. Dependence on govt. expenditure has almost remained the same with a coefficient of 0.71. However, dependence on money flow in the market has increased to a co-efficient of around 0.44 indicating a stronger dependence when the time effect is taken into account.

We again take a look at the relevant graphs to find out the goodness of fit that exists

We observe that for most parts the residual fluctuates around the zero mark and the model for both the actual and the fitted graph provides a good fit to the model.

However, the analysis done above needs to be validated by the fact that all variables are non-stationary in level form and stationary in the first difference form. This is done by conducting the augmented Dickey-Fuller test on all variables before and after the first difference is taken. The results of the Dickey-Fuller test are presented below

Government Expenditure before first difference

Govt. expenditure after first difference

Fiscal Deficit before first difference

Fiscal Deficit after first difference

CPI before first difference

CPI after first difference

Broad Money before first difference

Broad Money after first difference

Summary and Recommendations

The growing importance of research on the determinants of the fiscal deficit has been burnished over the years by the way rising fiscal deficit is dragging down the Indian economy. However, the scope for any such research has to be extended from inflation to include other factors and create an umbrella relationship covering all factors.

Most research papers prefer to focus solely on inflation without giving a thought to other factors like government expenditure and money flow in the economy before finding a dependency relationship. Hence, while a relation between inflation and gross fiscal deficit, which is already proved theoretically, becomes obvious via empirical analysis, what should be considered is whether inflation in the first place is a very big determinant of the fiscal deficit.

The analysis conducted in this dissertation is a clear indicator that the government expenditure is probably the single largest determinant of the gross fiscal deficit. Inflation forms just a minute part of the factors causing the fiscal deficit. While there was no clarity on the negativity or the positivity of the relationship initially, tests which are further refined indicate that all the factors hold a positive relationship with gross fiscal deficit. This basically implies that as any of these factors increases, the gross fiscal deficit is expected to increase.

"Findings imply that past values of government expenditure contain important information to predict fiscal deficit. Similarly, past values of money supply contain important information to predict government expenditure and fiscal deficit contains important information to predict fiscal deficit. Therefore, while deciding upon the fiscal policies government must use the important information contained by these variables. An important implication of this study is that while financing of deficit through the banking system from printing of new money and creating interest-bearing bonds decreases fiscal deficit, increasing government expenditure is the main cause of mounting fiscal deficit.

This may be due to deficient and inefficient social programs as Tanzi (2000) reveals that in Latin American countries disequilibrium between public budget and budget deficit results from governments’ wrong policies such as using borrowing in order to finance the deficit as found by Egeli (2000). It may be construed here that government’s consumption expenditure is much more propelling force for fiscal deficit growth as compared to its investment-inducing expenditure programmes. Hence, an efficient prioritization of public spending is needed for fiscal consolidation. Increased accountability and transparency may control government expenditure and thereby fiscal deficit. Reduction in fiscal deficit may contain ‘crowding out’ and thus boost investment which concomitant with increase in productivity and production may help control inflation. Thus, in order to analyze this issue in depth one can go for empirical analysis in this direction for India. Besides, the present study can be extended by analyzing the impact of different components of government expenditure on fiscal deficit. This may give more insights about the problem."