INTRODUCTION

“Fiscal deficit” becomes one of the buzzword during every budget presentation in parliament.
Economists often test it on several parameters to understand and evaluate the sustainability of
carrying such deficit. To put forward simply, fiscal deficit is the difference between the
Government’s earnings and expenditure. So, when the government’s spending surpasses its
earnings in any financial year, it’s a fiscal deficit situation. The formula for fiscal deficit is
given as:

( )

It is often interpreted as a percentage of a GDP, and at the current financial year, the
Government expects the deficit at 6.8% of the GDP. As we observe, fiscal deficit has two
components- Total receipts and Total expenditure. Receipts include tax revenue such as
income tax proceeds and non-tax revenue such as external grants, interest receipts, dividends
and profit.

Fiscal deficit does not necessarily imply a negative indicator. Moderate levels of fiscal deficit
are considered as indicator that Government is spending on schemes, infrastructural and
developmental projects that may reap benefits in future. The central government’s fiscal
deficit for April to November 2021 narrowed to 46.2% of the annual budget target on the
back of a rise in tax collections.1

Rakshit (2005) observes those fiscal deficits are often incurred even while the economy was
close to full-employment. While in an inefficient and short-sighted economy, this could be
owing to the “enlargement of opportunities for defrauding public funds” for short-term
electoral goals. It was also reiterated by Eslava (2011) that deficit also arises from
“opportunistic motivation” by the incumbents trying to improve their chances of staying in
the office. As it was observed in case of advanced countries, Government provides for some
minimum social welfare security in form of unemployment allowances, age-old pensions,
health services. As it was further observed that in a country like India, with young thriving
population than any other country, facing issues of collecting tax revenue in one hand and the
need for development and infrastructural projects have made a fiscal deficit a normal
phenomenon. It is based on this aspect that we need to have a discussion on sustainability of
fiscal policy and related issues.

1
Vanamali(2022), Business Standard
On this aspect, it is important to discuss the FRBM act- Fiscal Responsibility and Budget
Management Act (2003). The act was institutionalized to impose financial discipline of the
country and limit the fiscal deficit to 3% of the GDP by March 2008. Though, at this point,
we are lagging way behind the targeted levels. Due to the pandemic, fiscal deficit reached a
record high of 9.5% of the GDP.2 In the Union Budget speech, the Finance Minister has
announced the Government’s aim to reduce the deficit to 4.5% of the GDP by 2025-26.It has
also been shown in few literatures that high fiscal deficits are associated with macroeconomic
instability.

The debate on the determinants and consequences of budget deficit has received much
attention in the recent past. In the following sections we will try to discuss few literatures on
theoretical and empirical explanation of fiscal deficit.

THEORETICAL LITERATURE

Neo-Classical Theory

The neoclassical framework presents budget deficits as an inter-temporal optimization

problem. As Berheim (1989) puts forward: “the neo-classical paradigm envisions farsighted
individuals planning consumption.”- which basically suggests budget deficits raises total
lifetime consumption by shifting taxes to the future generation. The paper explains further
that in a full employment model, increased consumption will lead to reduction in savings. As
a result of which, interest rate rises to bring the capital market in equilibrium, but at the same
time there is instances of crowding out of private investment. This can be considered as
highly detrimental for any economy.

Keynesian Theory

In the Keynesian view, Berheim (1989) points out that most individuals are myopic and
liquidity constrained. Owing to high marginal propensity to consume, a temporary tax
reduction therefore has a significant effect on aggregate demand. If the economy is operating
at under-employed level, national income rises, through the Keynesian multiplier. From the

2
Times of India Report (2021)
Neoclassical view, it differs in the aspect that since deficits, here are stimulating both national
income and consumptions, savings and capital accumulation doesn’t necessarily fall. But,
government spending does not necessarily suggest growth in the economy. Barro (1990) has
showcased that a higher percentage share of non-productive Government expenditure lowers
the growth and saving rate. This is because such expenditure tends to have no effect on
productivity of the private sector.

Ricardian Equivalence Perspective

The Ricardian theory highlights that deficit financed by tax cuts postpone taxes to the next
generation. Hence, there are no real effects of fiscal deficits. Berheim (1989) puts out in very
simplistic words that generations are connected with each other through “voluntary,
altruistically motivated resource transfer. Since deficits merely shifts the payment of taxes to
future generation, they leave “dynastic resources” unaffected. Hence, deficit policing from
Ricardian Equivalence Perspective is a matter of indifference. Berheim (1989) further
criticised and dismissed Ricardian framework since it is based on extreme and unrealistic
assumption. Eisner (1989), contrary to Barro, suggested budget deficit raises interest rate,
crowds out investment and thus budget deficit does matter.

Tax and Spend Hypothesis

As per hypothesis, raising taxes to cut down deficit may not work because it might only
encourage the politicians to spend more. Vedder et al (1987) puts forward the hypothesis
that raising taxes put pressure for contraction of government spending leaving national
savings and deficits unchanged, and stimulates private consumption is more desirable. It is
imperative to highlight that if Government expenditure does not fall, it has to run a deficit
leading to a rise in interest rate and increment in ratio of interest payments to GDP.
EMPERICAL LITERATURE

Though there exists a good literature on the effects of fiscal deficits on different
macroeconomic variables, very few concentrate on determinants of deficits. Maltritz and
Wuste (2015) analysed the determinants of budget balance of 27 EU countries spanning from
1991 to 2011 with a panel approach. As explained in the result section of the paper, they
focus on the joint influences of fiscal rules, fiscal council as well as creative accounting in
influencing the fiscal balance. From the panel regression, they obtained that debt and
unemployment rates as significant variable in their analysis. The election dummy in the
model is also significant highlighting the effects of election on fiscal deficit. De Haan et al
(2013) examined panel fixed effects of political and size fragmentation and impact of
budgetary institution on budget deficits.

Lis and Nickel (2010) examined the impact of extreme weather on the budget balance, but at
the same time it is worth mentioning that she did similar work like Maltritz and Wuste
(2015) and obtained that debt ratio, real-GDP growth and inflation are statistically significant
for developing countries, OECD and EU countries. However, there was no significant effects
were obtained for GDP growth and bond yields. Inflation as a significant variable was also
obtained by Lin and Chu (2013). They used an ARDL specification to show that inflation
has a strong impact on fiscal deficit in high inflation episodes.

A few literatures also discusses on the causality between current account balances and fiscal
deficit. Abell (1990) uses multivariate time series to highlight the linkage between budget
deficit and trade deficit. A VAR modelling showed that budget deficit influence trade
deficits, also confirmed through impulse response graph. A very similar result were obtained
by Sobrino (2013) which used Granger-Causality to indicate, with annual data spanning from
1980-2012, that current account balances cause budget deficit.

Cuellar and Cebula (2013) confirmed that federal budget deficits cause interest rate to rise.
Akinboarde (2004) investigated, for South African economy, the relationship between
budget deficits and interest rates with annual data during 1964-1999. However, unlike the
previous paper, Granger Causality did not define any significant relationship.

Adam and Bevan (2005) examined the linkage between fiscal deficit and growth for 45
developing countries. The evidence from the results portrays interaction effects between
deficit and debt stocks, also high debt stock exacerbating the adverse consequences of high
deficits. Roubini and Sachs (1989) through their descriptive analysis examine the trends
and evolution of the size of Government and of budget deficits in OECD democratic
economies. They further highlight that rise in budget deficit in 1970s has close
correspondence with a slowdown in output growth.

Beyond the above discussions, there also have been discussions on investment. Dua and
Arora (1993) majorly focussed on investment. It reported new evidence on the effects of
budget deficits on investment, and the results supported the view that budget deficits crowd
out domestic investment.

BRIEF DISCUSSION ON SUSTAINABILITY AND SOLVENCY (Rakshit, 2005)

Fiscal deficit financed through borrowing from the public is said to be sustainable in the long
run if the ratio of public debt to national income stabilizes or does not rise without limit.
Rakshit (2005) considered an economy growing at the rate g; interest rate constant at r.
Government revenue and consumption fixed at c and h. The increase in public liability (L) to
the public per unit of time is given by:

( )

Where

The subsequent solution to the first order differential equation is given as:

( )
l= (L/Y)= (( )

From the above expression, it can be easily understood that debt financing does not lead to an
unbounded value of l iff g>r.

So, the long run value of l (denoted by l*) would be given as:

l* =

The larger the primary deficit ratio and smaller growth-interest differential, higher will be the
l*.
Solvency of Government Finances: Longer term problem of debt financing can be answered
on the basis of solvency of the treasury. If we assume that interest rate remains unchanged
over time at r and let the Government surplus over expenditure be given as . If the
Government’s current liability to the public . Solvency condition requires that present
value of all future must not be less than i.e.

∑ ( )

It is clear from the condition that must be positive and large enough to satisfy the
solvency condition. If for the previous case of debt financing, all are negative, condition
will be violated and it won’t be sustainable even if r<g holds.

DATA & METHODOLOGY

Data

For our analysis we are taking following macroeconomic variables under consideration for
our analysis: Fiscal Deficit, current account balance, Inflation, GDP Growth rate, Inflation
rate, current account balance, Gross fixed capital formation (GCFC), real interest rate,
Government Debt (as percentage of GDP) and Unemployment rate. The data on Fiscal deficit
is compiled from financial reports of Controller General of Accounts. Data on current
account balance, GDP growth rate and Interest rate have been compiled from the World Bank
data. Data for inflation rate has been taken from the data section of the RBI website. GCFC,
also called investment, is defined as the acquisition of produced assets including the
production of such assets by producers for their own use, minus disposals. The data for
GCFC has been compiled from the National Income section of Indiastat.com. Data for all of
the variables mentioned are collected annually for the period 1978-2020, except the data for
unemployment and Government Debt (as percentage of GDP) (both collected from world
bank data) which has annual data availability for the period 1990-2020.
Methodology

As customary in case of any time series data we start our analysis with unit root test to
proceed with stationary data, free of unit root problem. The results of the stationary tests are
shared in the appendix. The objective of the analysis will be to understand and identify the
determinants of the fiscal deficit; we also check the causality of other variables with fiscal
deficit.

For this purpose we will proceed with the interaction analysis of fiscal deficit with other
macroeconomic variables, and since we have an annual data for analysis and also by
considering Lag length criterion we proceed in our analysis with 1 period lag. But before we
decide on any form of analysis, we might want to check if there is any form of cointegration
among the variable for this purpose we proceed with Johanssen cointegration test and we
obtain the following result:

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.868068 155.5176 95.75366 0.0000

At most 1 * 0.550747 76.52431 69.81889 0.0132
At most 2 0.425131 45.31774 47.85613 0.0849
At most 3 0.280231 23.72680 29.79707 0.2122
At most 4 0.221899 10.90262 15.49471 0.2175
At most 5 0.028248 1.117539 3.841466 0.2904

We observe that the trace test shows 2 cointegrating equation at 0.05 level.

Now, moving ahead with the model through VECM we get the following results:

Cointegrating Eq: CointEq1

FD2(-1) 1.000000

CA1(-1) 9.43E-09
(4.1E-09)
[ 2.30434]

GCFC(-1) -0.026689
(0.00456)
[-5.85025]

GDP_GROWTH_RATE(-1) -43.89420
 (25.4781)
[-1.72282]

INFLATION_RATE(-1) 18.43963
(15.2631)
[ 1.20812]

RI(-1) 7.141315
(23.8978)
[ 0.29883]

C 391.6257

D(GDP_GROWT D(INFLATION_
Error Correction: D(FD2) D(CA1) D(GCFC) H_RATE) RATE) D(RI)

CointEq1 -1.041598 0.000706 -1.773279 -0.000358 0.003405 -0.002272

(0.60365) (0.00064) (0.66855) (0.00164) (0.00123) (0.00102)
[-1.72550] [ 1.10249] [-2.65243] [-0.21757] [ 2.76457] [-2.22190]

D(FD2(-1)) -0.016556 -0.000499 0.355767 -4.60E-05 -0.002434 0.001684

(0.36931) (0.00039) (0.40902) (0.00101) (0.00075) (0.00063)
[-0.04483] [-1.27356] [ 0.86981] [-0.04577] [-3.23112] [ 2.69125]

D(CA1(-1)) 109.9787 -0.500365 -451.0787 -0.523714 0.186728 -0.159599

(152.764) (0.16205) (169.187) (0.41587) (0.31166) (0.25880)
[ 0.71993] [-3.08773] [-2.66615] [-1.25933] [ 0.59915] [-0.61668]

D(GCFC(-1)) 0.053194 0.000192 0.527226 -0.000467 0.000574 -0.000343

(0.14617) (0.00016) (0.16188) (0.00040) (0.00030) (0.00025)
[ 0.36392] [ 1.24086] [ 3.25684] [-1.17480] [ 1.92575] [-1.38602]

D(GDP_GROWTH_RATE(-
1)) -35.28013 -0.061527 -45.99362 -0.385140 -0.262825 -0.245340
(88.2891) (0.09366) (97.7810) (0.24035) (0.18012) (0.14957)
[-0.39960] [-0.65695] [-0.47037] [-1.60242] [-1.45916] [-1.64027]

D(INFLATION_RATE(-1)) -2.101618 0.067197 -0.786345 0.086476 -0.515793 0.286002

(76.2046) (0.08084) (84.3973) (0.20745) (0.15547) (0.12910)
[-0.02758] [ 0.83127] [-0.00932] [ 0.41685] [-3.31771] [ 2.21534]

D(RI(-1)) -46.97793 0.042613 -23.71895 -0.020954 -0.464383 -0.030935

(105.207) (0.11160) (116.517) (0.28640) (0.21463) (0.17823)
[-0.44653] [ 0.38183] [-0.20357] [-0.07316] [-2.16360] [-0.17356]

C 67.29594 -0.156783 584.4895 0.364997 -1.027097 0.464253

(280.356) (0.29740) (310.497) (0.76321) (0.57196) (0.47496)
[ 0.24004] [-0.52718] [ 1.88243] [ 0.47824] [-1.79575] [ 0.97746]
D(FD2) = C(1)*( FD2(-1) + 9.43144936645E-09*CA1(-1) - 0.026688622801
6*GCFC(-1) - 43.8942006502*GDP_GROWTH_RATE(-1) +
18.4396281787*INFLATION_RATE(-1) + 7.14131533094*RI(-1) +
391.625701349 ) + C(2)*D(FD2(-1)) + C(3)*D(CA1(-1)) + C(4)
*D(GCFC(-1)) + C(5)*D(GDP_GROWTH_RATE(-1)) + C(6)
*D(INFLATION_RATE(-1)) + C(7)*D(RI(-1)) + C(8)

Coefficient Std. Error t-Statistic Prob.

C(1) -3.137218 1.184906 -2.647651 0.0126

C(2) -0.016866 0.312040 -0.054051 0.9572
C(3) 4.50E-08 1.96E-08 2.289585 0.0290
C(4) -0.568969 0.395383 -1.439035 0.1602
C(5) -1090.003 306.3105 -3.558490 0.0012
C(6) 14.61879 304.2124 0.048055 0.9620
C(7) 195.0175 170.9759 1.140614 0.2628
C(8) 1061.619 1459.832 0.727220 0.4725

Fiscal Deficit ,Unemployment and Government Debt as percentage of GDP:

Johansen Cointegration Test:

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.896090 75.39776 29.79707 0.0000

At most 1 * 0.308659 16.52781 15.49471 0.0348
At most 2 * 0.233992 6.930620 3.841466 0.0085

Granger Causality:

Dependent variable: D(FD2)

Excluded Chi-sq df Prob.

D(UNEMPLOY
MENT_RATE) 3.818050 1 0.0507

All 3.818050 1 0.0507

Dependent variable: D(GOVERNMENT_DEBT_AS___OF_)

Excluded Chi-sq df Prob.

D(FD2) 10.45158 2 0.0054

All 10.45158 2 0.0054

ANALYSIS AND CONCLUSION

So as discussed previously in methodology, we proceeded in our analysis with VECM, given

that Johanson cointegration hinted the presence of more than 2 cointegration equations. From
the error correction model, we obtain that GCFC, inflation rate and Real interest are
significant. This basically gives us the speed of adjustment. The significance of variable
indicates that there is a convergence from short run dynamics to long run equilibrium in case
of disequilibrium situation.

As we observe from the table for long run and short run estimates, C(1) which is the long run
coefficient is negative and significant which shows the long run causality between current
account balance, GCFC, inflation rate and real interest rate with fiscal deficit. The negative
sign of the coefficient shows the ability to bounce back to equilibrium. Short run coefficient
C(3) (current account balance) and C(5) (GDP growth rate) are significant.

As previously discussed in empirical literature sections, there are few literatures which
discuss the causality of Government debt and unemployment rates to fiscal deficit. Maltritz
and Wuste (2015) being one of them. In our analysis through Granger causality we obtained
results, similar to Maltritz and Wuste (2015), that there exists causality running from
unemployment to fiscal deficit. But we differ in our results with regard to relation of debt
with fiscal deficit. Maltritz and Wuste (2015) in their analysis of 27 European Union
countries obtained that there is unidirectional causality from debt to fiscal deficit. But in our
analysis we obtained exactly the opposite.
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Arora, H., & Dua, P. (1993). Budget defcits, domestic investment, and trade defcits. Contemporary
Economics Policy.

Barro, R. (1990). Government Spending in a Simple Model of Endogenous Growth. Journal of Political
Economy.

Bernheim, B. (1989). A Neoclassical Perspective on Budget Deficits. Journal of Economic Perspectives,

55-72.

Cebulla, R., & Cuellar, P. (2010). Recent evidence on the impact of government budget deficits on
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Chu, & Lin. (2013). Are fiscal deficits inflationary? Journal of International Money and Finance, 214-
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CS, A., & DL, B. (2005). Fiscal defcits and growth in developing countries. Journal of Public Economics.

De Haan, J., & Klomp, J. (2013). Conditional political budget cycles: a review of recent evidence.
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Eslava, M. (2011). The political economy of fiscal deficits. Journal of Economic Surveys, 645-673.

Lis, E., & Nickel, C. (2010). The impact of extreme weather events on budget balances. International
Trade and Public Finance.

Maltritz, & Wuste. (2015). Determinants of budget deficits in Europe: The role and relations of fiscal
rules, fiscal councils, creative accounting and the Euro. Economic Modelling.

Mawejje, & Odhiambo. (2019). The determinants of fscal defcits. International Review of Economics.

OA, A. (2004). The relationship between budget defcit and interest rates in South Africa. Dev South
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Rakshit, M. (2005). Budget Deficit : Sustainability, Solvency and Optimality. In A. Bagchi, Readings in
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Rangarajan, & Srivastava. (n.d.). Fiscal Deficits and Government Debts is India: Implication for
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APPENDIX:

Stationary test results for current account balance at first difference:

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -5.542908 0.0000

Test critical values: 1% level -3.600987
5% level -2.935001
10% level -2.605836

Stationary test results for real interest rate:

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -4.764090 0.0004

Test critical values: 1% level -3.596616
5% level -2.933158
10% level -2.604867

Stationary test results for GCFC:

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -2.883374 0.0572

Test critical values: 1% level -3.626784
5% level -2.945842
10% level -2.611531
Stationary test results for GDP Growth rate:

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -4.378412 0.0011

Test critical values: 1% level -3.596616
5% level -2.933158
10% level -2.604867

Stationary test results for Inflation rate

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -3.762483 0.0064

Test critical values: 1% level -3.596616
5% level -2.933158
10% level -2.604867

Stationary test results for Fiscal Deficit ( at order 2)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -4.694553 0.0007

Test critical values: 1% level -3.661661
5% level -2.960411
10% level -2.619160