ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Impact of Public Debt on the Economic Growth of Subnational Economies in India

A Case of Uttar Pradesh

This study examines both the short- and long-run impact of public debt on the economic growth of Uttar Pradesh during the post-reform period of 30 years by employing the vector error correction model. The empirical analysis revealed that the increase in public debt-to-gross state domestic product ratio and interest payments burden would have an adverse impact on the long-run economic growth of UP, while having no significant impact on the short-run growth. It is also notable that the effective interest rate has negatively correlated with the gross capital formation in UP, and the latter has shown significant positive long-run association with the economic growth. In order to attract investments and economic growth, the state Government of UP should continue a countercyclical fiscal stance that would help in adhering to fiscal sustainability rules by smoothing out the repercussions of the COVID-19 pandemic.

The authors are grateful to the anonymous referee for providing insightful and detailed comments on an earlier draft of the paper.

Deficit finance has become unavoidable for emerging countries, such as India, where population growth is higher and per capita income is lower compared to other developing countries. In order to finance fiscal deficit, the government usually relies on public borrowings because deficit ­financing through additional taxes or increase in tax rate would cause leakage in the economic system and likely to ­affect production and employment in an adverse manner (Laffer 2004). On the contrary, persistently increasing public borrowing requirements to finance budget deficits would eventually result in an increase in the amount of outstanding liabilities and, as a result, debt service obligations over time.

Does public debt affect the economic growth of the economy? This question has gained importance since the era of classical economics. The economist, Adam Smith (1776) asser­ted the destructive impact of public borrowing on the economic growth through “crowding out” effect as he considered that the domestic borrowing for financing of public spending leads to the transfer of savings that was otherwise available for private investment and hence results in destruction in ­capital formation.

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Updated On : 28th Nov, 2022
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