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Productive Public Expenditure and Debt Dynamics: a Theoretical Framework based on Intertemporal Optimization

Bhatt Hakhu, Antra (2010): Productive Public Expenditure and Debt Dynamics: a Theoretical Framework based on Intertemporal Optimization.

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The paper aims to explore the dynamics between components of public expenditure and debt using an intertemporal optimization framework. Public expenditure is classified as productive and ‘less-productive’ based on the rationale that an increase in the share of productive expenditure in total public expenditure (phi) affects public debt inversely in the long-run. The ‘second-order’ conditions resulting from the model demonstrate that when phi is less than or equal to half, an inverse relationship between phi and public debt will hold only if private investment stimulus is high in the economy. Beyond its optimal level, an increase in phi could still affect public debt inversely; however, this will be at the cost of ‘crowding out’ of private investment. To understand whether phi is the share of capital type expenditure in total public expenditure, an empirical analysis using Indian Public Finances data (1980-2013) is performed. Time series methods are employed to test the hypothesis that capital expenditure of the government is productive public expenditure. The correlation, cointegration and ECM results support the hypothesis of an inverse relationship between public capital expenditure/GDP and debt/GDP. Further, it is also observed that in the long run, a one percent increase in public capital expenditure/GDP will lead to a reduction in public debt/GDP by 0.84 and 0.09 percentage points for the Central and the Consolidated General Government respectively. Key policy implications point towards a scope for increasing public capital expenditure in the Indian economy while complementing it with private investment stimulus to stabilize public debt in the long run.

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