The Effect of Budget Deficit on Investment in Nigeria: An Empirical Study

This study empirically analyzes the long-run and short-run effects of budget deficit on investment in Nigeria for the period 1975-2010. Employing error correction model and cointegration regression, the study argues that budget deficit has a significant inverse relationship with investment both in the short run and long run. Hence, there is evidence of crowding-out effect on investment. It further establishes the claim of debt overhang in the long run. Moreover, despite the debt forgiveness received by Nigeria in 2005, the study fails to find convincing evidence of investment accelerator effect in Nigeria.IntroductionPublic debt is the accumulation of deficits resulting from excess of government expenditure over revenue (majorly tax and return on investment). As all deficits need to be financed by borrowing, consistent deficits over the years have led to accumulation of different forms of borrowing, ranging from domestic to external. These accumulated borrowed funds by the government are referred to as 'public debt'. According to Public Finance literature, a rising public debt above the sustainable level, especially when it is calculated as a ratio of GDP, is dangerous and indicates that bad economic time is round the corner; although this is expected to be in the long run. To avert such situation, both the developed and developing economies have been striving hard to regulate the level of their public debt and ensure a sustainable debt position. Many countries in the past have benefited from debt relief to put their debts in a manageable position that will allow for targeted level of development.Theoretical literature has produced diverse arguments regarding the relationship between budget deficit and macroeconomic variables. On the one hand, the Neoclassicalists stated that increasing budget deficit will have a negative impact on growth. They argued that whether government chooses to finance budget deficit by taxes or borrowing, resources are drawn from the private sector. Hence, they postulated that debt has most of its effect on private investment. This assumption in literature is often referred to as the 'crowding-out hypothesis' that when the public sector draws on the pool of resources available for investment, private investment gets crowded out. Crowding out is induced by changes in the interest rate. When the government increases its demand for credit, the interest rate goes up, as interest rate increases, private investment becomes more expensive and less of it is undertaken. On the other hand, the Ricardian view postulates that the form of government finance is irrelevant; consumers internalize government's budget constraint, holding that the timing of any tax change does not affect expenditure of the private sector. Therefore, the theory holds that no matter how government finances its deficits, the level of total demand in the economy remain the same1.In search of the relationship between budget deficit and interest rate, empirical evidence remains unclear as different studies concluded on different results. This has made the investigation inconclusive till today. Many in their studies argued that budget deficit indeed has a positive relationship with interest rate and thereby reduces the level of private investment, while some studies concluded that budget deficit does not affect interest rate. Between these two arguments, some studies justify as to why budget deficit will put pressure on interest rate and why it will be of no influence2.Nigeria in her early years of independence until 2005, when she was relieved of US$18 bn of her accrued debts, was characterized by unsustainable debt which has impeded her ability to achieve the desired fiscal and monetary objectives, building of infrastructures necessary for growth and development, and expenditure on social services like health and education. The cost of servicing public debt during this period stood beyond the capacity of the economy to pay for such obligation. …