Nexus between government expenditure and economic growth: Evidence from sub-national governments in India

The nexus between government spending and economic growth has remained a hot topic of discussion when Wagner (1958) stated about the 'demand following response' hypothesis, whereas Keynes (1936) advocated the 'supply leading response' hypothesis. Other two hypotheses are contemporaneous relationship, and neutrality or independence between government spending and economic growth. In the wake of the recent global economic crisis it is pertinent to analyze the nexus between government spending and economic growth to ascertain the implication of fiscal expansion on economic growth in India. This study tries to assess the influence of government expenditure on economic growth using a production function approach. We examine the influence of government spending, institutional credit and commercial electricity consumption on economic growth using panel data from 14 major (non-special category) sub-national governments in India during the period 1980-81 to 2013-14. After establishing long-run relationship among the variables, panel long-run estimates are drawn by using both Dynamic Ordinary Least Square (DOLS) and Fully-Modified Ordinary Least Square (FMOLS) methods. Results from both the methods suggest positive and statistically significant impact of government spending, institutional credit and commercial electricity consumption on economic growth. Among the three variables the impact of government size on economic growth is found to be highest and the influence of electricity consumption on economic growth is found to be lowest. Dumitrescu-Hurlin pairwise causality test reveals existence of bi-directional causality between government expenditure and economic growth, and between electricity consumption and economic growth. Unidirectional causality running from institutional credit to economic growth is established. The analysis reveals that at sub-national level in India, expansionary fiscal policy through building infrastructure and investing in productive sector, and escalation in credit facility with a lower rate of interest to the private sector will be helpful for the economy in generating higher economic growth. Though the influence of commercial credit consumption on economic growth is found to be low, electrification in India has to be expanded to reap more economies of scale and garner higher economic growth. The conservationist approach cannot be followed because low consumption of electricity can retard economic growth.