Productive Public Expenditure and Debt Dynamics: An Error Correction Representation using Indian Data

The paper aims to explore the dynamics between components of public expenditure and public debt using an intertemporal optimization framework based on Turnovsky (2007). Public expenditure is classified as `productive' and `less-productive' based on the rationale that a proportion of the productive public expenditure (phi) corrects disequilibrium in the public debt in the long-run. The `second-order' conditions resulting from the model demonstrate that as phi increases, the marginal social value of a unit of capital reduces. Thus, 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 test the theoretical representation and to analyse the relationship between public expenditure and debt, an empirical analysis using Indian Public Finance data (1980-2013) is carried out in this study. 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 show that real capital expenditure is cointegrated with real public debt of the Central and the General government. Additionally, in the long run, real capital expenditure adjusts to bring real public debt on a convergent path. The amount of disequilibrium corrected is 0.01 and 0.035 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.