The relationship between Fiscal Deficits and Economic Growth in Sri Lanka: An

Empirical Study

Introduction

It is very important for a country to strike a balance between its macroeconomic objectives
which are the price stability, full employment and growth etc. in order for it to become
effective. Two distinct policies are used by a country namely the Fiscal policy and the
Monetary policy in order to achieve its balance in macroeconomic objectives. Fiscal policy
and its indicators play an important role in the design and execution of economic and
political strategies of the governments of many countries. They play a major role in the
formulation and implementation of programs under arrangements between the International
Monetary Fund and its member countries.

Within the context of the Fiscal policy, the concept of budget deficit becomes a major social
and a political issue (Vuyyuri and Seshaiah, 2004). In general terms the gross fiscal deficit is
defined as the excess of the sum total of revenue expenditure, capital outlay and net
lending over revenue receipts and non-debt capital receipts including the proceeds from
disinvestment. The government has to incur deficits to finance its revenue and expenditure
mismatches and also to finance investments. The problem arises when the deficit level
becomes too high and troublesome. The negative side of high deficits are linked to the way
they are financed and how it is used. The fiscal deficits can be financed through domestic
borrowing, foreign borrowing or by issuing new money. Excess use of any method of
financing of the fiscal deficit has negative macroeconomic consequences.

Financing of fiscal deficit can create inflationary pressures in the economy, bond financing of
fiscal deficit can lead to rise in interest rates and in turn can crowd out private investment
and the external financing of fiscal deficit can spill over to balance of payment crisis and
appreciation of exchange rates and in turn increase the debt. Sometime large fiscal deficit
can affect the country’s economic growth adversely. A higher fiscal deficit implies high
government borrowing and high debt servicing which forces the government to cut back in
spending on relevant sectors like health, education and infrastructure. This reduces growth
in human and physical capital, both of which have a long-term impact on economic growth.
Large public borrowing can also lead to crowding out of private investment, inflation and
exchange rate fluctuations. However, if productive public investments increase and if public

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and private investments are complementary, then the negative impact of high public
borrowings on private investments and economic growth may be offset. Fiscal deficit used
for creating infrastructure and human capital will have a different impact than if it is used for
financing ill targeted subsidies and wasteful recurrent expenditure. Therefore the fear about
high fiscal deficit is justified if the government incur deficit to finance its current expenditure
rather than capital expenditure.

In the Sri Lankan context, tax revenue has the major role in the government income where
as expenditure on goods and services, interest payments and current transfer and subsidies
are considered as the main elements in the current expenditure in the government
expenditure perspective, and also government capital expenditure has the elements as
acquisition of real assets and capital transfers in which, the government current expenditure
has the major share in the expenditure as compared to capital expenditure. (Central Bank
Report, Sri Lanka, 2010)

Sri Lanka’s budget deficit in fiscal year 2000-01 was around 9-10% of GDP, reduced to 8.2%
in the next year. The figure further reduced to 8.2% in FY 2003 and remained at the rate of
7% until 2010, but it raised upto 9.9% in FY 2010. One of the reasons for budget deficit
may be lack of clearly outlined budget. The inability of the government to forecast
expenditure and revenues results in the deficits of the budget.