Relationship between fiscal deficit composition and economic growth in India: A time series econometric analysis

High and persistent fiscal deficit is one of the major macroeconomic problems in India since the mid-1980s. Fiscal consolidation is in the forefront of policy discussion in India not only at present but since the early 1990s. But the actual administrative measure to control it constitutionally by enacting an Act took place in 2003 and the Fiscal Responsibility & Budget Management (FRBM) Act came into force in April 2004. The major reason behind controlling fiscal deficit is its adverse effect on the macro economy, particularly output growth. Monetary policy makers in India (RBI) argue that high deficit will adversely affect growth and hence requires control. But fiscal policy makers (Ministry of Finance) argue that government spending will promote growth. Hence, there exists a puzzle about how fiscal deficit is affecting GDP in India. This paper tries to answer the puzzle by taking up a long-term time series analysis starting from 1980-81 to 2012-13. It also carries a detailed analysis by including the composition of fiscal deficit and its impact on GDP. By adopting a Vector Error Correction method, this paper proves that fiscal deficit is adversely affecting growth and also argues that if fiscal deficit money is spent on capital formation, it promotes growth, supporting the ‘Golden Rule’ of public finance