Does the Composition of Fiscal Deficit Matter for Economic Growth at the Sub-National levels? An Empirical Analysis for India

Abstract

In a federal system like India, the states’ fiscal performance shapes their growth trajectories. However, the empirical studies on the relationship between the composition of fiscal deficit and economic growth in India are limited. This study attempts to fill the gap by bifurcating the gross fiscal deficit into revenue deficit (RD) and effective fiscal deficit (EFD) for 14 major Indian states from 1980-81 to 2019-20. The findings reveal that RD, EFD, tax revenues, non-tax revenues, and inflation rates negatively impact the state's economic growth. Nevertheless, the effect of RD is relatively stronger than EFD. Additionally, private investment and Fiscal Responsibility Legislation (FRLs) have positive impacts. The interaction between the FRL dummy and EFD significantly impacts growth, but economic policy reform (EPR) does not affect growth. Further, the panel threshold fixed-effect model confirms the existence of a threshold effect of both RD and EFD, which implies that not all deficits have detrimental effects on growth. When deficit is constrained within the specific limits, it stimulates economic growth. However, surpassing the critical limits have an adverse impact on growth. These findings highlight the importance of prudent fiscal management and effective policy implementation for the economy's sustainable and inclusive economic development.