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Public Expenditure and Economic Development
Using univariate and multivariate time series analysis, like panel unit root test and panel co-integration, and the Toda–Yamamoto causality test, the causal relationship between economic development and public expenditure is examined in 28 states of India at different stages of development from 2003 to 2015. In relatively developed and less developed states, a causal flow exists from real sector growth to increase in public expenditure, in line with Wagner’s hypothesis. In least developed states, however, bidirectional causality exists between both capital and revenue expenditure to growth, and from growth to capital and revenue expenditure.
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Research on the association between public expenditure and economic growth dates to the 19th and 20th centuries (Wagner 1883; Keynes 1936; Peacock and Wiseman 1961; Peacock et al 1967; Gupta 1967, 1969; Musgrave 1969; Michas 1975; Rubinson 1977; Landau 1983). There is much empirical research on the positive and adverse impacts of public expenditure on economic growth and of economic growth on public expenditure. Public expenditure is considered a positive determinant of economic growth in Barro (1990) and Baffes et al (1993), whereas the negative impact is evident in Sheehey (1993); Vedder and Gallaway (1998); Fölster and Henrekson (2001); Furceri and Ribeiro (2008); and Romer and Romer (2010). Other aspects, such as how the structure and composition of public expenditure has an impact on the growth of the economy, have also been studied by Dar and AmirKhalkhali (2002), Gregoriou and Ghosh (2009), Maitra and Mukhopadhyay (2012), and Taiwo and Abayomi (2011). These contradictory results, that is, public expenditure affecting economic growth both positively and adversely, motivate this exploration of the issue at the regional level in India.
The possible direction of causality between public expenditure and economic growth is highlighted by two approaches: Wagner’s law (1883) and Keynes’s law (1936). Wagner’s law of “increasing public and state activities” claims that the role of public expenditure is an endogenous variable in the process of economic growth. His hypothesis asserts that economic growth leads to increase in real income, which results in increased demand for infrastructure, health, education, and social security services. The demand for such public utilities is due to industrialisation and urbanisation, and it increases perpetually; to continue to provide these services, the government needs to make huge expenditures. The Keynesian framework holds that public expenditure is an exogenous factor that influences growth, or public expenditure can be used as a policy measure to generate employment, and boost growth and economic activity.
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