Fiscal Deficit, Crowding Out, and the Sustainability of Economic Growth: The Case of the Indian Economy Asie Visions, No. 31, July 2010

Applying unit root tests and cointegration techniques that allow for endogenously determined structural breaks, the analysis is done separately with the gross fiscal deficit of the central government, and the combined deficits of the central and state governments. The results do not indicate any long-run relationship among the variables, despite the balance-of-payments crisis of 1990-91 and sudden jump in deficits from 1997-98 onwards. Our finding supports neither a crowding out nor a crowding in hypothesis between government spending and private investment. On the contrary, our result hints at the Ricardian Equivalence Theory on public debt, implying thereby that it does not matter whether a government finances its spending with debt or a tax increase, the effect on the total level of demand in an economy will be the same.

The fiscal adjustment carried out as a combination of revenue augmenting measures as well as appropriate expenditure adjustment has helped to achieve sustained high economic growth with macroeconomic stability. While the actual numbers for disciplining fiscal deficit is debatable, the way forward for India is the recognition that fiscal responsibility rules are imperative for sustaining macro output growth. Further, standalone fiscal deficit targets would not be sufficient if not supported by targets on revenue or primary deficit.