Capital Illusions about India's Revenue Deficit

Abstract

There is a broad consensus that India's fiscal situation worsened over the 1990s due to a sharp rise in the revenue deficit, which in turn has raised interest rates, crowded out private investment and hindered growth. This article critiques this consensus view. It shows, using Domar arithmetic, that a rise in the fiscal deficit and revenue deficit can occur due to the casing of financial repression that leads to higher interest rates and thus higher interest payments on government debt, but simultaneously stimulates growth by lowering private borrowing rates.It then provides robust evidence that the rise in the revenue deficit (Centre) has been the byproduct of financial liberalization. This rise was accelerated by the policy changes associated with the structural adjustment program of 1991, leading to higher rates on government borrowing but lower private rates and greater private credit availability. The decline in private interest rates is consistent with a surge in private investment during the 1990s substituting for a fall in public investment, indicative of a reverse crowding out effect. The consolidated Centre-State finances indicate some deterioration, judged by the rise in the primary revenue deficit, but much less than that implied by the rise in the revenue deficit.

Keywords: Revenue and fiscal deficit, Financial liberalization, interest rates, Crowding out

JEL Classification: E43, E62, E63