Notes

# On Bringing Down theFiscal Deficit

#### This article argues that undertaking a contractionary policy to cut down various government expenditures with the intention of bringing down the fiscal deficit as a proportion of GDP is fundamentally flawed. And that it is the responsibility of the central government to step up government expenditure.

###### SURAJIT DAS

olicymakers are very often seen to undertake contractionary fiscal policy, irrespective of the level of aggregate demand in the economy. They try to bring down the fiscal deficit as a proportion to GDP by cutting down many important components of government expenditure. Now, the fiscal deficit is not necessarily bad for the health of the economy; whether it is good or bad for the health of the economy depends on the level of aggregate demand in the economy. In this article we would like to argue that even if the ratio of fiscal deficit to GDP has to be brought down, the contractionary policy of cutting down the government expenditure would not really help. In fact, the contractionary fiscal policy may actually increase the ratio of fiscal deficit to GDP particularly in demand constrained developing countries like India – characterised by the co-existence of large involuntary unemployment and unutilised capacity.##### Conceptual Issues

Domar (1944) argued that the ratio of public debt to GDP would be stable in the long run provided that the growth rate of GDP exceeds the effective interest rate on public debt. Domar has successfully argued that for a growing economy, the tax income of the government may very well rise without any necessary increase in the tax rate simply because of the fact that tax is a positive function of income. If income increases, the revenue would also go up in the same proportion, for any given tax-GDP ratio. However, the Domar equation does not consider the effect of government expenditure on aggregate income.

We would like to argue here that the growth rate of nominal GDP would always depend on government expenditure. There is absolutely no reason to believe that under a demand constrained situation in the presence of huge involuntary unemployment, why price adjustment alone would take place and real output would not grow through the Keynes-Kahn multiplier. Therefore, in such a situation, the growth in real output would also depend on government expenditure until the economy is operating well below the full employment situation. In fact, many studies have shown that in the Indian context, government investments crowd-in private investment and had a double effect in increasing output. Now if part of the total government expenditure (over its total revenue) is financed by domestic borrowing, the fiscal deficit to GDP ratio could very well be stable in the long run if government expenditure elasticity of GDP (GηY) is higher than (or equal to) that of debt (GηZ).

For simplicity, let us assume a standard transitive causality in its simplest form as follows: autonomous government expenditure (G) yields GDP (Y) and in turn GDP yields revenue (R) of the government. Now if government expenditure rises by one unit, then the fiscal deficit (Z) rises by dZ/dG units and GDP rises by dY/dG units. Also Z = G – R or dZ = dG – dR, in its simplest form. We are interested in what happens to the fiscal deficit to GDP ratio (Z/Y) with changes in government expenditure. Now,

d(Z/Y)/dG = [Y(dZ/dG) – Z(dY/dG)]/Y2

= (Z/G.Y)[(dZ/dG).(G/Z) – (dY/dG).(G/Y)]

= (Z/G.Y).(GηZ – GηY) (where, Gη represents the government expenditure elasticity).

Since, Z/G.Y > 0 always in the case of a positive fiscal deficit, d(Z/Y)/dG ≥ 0 if and only if GηZ ≥ GηY, i e, due to a percentage change in government expenditure, the percentage change in fiscal deficit has to be greater than that in income. Otherwise if GηZ ≤ GηY, then d(Z/Y)/dG ≤ 0. That is, with an increase in government expenditure, if income or GDP increases more than proportionately compared to the fiscal deficit, then fiscal deficit to GDP ratio falls.

When GηZ = GηY, the ratio Z/Y remains the same with change in G. And GηZ<GηY ⇒GηY.YηZ < GηY ⇒YηZ <1 (ηs are respective elasticities).

This is a very simple proposition as follows: due to an increase in G, if Z rises less than proportionately compared to the percentage rise in Y, then Z/Y falls and vice versa. Now, YηZ < 1

where small letters indicate their ratio to GDP. (g – r) is nothing but the ratio of fiscal deficit to GDP. It is clear that in case of a higher GηY, ceteris paribus, the probability of the above to hold will increase and vice versa. Similarly, in case of a larger YηR, ceteris paribus, the probability of the above to hold increases too. Again, as g increases or as r decreases, ceteris paribus, the same probability of (A) to hold decreases. Only in the case of GηY = YηR = 1, the above becomes an identity.

The holding of the inequality (A) means that due to an increase in government expenditure, the fiscal deficit rises less than proportionately, compared to the increase in GDP or in other words, it causes the ratio of the former to latter to fall. If the above mentioned inequality (A) holds, given our simple framework, it could

Economic and Political Weekly May 5, 2007

also be argued that at the same time with the decrease in government expenditure, the ratio of fiscal deficit to GDP will actually rise. However, essentially the question is whether the inequality (A) really holds or not in the case of the Indian economy.

##### Data Source, Methodology and Empirical Evidence

We have taken data from the Handbook of Statistics on the Indian Economy 2004-05. Only the GDP data at current prices at factor cost is taken from the Economic Survey 2004-05. The period under consideration is a span of 25 years from 1980-81 to 2004-05. Ratios of government expenditure to GDP and total revenue to GDP have been calculated taking an average of the last five years, i e, the average of 2000-01 to 2004-05 (“ratio to GDP” column in the tables). Different kinds of government expenditures, viz, total government expenditure less the interest payment component (GEINT), total government expenditure (GE), capital expenditure (CE), revenue expenditure less the interest payment component (REINT), revenue expenditure (RE), developmental expenditure (DE) and non-developmental expenditure (NDE) of the central government, state governments taken together and combining central and state governments have been considered for this analysis. Total revenue of the government has been calculated as total revenue receipts plus total capital receipts minus the fiscal deficit.

We have taken the natural logarithm of all the series and regressed (bi-variate) them to calculate the respective elasticities. For example, to calculate xηy, we have regressed ln(y) on ln(x) and taken the regression coefficient as the required elasticity, i e, xηy = (dy/dx).(x/y) = (dy/y)/(dx/x) = dln(y)/dln(x). Values of adjusted R2 and t-values are comfortably high in all the cases. All the elasticities are significant at a 99 per cent level of confidence. For inequality (A) to be true, the figures in the column “Gap” = g/GηY– r. YηR are required to be less than the corresponding figures in the column “g – r” in the Tables 1, 2 and 3. Table 1 depicts evidence for the central government, Table 2 for state governments taken together and Table 3 exhibits evidence for the combined government accounts.

From Table 1, it is evident that if GDP rises by 1 per cent, the total revenue of the central government increases by more than 1 per cent (1.04 per cent). Again if total expenditure of the central government increases by 1 per cent, GDP rises by more than 1 per cent (1.03 per cent). If we subtract the interest payment component from total government expenditure, then a 1 per cent increase in the government expenditure leads to a 1.12 per cent increase in GDP. The 1 per cent increase in capital expenditure by the central government raises GDP by 1.3 per cent and vice versa. This is why selling public sector units or reducing capital expenditure would not help the government to bring down its fiscal deficit as a proportion of GDP (FD-GDP ratio). The developmental expenditure increase by 1 per cent causes a

1.11 per cent increase in GDP.

However, we are more interested in knowing whether the above-mentioned inequality (A) holds or not. It does not hold in the case of revenue expenditure which includes the interest payment component and non-developmental expenditure which also comprises the interest payment component on government borrowings. But cutting down capital expenditure, revenue expenditure except interest payment, developmental expenditure, total government expenditure except interest payment would cause the FD-GDP ratio to actually increase. Therefore, reduction only in the interest payment component of government expenditure would help and cuts in other components of central government expenditure would increase the FD-GDP ratio. Even including the interest payment component given the present rates of effective interest on central government borrowings and given the present composition of government expenditure, any contractionary policy on the part of the central government would not bring down the FD-GDP ratio.

As far as state finance is concerned, a 1 per cent increase in capital expenditure and developmental expenditure would raise

Table 1: Centre’s Elasticities With Respect to Nominal GDP

Dep Var | Indep Var | Ratio | η | t | adj R2 | g/GηY | r. YηR | Gap | g – r |
---|---|---|---|---|---|---|---|---|---|

to GDP | |||||||||

REV | GDP | 0.12 | 1.04 | 59.89 | 0.99 | ||||

GDP | GEINT | 0.13 | 1.12 | 39.73 | 0.99 | 0.12 | 0.12 | 0.00 | 0.01 |

GDP | G E | 0.18 | 1.03 | 52.31 | 0.99 | 0.17 | 0.12 | 0.05 | 0.06 |

GDP | C E | 0.03 | 1.37 | 18.85 | 0.94 | 0.02 | 0.12 | -0.10 | -0.09 |

GDP | REINT | 0.09 | 1.01 | 48.88 | 0.99 | 0.09 | 0.12 | -0.03 | -0.03 |

GDP | R E | 0.14 | 0.94 | 58.98 | 0.99 | 0.15 | 0.12 | 0.03 | 0.02 |

GDP | DE | 0.08 | 1.15 | 32.42 | 0.98 | 0.07 | 0.12 | -0.05 | -0.04 |

GDP | NDE | 0.10 | 0.95 | 89.57 | 1.00 | 0.11 | 0.12 | -0.01 | -0.02 |

Table 2: States’ Elasticities With Respect to Nominal GDP

Dep Var | Indep Var | Ratio | η | t | adj R2 | g/GηY | r. YηR | Gap | g – r |
---|---|---|---|---|---|---|---|---|---|

to GDP | |||||||||

REV | GDP | 0.15 | 1.00 | 60.86 | 0.99 | ||||

GDP | GEINT | 0.16 | 1.02 | 81.44 | 1.00 | 0.16 | 0.15 | 0.01 | 0.02 |

GDP | G E | 0.19 | 0.98 | 85.57 | 1.00 | 0.19 | 0.15 | 0.04 | 0.05 |

GDP | C E | 0.04 | 1.10 | 18.96 | 0.94 | 0.04 | 0.15 | -0.11 | -0.10 |

GDP | REINT | 0.12 | 0.98 | 91.46 | 1.00 | 0.12 | 0.15 | -0.03 | -0.03 |

GDP | R E | 0.15 | 0.93 | 101.13 | 1.00 | 0.16 | 0.15 | 0.01 | 0.00 |

GDP | DE | 0.11 | 1.07 | 90.42 | 1.00 | 0.10 | 0.15 | -0.05 | -0.04 |

GDP | NDE | 0.07 | 0.81 | 135.15 | 1.00 | 0.09 | 0.15 | -0.06 | -0.08 |

Table 3: Combined Elasticities With Respect to Nominal GDP

Dep Var | Indep Var | Ratio | η | t | adj R2 | g/GηY | r. YηR | Gap | g – r |
---|---|---|---|---|---|---|---|---|---|

to GDP | |||||||||

REV | GDP | 0.22 | 1.01 | 64.74 | 0.99 | ||||

GDP | GEINT | 0.25 | 1.06 | 58.44 | 0.99 | 0.24 | 0.22 | 0.02 | 0.03 |

GDP | G E | 0.32 | 1.00 | 69.76 | 1.00 | 0.32 | 0.22 | 0.10 | 0.10 |

GDP | C E | 0.05 | 1.29 | 16.88 | 0.92 | 0.04 | 0.22 | -0.18 | -0.17 |

GDP | REINT | 0.20 | 0.98 | 74.89 | 1.00 | 0.20 | 0.22 | -0.02 | -0.02 |

GDP | R E | 0.27 | 0.93 | 81.07 | 1.00 | 0.29 | 0.22 | 0.07 | 0.04 |

GDP | DE | 0.16 | 1.11 | 61.06 | 0.99 | 0.14 | 0.22 | -0.08 | -0.06 |

GDP | NDE | 0.15 | 0.88 | 102.21 | 1.00 | 0.17 | 0.22 | -0.05 | -0.08 |

Notes: Figures are tabulated upto two decimal points. DepVar ⇒ the dependent variable and Indep Var ⇒ the independent variable.Ratio to GDP implies r=R/Y or g=G/Y.

Sources: Calculated from the Handbook of Statistics on the Indian Economy 2004-05, RBI, GoI and GDP figures are taken from the Economic Survey 2005-06, Ministry of Finance, GoI.

Economic and Political Weekly May 5, 2007 GDP by 1.1 per cent and 1.07 per cent respectively (Table 2). Therefore, any reduction in these would cause more than a proportionate decline in GDP. We witness a similar picture vis-à-vis inequality (A) in the sense that it holds in all other cases except revenue expenditure including interest payment and non-developmental expenditure including interest payment. Therefore, for the states it would not be prudent to cut any other revenue or capital expenditure in order to bring down the FD-GDP ratio because then this ratio will actually increase.

Combining union and state finances (Table 3), the objective reality is that the capital expenditure component of government expenditure is the most effective component in raising GDP but its share is only 5 per cent in GDP and 15 per cent in total government expenditure. The situation of the centre and states separately vis-à-vis inequality (A) are bound to be reflected here also and except the interest payment component, a cut in any other component of government expenditure would not necessarily help in bringing down the FD-GDP ratio.

Another interesting observation as far as fiscal federalism is concerned is as follows. If we compare the GDP elasticity of revenue (YηR) of the centre to that of the states, we find that it is much larger for the centre (1.04) than for the states (1.00). Again, as far as the effectiveness of government expenditure in raising GDP is concerned, it is evident that all kinds of central government expenditures are much more efficient. Therefore, if the central government spends more, it helps in bringing down the FD-GDP ratio at a faster rate. Increases in state government spending would also bring down the ratio but only at a comparatively slower pace. Hence, it is primarily the responsibility of the central government to bring down the FD-GDP ratio by stepping up government expenditure as opposed to undertaking any contractionary policy. Moreover, it would be completely erroneous to pass on more and more of the centre’s fiscal burden to the states.

##### Policy Perspective

Let us consider a simple numerical example. Let the government expenditure as a proportion to GDP be g = G/Y = 0.32, revenue-GDP ratio be r = R/Y = 0.22, FD-GDP ratio be z = Z/Y = 0.10 which is fully financed by borrowing, GDP elasticity of revenue be YηR = 1 (i e, R/Y remains constant), for some government expenditure the growth rate of GDP be 10 per cent and the effective interest rate on government borrowing be 11 per cent. For FD-GDP ratio to increase we need: (g – r) < {(g/ GηY) – (r. YηR)}, i e, g < g/GηY [since r = 1], i e, GηY <1.

But, if GηY >1 then FD-GDP ratio may very well decline with increases in government expenditure. Again, if the effective interest rate on government borrowing is 9 per cent, then for a decline in the FD-GDP ratio we require GηY >1. But if GηY <1, then the FD-GDP ratio may very well increase with increases in government expenditure. Therefore, GDP growth rate being greater than the effective interest rate is neither a necessary nor a sufficient condition for the sustainability of the ratio of fiscal deficit to GDP. It might be a condition for sustainability of the ratio of total outstanding debt to GDP if and only if primary deficit is assumed to be zero and GDP growth is considered to be independent of growth of government expenditure.

##### Conclusion

The available empirical evidence since 1980-81 to 2004-05 in the context of the Indian economy shows that government spending has historically generated enough revenue and raised GDP to ensure that the economy operates under a situation where more government expenditure actually brings down the FD-GDP ratio. Hence, any attempt to cut down various government expenditures (only except the interest payment component) with the intention of bringing down the fiscal deficit as a proportion of GDP would be a wrong tactic because this will actually increase the FD-GDP ratio. This is true for the centre and the states but truer for the centre.

Email: dsurajit_jnu@yahoo.com

[The author is indebted to Prabhat Patnaik for his support and grateful to an anonymous referee for her/his comments. Views are personal.]

#### References

Domar, Evsey D (1944): ‘The ‘Burden of the

Debt’ and the National Income’, The American

Economic Review, Vol 34, No 4, pp 798-827. Ministry of Finance (2005): Ecoomic Survey 2004

05, Ministry of Finance, Government of India. Reserve Bank of India (2005): The Handbook of

Statistics on the Indian Economy 2004-05,

RBI, Mumbai.

Economic and Political Weekly May 5, 2007