Does Government Deficit Crowd Out Private Investment? An Empirical Analysis for National and Sub-National Governments

Expansionary fiscal policy can stimulate or retard growth in an economy depending on whether it crowds in or crowds out private investment. Amidst mixed results in the literature, the present study makes a comprehensive attempt to examine crowding out evidence by exploring the link between Gross Fiscal Deficit (GFD) on the one hand, and real interest rates and private investment, on the other, in a time series framework for the central government and panel framework for 23 state governments. The Autoregressive Distributed Lag (ARDL) cointegration results confirm the existence of a long-run equilibrium relationship between GFD, adjusted for cycles, and real rate of interest for central government for the period 1980-81 to 2017-18, thus supporting financial crowding out. While support for real crowding out is weak for central government, for the state governments, support has been found for real crowding out, with the strength of the coefficient rising when GFD is financed by gross market borrowings. This reinforces the need for both tiers of government—national and sub-national—to continue efforts towards fiscal consolidation, improving the quality of expenditure and to try financing their deficits less via market borrowings and more through own revenues