The literature regarding the impact of government expenditure on economic growth is at best mixed. Given the conflicting results, we examine the impact of government developmental expenditure on India's economic growth. Our study spans the period from 1950 to 2007. We have employed standard time series technique (unit root test and cointegration analysis) for our analysis. By applying Engle and Granger two-step methodology for cointegration analysis, we found that investment and trade have positive impact on economic growth, as their coefficients are significant at 5% level of confidence. The impact of government expenditure on economic growth, which is the focus of this study, is found to be positive and significant at 1% confidence level. From short run analysis, it is clear that government expenditure is also significant, indicating that it has a permanent and transitory effect.
The Error Correction Model (ECM) term suggests that if we insert a shock into the model through one of these variables, approximately 33% of the deviation will be corrected within the first year. This is a rather slow adjustment process.
The relationship between economic growth and government spending, or more generally the size of the public sector, is an important subject of debate on the part of economic researchers both at the theoretical and at the empirical level. The size of the government is expected to affect the economic growth of a country through the impact of taxation, expenditure and budget balance on several economic issues such as the efficiency of resource allocation and the rate of factor accumulation (Dar and Amir Khalkhali, 2002). A central question is whether the public sector spending will increase the long run steady state growth rate of the economy.
The general view is that public expenditure, notably on physical infrastructure or human capital, can be growth-enhancing although the financing of such expenditures can be growth-retarding (for example, because of disincentive effects associated with taxation). Lin (1994), outlines some important ways in which government can increase growth. These include provision of public goods and infrastructure, social services and targeted intervention (such as export subsidies). Positive effect of government expenditure also depends on its size. In a panel study, Dar and Amir Khalkhali (2002) suggest that the optimal size of the government in the sample of 12 European countries is approximately between 36 and 42% of GDP.
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