Deficit Financing and Ricardian Equivalence: A Study of Indian Economy

Abstract

The theme of this thesis is Ricardian equivalence, and its objective is to examine the effects of deficit financing on private consumption expenditures, interest rates, and current account balance. According to the Ricardian equivalence proposition, the method of deficit financing will have no impact on the economy, subject to certain assumptions. Contradictory to the Ricardian proposition is the Keynesian proposition, which says that the method of deficit financing does have an impact on the economy. It is important to study the impact of debt versus tax mode of deficit financing on macroeconomic variables such as consumption, interest rate, and current account balance, because if the effects of deficit financing are neutral (Ricardian view), then a stabilization program that is based on demand management policy to curtail fiscal deficits will not be operative. On the other hand, if the effect of deficit financing is not neutral (Keynesian view) then deficit financing may induce private consumption, boost interest rates, crowd out investment, and retard economic growth. Most governments alter fiscal policies to fight macroeconomic challenges and stimulate economic growth. Due to an increase in government spending, budget deficits also increase. The Indian economy has continuously faced budgetary deficits for decades; all the budgets presented in the parliament have been deficit budgets. Given India’s long history of running huge fiscal deficits, the sharp increase in fiscal deficit over the last few years is a major concern for both, academicians and policy makers in India. If the Ricardian equivalence holds true in the Indian economy, does households alter its spending patterns and consequently increase their savings, resulting in making the policy changes ineffective. The study is an attempt to validate empirically the Ricardian equivalence in the Indian context. It has been always argued that higher deficits may adversely affect the economy, and hence, should be kept under control. Administrative measures to control fiscal deficits by enacting an Act took place in 2003, and the Fiscal Responsibility & Budget anagement (FRBM) Act came into force in April, 2004. The impact of fiscal discipline on deficit financing and the economy has also been incorporated in the study by taking a dummy variable of the FRBM Act. This study has examined the effect of deficit financing on: private consumption expenditures, interest rates, and current account balance of Indian economy. The aggregate consumption is used to measure the effect of deficit financing on the per capita private consumption expenditure of India. All the three tests of Ricardian equivalence — the impact of fiscal deficit on private consumption, domestic real interest rate, and current account deficit — provide more support for the Keynesian prediction rather than for the Ricardian prediction. The non-stationary nature of public debt also suggests that debt is unsustainable. The government needs to shift from debt to taxation as an alternative way of financing. The government should not roll over public debt without caution, as debt-financed deficits may retard capital formation and economic growth. The policy prescription is to raise tax collections. In order to do so, buoyancy and efficiency need to be achieved in the taxation system. India has a history of consistent fiscal deficits, and modern measures such as the FRBM Act need to be put in place to control fiscal imbalances. It is important for policy makers to allocate economic resources to venues inducing economic growth, and to curtail non-developmental expenditures, as the Indian economy is sensitive to fiscal deficits, and to ways of financing these deficits.