In India, 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 chronic. The ill-effects 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 printing money. Excess use of any particular mode of financing of the fiscal deficit has adverse macroeconomic consequences, viz, seigniorage 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 debt spiraling. Sometime large fiscal deficit can affect the countrys 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 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.

Pakistans budget deficit in fiscal year 2003-4 was around 4% of GDP, reduced to 3.4 in the next year. The figure further reduced to 3.2% in FY 2005-6, but it raised upto 4.2% in FY 2006-7. The deficit touched the highest points of 7.3 % in the FY 2007-8, but slightly reduced to 4.7% of GDP in FY 2008-9 (Report, 2008). 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.

Research evidences on the relationship between fiscal deficit and economic growth are in the mixed form. Al-Khedar (1996) has focused on the study on budget deficit and key macro economic variables in the major industrial countries. And he has found that deficit negatively affects the trade balance. However the budget deficit has a positive and significant impact on the economic growth of the country. In the same perspective, Barro (1979) explored a positive and significant impact of budget deficit on the growth. In contrast, Lucas and Sargent (1981) have approached the study on rational expectations and economic practice; findings revealed that massive government budget deficits and high rates of monetary expansion were not accompanied by economic growth. Further, Prunera (2000) has noted that the relation between growth and deficit is significantly negative. High deficit countries seem to face slow and poor growth performance. Vuyyuri and Seehaiah (2004) found that the fiscal deficit has the neutral effect on the economic growth. It means that any significant impact whether positive or negative was not found. Therefore, it is important to empirically examine the impact of fiscal deficit on economic growth in the Sri Lankan perspective. Literature review There is no agreement among economists either on analytical grounds or on the basis of empirical results whether financing government expenditure by incurring a fiscal deficit is good, bad, or neutral in terms of its real effects, particularly on investment and growth. Generally speaking, there are three schools of thought concerning the economic effects of budget deficits: Neoclassical, Keynesian and Ricardian. Among the mainstream analytical perspectives, the neoclassical view considers fiscal deficits detrimental to investment and growth, while in the Keynesian paradigm, it constitutes a key policy prescription. Theorists

persuaded by Ricardian equivalence assert that fiscal deficits do not really matter except for smoothening the adjustment to expenditure or revenue shocks. While the neo-classical and Ricardian schools focus on the long run, the Keynesian view emphasizes the short run effects. The component of revenue deficit in fiscal deficits implies a reduction in government saving or an increase in government dis-saving. In the neoclassical perspective, this will have a detrimental effect on growth if the reduction in government saving is not fully offset by a rise in private saving, thereby resulting in a fall in the overall saving rate. This, apart from putting pressure on the interest rate, will adversely affect growth. The neo-classical economists assume that markets clear so that full employment of resources is attained. In this paradigm, fiscal deficits raise lifetime consumption by shifting taxes to the future generations. If economic resources are fully employed, increased consumption necessarily implies decreased savings in a closed economy. In an open economy, real interest rates and investment may remain unaffected, but the fall in national saving is financed by higher external borrowing accompanied by an appreciation of the domestic currency and fall in exports. In both cases, net national saving falls and consumption rises accompanied by some combination of fall in investment and exports. The Keynesian view in the context of the existence of some unemployed resources, envisages that an increase in autonomous government expenditure, whether investment or consumption, financed by borrowing would cause output to expand through a multiplier process. The traditional Keynesian framework does not distinguish between alternative uses of the fiscal deficit as between government consumption or investment expenditure, nor does it distinguish between alternative sources of financing the fiscal deficit through monetisation or external or internal borrowing. In fact, there is no explicit budget constraint in the analysis. Subsequent elaborations of the Keynesian paradigm envisage that the multiplier-based expansion of output leads to a rise in the demand for money, and if money supply is fixed and deficit is bond financed, interest rates would rise partially offsetting the multiplier effect. However, the Keynesians argue that increased aggregate demand enhances the profitability of private investment and leads to higher investment at any given rate of interest. The effect of a rise in interest rate may thus be more than neutralised by the increased profitability of investment. Keynesians argue that deficits may stimulate savings and investment even if interest rate rises, primarily because of the employment of hitherto unutilised resources. However, at full employment, deficits would lead to crowding out even in the Keynesian paradigm

In the perspective of Ricardian, fiscal deficits are viewed as neutral in terms of their impact on growth. The financing of budgets by deficits amounts only to postponement of taxes. The deficit in any current period is exactly equal to the present value of future taxation that is required to pay off the increment to debt resulting from the deficit. In other words, government spending must be paid for, whether now or later, and the present value of spending must be equal to the present value of tax and non-tax revenues. Fiscal deficits are a useful device for smoothening the impact of revenue shocks or for meeting the requirements of lumpy expenditures, the financing of which through taxes may be spread over a period of time. However, such fiscal deficits do not have an impact on aggregate demand if household spending decisions are based on the present value of their incomes that takes into account the present value of their future tax liabilities. Alternatively, a

decrease in current government saving that is implied by the fiscal deficit may be accompanied by an offsetting increase in private saving, leaving the national saving and, therefore, investment unchanged. Then, there is no impact on the real interest rate.

No single paradigm corresponds exactly to reality, nevertheless, it is concluded that the neoclassical framework offers the most relevant insights into the economic effects of deficits (Mohanthy, 2011; Vuyyuri and Seshaiah, 2004; Fatima, Ahmed and Rehman, 2012; Bernheim, 1989). In the Indian context, Vuyyuri and Seshaiah (2004) have approached the study on the budget deficits and other macroeconomic variables and concluded that there is no significant impact of budget deficit on economic growth. Further, they have found that there is no significant relation between money supply, consumer price and economic growth. In contrast, Fatima, Ahmed and Rehman (2011) have focused the study on the fiscal deficit and economic growth in the Pakistan perspective. They have found that, fiscal deficit affects economic growth of country very adversely. In case of Pakistan, country is facing this adverse situation of fiscal deficit from last many decades. There are many reasons behind it. Such as narrow tax base, inelastic tax system, complex tax laws, defense and debt serving are taking a very major share of the current revenue, price instability; political instability etc. in this context, Huynh (2007) focused on the budget deficit and economic growth in developing counties. It was concluded that there is a negative impact of the budget deficit on the economic growth. Christopher, Adam and Bevan (2004) have approached the relation between fiscal deficits and growth for a panel of 45 developing countries and found a possible non-linearity in the relation between growth and the fiscal deficit for a sample of developing countries. They have suggested that while the impacts on growth of taxes and grants are reasonably straightforward, the impact of the deficit is likely to be complex, depending on the financing mix and the outstanding debt stock. In particular, deficits may be growth-enhancing if financed by limited seigniorage; they are likely to be growth inhibiting if financed by domestic debt; and to have opposite flow and stock effects if financed by external loans at market rates. In particular, two types of nonlinearity may emerge, one involving the size of the deficit and the other interactions between the deficit and the public debt stock. In brief way, Prunera (2000) has argued that public debt has sense depending on the objective money is used for. Running deficits due to something that is going to be used for a long time (spending on education, infrastructures etc) could not be bad. However, when running them for something temporary, investing in wrong conceived projects could be deleterious, especially when it is difficult to pay it back. Several countries have increased taxes and reduced their standard of living so as to pay back, which can be dangerous both for future growth and for their ability to ask for future loans. It may also impose borrowing constraints. Finally, the empirical evidence on the historical link between economic growth and deficits is extremely weak, and essentially uninformative. Based on the above literature, the following hypotheses are taken for the studies.

According to Al-Khedar (1996) interest rates increases in short run due to budget deficit, but in long run there is not impact explored. He studied taking VAR model by selecting data of G-7 countries for the period 1964-1993. He also explored that the deficit negatively affects the trade balance. However the budget deficit has a positive and significant impact on the economic growth of the country. Aisen and Hauner (2008) explored that the budget deficit negatively affecting the interest rate. The results were taken from the study of the period 1985-1994 for different countries. However, the effect is positive after the year 1995. They further argued that there is a positive effect

of budget deficit on interest rate, which the effect varies from state to state. In a study conducted by Bahmani (1999), with the help of Johansen Juselius co integration technique, the association between the budget deficit and investment while using quarterly data for the period of 1947-1992. There is a crowding in impact of the budget deficit on the real investment, which is validation of the arguments of Keynesian regarding the expansionary effect of the budget deficit on the investment. Barro (1979) explored a positive and significant impact of budget deficit on the growth. This impact is due to the positive relationship between the budget deficit and the inflation. There is a positive impact of the budget deficit and the interest rate. This impact is because of the high prices of the bonds. The study was conducted considering period of 1973 to 1996 to explore the relationship between the budget deficit and real interest rate, while using error correction model (Cebula, 2003). However, according to Ghali and Al-shamsi (1997) an increase in investment leads to increase in the economic growth of the country. The results were explored by taking quarterly data from oil producing country i.e. United Arab Emirates (UAE) for the period of 1973 to 1995. Gulcan and Bilman (2005) used co-integration method and causality test and applied ADF, PP and RPSS unit root test to investigate the stationarity of the individual time series. They considered data of Turkey for the period 1960 to 2003 and proved there is a strong impact of budget deficit on the real exchange rate. The study shows that the role of the budget deficit to maintain the real exchange rate is very crucial. They suggested that government must focus to stable the budget because the trade balance is significantly affected by the real exchange rates. Hakkio (1996) collected data of USA, Finland, Sweden and Germany for the period of 1979-1995, but could not explore any empirical association between the economies of United States of America (USA) and Germany. However, by applying simple regression technique and considering data from Sweden and Finland he was successful in exploring negative relationship between the budget deficit and the exchange rate.
Mohanty, K.R. (2011). Fiscal Deficit Economic Growth nexus in India: A co integration analysis.