Contractionary Fiscal Policy, Public Investment and Regional Growth Dynamics in India: An Empirical Analysis

Abstract

Contractionary fiscal policy, which remains at the core of fiscal policy discourse in India, is built on the notion that there is a tradeoff between fiscal deficit and economic growth. Higher deficit due to expansion of government’s economic activities tends to crowd out private investment through its impact on interest rates thereby hampering economic growth. The present paper examines the empirical foundation of current policy discourse in India. The findings of this study do not support the predominant thesis that fiscal deficit positively influences the rate of interest. After empirically testing for the trade-off between fiscal deficit and economic growth, the paper analyses the implications of current fiscal policy, which is opposed to fiscal expansion, on public investment and regional economic growth in India. The study illustrates that the policy of fiscal squeezing has resulted in reduction in the level of public investment in a majority of Indian states during the post-liberalisation period. It is illustrated that a decline in public investment is likely to have adverse impact on the growth potential of regional economies.