Alesina, Alberto and Guido Tabellini, 1989, “External Debt, Capital Flights and Political Risk,” Journal of International Economics, No. 27, pp. 199-220.
Barro, Robert J., 1981, “On the Predictability of Tax Rate Changes,” Chapter 11 of Macroeconomic Policy, by Robert J. Barro, (Cambridge, Massachusetts: Harvard University Press), pp. 268-97.
Barro, Robert J., 1987, “Government Spending, Interest Rates, Prices and Budget Deficits in the United Kingdom, 1701-1918,” Journal of Monetary Economics, No. 20, pp. 221-47.
Barro, Robert J., 1995, “Optimal Debt Management,” Working Paper No. 5327, (Cambridge, Massachusetts: National Bureau of Economic Research),
Benjamin, Daniel K. and Levis A. Kochin, 1982, “A Proposition on Windfalls and Taxes When Some But Not All Resources are Mobile,” Economic Inquiry, No. 10, pp. 393-404.
Bhat, K. Sham and S. Varalakshmi, 1994, “The Impact of Political Economy on Public Expenditure in Indian States,” Indian Journal of Economics, No. 74, pp. 405-29.
Buiter, Willem H. and Urjit R. Patel, 1992, “Debt, Deficits and Inflation: An Application to the Public Finances of India,” Journal of Public Economics, No. 47, pp. 172-205.
Buiter, Willem H. and Urjit R. Patel, 1993, “Indian Public Finance in the 1990s: Challenges and Prospects,” Discussion Paper No. 706, (New Haven, Connecticut: Economic Growth Center, Yale University).
Campbell, John, 1987, “Does Saving Anticipate Declining Labor Income, An Alternative Test of the Permanent Income Hypothesis,” Econometrica, No. 55, pp. 1249-73.
Campbell, John and Robert Shiller, 1987, “Cointegration and Tests of Present Value Models,” Journal of Political Economy, No. 95, pp. 1062-88.
Campbell, John and Pierre Perron, 1991, “Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots,” in NBER Macroeconomics Annual, Oliver Blanchard and Stanley Fischer (eds.), (Cambridge, Massachusetts: MIT Press).
Cashin, Paul A. and Ratna Sahay, 1995, “Internal Migration, Center-State Grants, and Economic Growth in the States of India,” IMF Staff Papers, No. 43, (Washington: International Monetary Fund), pp. 123-71.
Cashin, Paul A. and C.John McDermott, 1998, “Are Australia’s Current Account Deficits Excessive?,” Economic Record, No. 74, (forthcoming).
Central Statistical Organization, 1996, National Accounts Statistics, Ministry of Planning and Program Implementation, New Delhi.
Chelliah, Raja J., 1991, “The Growth of Indian Public Debt-Dimensions of the Problem and Corrective Measures,” IMF Working Paper WP/91/72, (Washington: International Monetary Fund).
Chopra, Ajai, Charles Collins, Richard Hemming, and Karen Parker, 1995, “India: Economic Reform and Growth,” IMF Occasional Paper 134, (Washington: International Monetary Fund).
Cooley, Thomas F., and Lee E. Ohanian, 1997, “Postwar British Economic Growth and the Legacy of Keynes,” Journal of Political Economy, No. 105, pp. 439-72.
Dickey, David and William Fuller, 1979, “Distribution of the Estimators for Autoregressive Time Series with a Unit Root,” Journal of the American Statistical Association, No. 74, pp. 427-31.
Edwards, Sebastian and Guido Tabellini, 1990, “Explaining Fiscal Policies and Inflation in Developing Countries,” NBER Working Paper No. 3493, (Cambridge, Massachusetts: National Bureau of Economic Research).
Fry, Maxwell J., Charles A.E. Goodhart and Alvaro Almeida, 1996, Central Banking in Developing Countries: Objectives, Activities and Independence, (Routledge, London).
Fry, Maxwell J., Charles A.E. Goodhart and Alvaro Almeida, 1997, Emancipating the Banking System and Developing Markets for Government Debt, (Routledge, London).
Gerson, Philip and David Nellor, 1997, “Philippine Fiscal Policy: Sustainability, Growth and Savings,” in John Hicklin, David Robinson and Anoop Singh (eds.), Macroeconomic Issues Facing ASEAN Countries, (Washington: International Monetary Fund), pp. 91-129.
- Search Google Scholar
- Export Citation
)| false Gerson, Philipand David Nellor, 1997, “ Philippine Fiscal Policy: Sustainability, Growth and Savings,” in ( John Hicklin, David Robinsonand Anoop Singh eds.), Macroeconomic Issues Facing ASEAN Countries, ( Washington: International Monetary Fund), pp. 91- 129.
Ghosh, Atish R., 1995, “Intertemporal Tax Smoothing and the Government Budget Surplus: Canada and the United States,” Journal of Money, Credit and Banking, No. 27, pp. 1031-45.
Giovannini, Alberto and Martha de Melo, 1993, “Government Revenue from Financial Repression,” American Economic Review, No. 83, pp. 953-63.
Haque, Nadeem Ul and Peter Montiel, 1994, “Pakistan: Fiscal Sustainability and Macroeconomic Policy,” in William Easterly, Carlos Rodriguez and Klaus Schmidt-Hebble (eds.), Public Sector Deficits and Macroeconomic Performance, (Washington: World Bank; Oxford, England: Oxford University Press), pp. 413-57.
- Search Google Scholar
- Export Citation
)| false Haque, Nadeem Uland Peter Montiel, 1994, “ Pakistan: Fiscal Sustainability and Macroeconomic Policy,” in ( William Easterly, Carlos Rodriguezand Klaus Schmidt-Hebble eds.), Public Sector Deficits and Macroeconomic Performance, ( Washington: World Bank; Oxford, England: Oxford University Press), pp. 413- 57.
Hemming, Richard, Neven Mates, and Barry Potter, 1997, “India,” in Teresa Ter-Minassian, (ed.), Fiscal Federalism in Theory and Practice, (Washington: International Monetary Fund), pp. 527-39.
Horrigan, Brian R., 1986, “The Determinants of the Public Debt in the United States, 1953-1978,” Economic Inquiry, No. 24, pp. 1-23.
Huang, Chao-Hsi and Kenneth S. Lin, 1993, “Deficits, Government Expenditures, and Tax Smoothing in the United States: 1929-1988,” Journal of Monetary Economics, No. 31, pp. 317-39.
International Monetary Fund, 1996, India—Selected Issues, IMF Staff Country Report 96/132, (Washington: International Monetary Fund).
International Monetary Fund, 1997, India—Selected Issues, IMF Staff Country Report 97/74, (Washington: International Monetary Fund).
International Monetary Fund, March 1998, (Washington: International Monetary Fund).
Kingston, Geoffrey H. and Allan P. Layton, 1986, “The Tax-Smoothing Hypothesis: Some Australian Empirical Results,” Australian Economic Papers, No. 25, pp. 247-51.
Kwiatkowski, Denis, Peter Phillips, Peter Schmidt and Yoncheol Shin, 1992, “Testing the Null Hypothesis of Stationarity Against the Alternative of a Unit Root: How Sure Are We that Economic Time Series Have a Unit Root?,” Journal of Econometrics, No. 54, pp. 1597-78.
- Search Google Scholar
- Export Citation
)| false Kwiatkowski, Denis, Peter Phillips, Peter Schmidtand Yoncheol Shin, 1992, “ Testing the Null Hypothesis of Stationarity Against the Alternative of a Unit Root: How Sure Are We that Economic Time Series Have a Unit Root?,” Journal of Econometrics, No. 54, pp. 1597- 78.
Mackenzie, G.A. and Peter Stella, 1996, “Quasi-Fiscal Operations of Public Financial Institutions,” IMF Occasional Paper No. 142, (Washington: International Monetary Fund).
Mühleisen, Martin, 1997, “Improving India’s Saving Performance,” IMF Working Paper WP/97/4, (Washington: International Monetary Fund).
Ohanian, Lee E., 1997, “The Macroeconomic Effects of War Finance in the United States: World War II and the Korean War,” American Economic Review, No. 87, pp. 23-40.
Olekalns, Nilss, 1997, “Australian Evidence on Tax Smoothing and the Optimal Budget Surplus,” Economic Record, No. 73, pp. 248-57.
Olekalns, Nilss and Mark Crosby, 1998, “Some Long Run Evidence on Tax Smoothing,” Department of Economics Research Paper Number 609, (Australia: University of Melbourne).
Phillips, Peter C.B. and Bruce E. Hansen, 1990, “Statistical Inference in Instrumental Variables Regression with 1(1) Processes,” Review of Economic Studies, No. 57, pp. 99-125.
Phillips, Peter C.B. and Samuel Ouliaris, 1990, “Asymptotic Properties of Residual-Based Tests for Cointegration,” Econometrica, No. 58, pp. 165-93.
Phillips, Peter C.B. and Pierre Perron, 1988, “Testing for a Unit Root in Time Series Regression,” Biometrika, No. 75, pp. 335-46.
Rao, M.Govinda, 1997, “Fiscal Adjustment and the Role of State Governments,” Journal of International Trade and Economic Development, No. 6, pp. 231-48.
Reserve Bank of India, 1997, Report on Currency and Finance, 1996-97, and earlier issues, (Mumbai, India: Reserve Bank of India).
Reserve Bank of India, 1998, Bulletin, February 1998, Reserve Bank of India, and earlier issues, (Mumbai, India: Reserve Bank of India).
Roubini, Nouriel, 1991, “Economic and Political Determinants of Budget Deficits in Developing Countries,” Journal of International Money and Finance, No. 10, pp. 49-72.
Schwert, G. William, 1989, “Tests for Unit Roots. A Monte Carlo Investigation,” Journal of Business and Economic Statistics, No. 7, pp. 147-59.
Shome, Parthasarathi, 1997, “Economic Liberalization, Fiscal Performance, and Tax Reform: Indian Experience and Cross-Country Comparisons,” in Sudpto Mundle (ed.), Public Finance-Policy Issues for India, (Oxford University Press, Delhi), pp. 76-103.
Strazicich, Mark C, 1996, “Are State and Provincial Governments Tax Smoothing? Evidence from Panel Data,” Southern Economic Journal, No. 62, pp. 979-88.
Strazicich, Mark C, 1997, “Does Tax Smoothing Differ by Level of Government? Time Series Evidence from Canada and the United States,” Journal of Macroeconomics, No. 19, pp. 305-26.
Sury, M. M., 1992, “Center-State Financial Relations in India: 1870-1990,” Journal of Indian School of Political Economy, No. 4, pp. 15-54.
Talvi, Ernesto and Carlos A. Végh, 1997, “Can Optimal Fiscal Policy be Procyclical?,” (mimeo; Los Angeles, California: University of California, Department of Economics).
Trehan, Bharat and Carl E. Walsh, 1988, “Common Trends, the Government’s Budget Constraint, and Revenue Smoothing,” Journal of Economic Dynamics and Control, No. 12, pp. 425-44.
World Bank, 1997, “India, Andhra Pradesh: Agenda for Economic Reforms,” Report No. 15901-IN, Country Operations, Industry and Finance Division, South Asia Region (Washington: World Bank).
Nilss Olekalns is Associate Professor of Economics at the University of Melbourne. The authors thank the Australian Research Council and the Faculty of Economics and Commerce at the University of Melbourne for financial assistance. The authors are grateful to Eduardo Borensztein, Ajai Chopra, Pietro Garibaldi, Nadeem Ul Haque, Mohsin Khan, Paul Masson, John McDermott, Xavier Sala-i-Martin, Parthasarathi Shome, M.R. Sivaraman, Peter Wickham, and especially Martin Mühleisen for their valuable comments and suggestions on earlier drafts.
As noted by Barro (1979, 1995), for a given amount of public expenditure, if taxes are lump sum and the other conditions for Ricardian equivalence are present, there are no real effects from shifts between taxes and the issuance of public debt as modes of financing fiscal imbalances. However, if taxes are distorting then the timing of taxes will matter, and it will be desirable to smooth tax rates over time, financing any temporary difference between public revenue and public expenditure by creating public debt.
Indian output levels and growth rates could have been mismeasured in recent years. This is because India’s system of national accounts appears to grossly underestimate economic activity in the informal manufacturing and nongovernment services sectors of the economy, both of which have expanded strongly since the early 1990s (IMF (1997)).
An example is the study by Barro (1981), who found that the average tax rate in the United States between 1884–1979 followed a random walk. Other studies include: Kingston and Layton (1986) for Australia; Gupta (1992) for Canada; Barro (1986), Sahasakul (1986), and Barro (1987) for the United Kingdom; and Trehan and Walsh (1988), and Huang and Lin (1993) for the United States.
For example, taxes could follow a random walk if rates were determined by a random political process, or if the budget surplus was adjusted to help satisfy a country’s external constraint. See Section V, and Ghosh (1995) for a more detailed discussion.
See also Cooley and Ohanian (1997), who found that the abandonment of tax smoothing by the British government during World War II contributed significantly to a reduction in post-War welfare. Ohanian (1997) has a similar finding for the implications of fiscal policy in the United States during the balanced-budget Korean War period.
While balanced budget rules may in principle preclude tax smoothing by subnational governments, tax smoothing could still occur in such an environment if the national government uses its revenue sharing powers as a countercyclical revenue source for subnational governments (Horrigan (1986)).
The percentage share of total grants sourced from each component is currently about 55 percent (Finance Commission), 40 percent (Planning Commission) and 5 percent (deficit financing)—of the total transfers distributed, loans comprise about 75 percent and grants 25 percent (Hemming, Mates and Potter (1997), IMF (1997)).
For details on the public finances of an important state, see the World Bank’s (1997) report on Andhra Pradesh.
About 70 percent of the financing for the states’ gross fiscal deficit is through loans from the central government, with part of these loans (block plan loans and nonplan loans against state small savings collections) available at less than market terms. The other 30 percent of deficit financing is through either loans raised from the market (the size of which are determined administratively by the Government of India and the Reserve Bank of India, given prevailing statutory liquidity requirements) and through state-level employee funds (such as state provident funds), with the latter at significantly less than market rates of interest (IMF (1997)). Through its control of the size of market borrowing of the states, the central government effectively sets the limits on the states’ fiscal deficits.
See Saibaba and Sarangi (1997) for a discussion of the concept of gross fiscal deficit and other issues in Indian public finance. Appendix I has a detailed description of the variables discussed in this Section.
Statutory grants to the states (to cover any deficits on current operations) and periodic debt write-offs have reduced the incentive for individual states to boost their own revenue-raising and lower their deficits (see IMF (1997))
While the debt burden of the states has remained relatively constant, the burden of interest payments as a share of revenue receipts (that is, current revenue) has risen from an average of about 11 percent in the latter half of the 1980s to almost 17 percent in 1996–97 (Reserve Bank of India 1997).
In turn, the states have typically relied on hikes in tax rates (rather than broadening of tax bases) for greater net revenue, along with cuts to capital and social sector expenditure (see IMF (1997)).
Fry (1997) also found that annual seigniorage revenue averaged 2.0 percent of GDP (or 14.7 percent of government revenue) between 1979–93.
Annual average revenue from financial repression in India has been estimated by Giovannini and de Melo (1993) at a sizeable 2.86 percent of GDP and over 22 percent of government revenue (excluding revenue from financial repression) for the period 1980–85. Following the technique of Giovannini and de Melo (1993), Fry et al. (1996) found that the implicit subsidy to private sector borrowing (through nominal interest rate ceilings) from Indian financial repression averaged 0.83 percent of GDP (or 6.1 percent of government revenue) between 1979–93; data was unavailable to calculate the subsidy on government debt.
However, the liberalization of India’s financial sector in the 1990s has reduced the impact of many of these quasi-fiscal activities, with (for example) exchange guarantees being transferred to the Government of India from the central bank, reserve requirements on commercial banks being reduced, and many of the restrictions on the setting of commercial bank interest rates being removed (see Joshi and Little (1996), IMF (1996, 1997)).
When the rate of real output growth, n, is positive, the effective interest rate faced by the government (R -1≡ (1+r)/(1+n)) will be smaller than the actual market interest rate, (1+r), where r is the assumed (constant) real rate of interest.
Tax tilting could occur, for example, if the current government is unsure of its reelection prospects and therefore favors higher current debt levels than are implied by tax smoothing, in order to exert an influence of the future spending activities of rival political parties who assume office (Alesina and Perotti (1995) and Olekalns (1997)). See Ghosh (1995) for a discussion of tax tilting.
The tax-tilting (nonstationary) component of the actual fiscal surplus is removed to construct the tax-smoothing (stationary) component of the fiscal surplus. Beyond our desire to focus on tax smoothing, this is necessary to ensure the validity of standard statistical inference techniques, which will be used for hypothesis testing in Sections VII and VIII below.
When calculating the surplus, r and n are set equal to their respective average values. One of the advantages of doing so is to eliminate another possible source of tilting, involving changing the time path of taxation in response to deviations of the effective interest rate away from its permanent value. Obstfeld and Rogoff (1996, Chapter 2) discuss the same point, but in relation to private savings behavior.
A correction for serial correlation and endogeneity is needed because while
As the series for
Accordingly, the budget surplus should Granger-cause (help predict) future changes in government expenditure.
In addition, while the average marginal tax rate drives the allocative effects of taxation, data is available only on the aggregate average tax rate. As noted by Barro (1981), use of the latter to proxy for the former implies that there has not been a substantial change over time in the relationship between the two tax measures.
An alternative means to construct the relevant measure of the fiscal surplus is to use the left-hand side of the dynamic budget constraint, and examine the change in the outstanding stock of public liabilities for both tiers of government. However, in the case of India the traditionally extensive conduct of quasi-fiscal operations by its public financial institutions (see Section III.) results in the extraction of off-budget resources from the financial sector, yet at the same time often stimulates the growth of government liabilities. It also means that changes in the stock of public liabilities reflect more than accretions due to the running of gross fiscal deficits, even though the latter is a critical indicator of the stance of Indian fiscal policy. For further details on such quasi-fiscal activities, see Reserve Bank of India (1997) and Mackenzie and Stella (1996).
As with many developing countries, in India’s case there are two main reasons why the stock of public debt may not be willingly held by market agents. First, part of India’s external debt was obtained on concessional terms from official bilateral and multilateral sources, and second, part of India’s domestic debt is held by financial institutions (at below-market rates of return) to satisfy liquidity requirements. See Haque and Montiel (1994) for the similar case of Pakistan.
The consumer price index (CPI) is used to convert these nominal rates to real rates, and we assume that the states borrow at the same interest rate as the central government.
Phillips-Perron unit root tests (using an intercept and trend) for the center reveal that both τt (-1.317) and [gt+ (r-n)dt] (-2.037) are integrated of order one (the null hypothesis of a unit root cannot be rejected at the 5 percent level of significance), and so the possibility of cointegration exists. A similar result was found for the states, with τt (-1.905) and [gt+ (r-n)dt] (-3.026) also integrated of order one.
Using the critical values from the Phillips-Ouliaris (1990) Z(t) residual-based cointegration test, we find that the null hypothesis of a unit root for
This inability to garner sufficient revenue stems largely from the narrowness of the tax base, widespread tax evasion and exemptions, weak tax administration, the poor economic performance of revenue-earning public enterprises, and the fact that a large part of economic activity is undertaken in the underground economy (see Joshi and Little (1994, 1996)).
In addition, India, like many developing countries, has viewed public expenditure (and especially public investment) as an engine of growth and development. Given that revenue has traditionally been difficult to raise, there has consequently been an ongoing incentive to run fiscal deficits (Joshi and Little (1994)).
Bhat and Varalakshmi (1994) find evidence for the impact of political changes on the expenditure patterns of state governments, yet only for the post-1977 period, when non-Congress Party governments came to power in many Indian states.
In recent related work, Talvi and Végh (1997) adapt Barro’s (1979) tax-smoothing model by incorporating a political distortion. This distortion makes it costly to run budget surpluses in good times (as required under tax smoothing), due to the consequent pressures induced to raise public expenditure. Their model predicts that optimal fiscal policy will be procyclical, varying positively with fluctuations in the tax base, and accords with evidence from several Latin American countries.
The tax-smoothing model generates conditions under which the stock of public liabilities can be repaid, as fiscal deficits derived under the model are sustainable, by definition. Accordingly, if the actual stock of public liabilities is rising more rapidly than the stock of liabilities implied by the tax-smoothing model, then the current path of fiscal deficits under unchanged policies is unsustainable.