ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

THE DETERMINANTS OF BUDGET DEFICIT IN ETHIOPIA

BY: ASAMINO MULUGETA

A SENIOR ESSAY SUBMITTED TO THE DEPARTEMENT OF

ECONOMICS IN THE PARTIAL FULLFILLMENT OF THE
REQURIMENT OF BACHLIOR OF ART DEGREE IN
ECONOMICS.

ADVISOR: DEREJE YOHANNES (Msc)

JUNE, 2018

ADDIS ABABA, ETHIOPIA

1
 DECLARATIONS

I, AsaminoMulugeta that this Research paper, entitled “the Determinants of Budget Deficit in
Ethiopia”, is my original work submitted for the award of the fulfillment of requirement for
Bachelor of Art (BA) Degree in Economics at the Department of Economics, Addis Ababa
University. It has not been presented for the award of any Degree or other similar titles in any
other Institutions of higher learning to the best of my Knowledge, and all resources used have
been duly acknowledged.

STUDENT ADVISOR

NAME------------------------------------------ NAME----------------------------------------

SIGNITURE----------------------------------- SIGNATURE-------------------------------

DATE------------------------------------------ DATE-----------------------------------------

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 Table of Contents
Content Page

Table of Contents ........................................................................................................................................... I

ACKNOWLEDGEMENT ........................................................................................................................... V

List of Figures ............................................................................................................................................. VI

List of Tables .............................................................................................................................................. VI

List of ACRONYMS ................................................................................................................................ VII

ABSTRACT............................................................................................................................................. VIII

CHAPTER ONE ........................................................................................................................................... 1

INTRODUCTION ........................................................................................................................................ 1

1.1. Introduction ........................................................................................................................................ 1

1.2. Statement of problem ......................................................................................................................... 2

1.3. Objective of the study ........................................................................................................................ 3

1.3.1. General objective ........................................................................................................................ 3

1.3.2. Specific objective ........................................................................................................................ 3

1.4. Research question .............................................................................................................................. 3

1.5. Sources of data and methods of analysis ........................................................................................... 3

1.5.1. Sources of data ............................................................................................................................ 3

1.5.2. Methodology of analysis ............................................................................................................. 3

1.5.3. Specification of the model .......................................................................................................... 4

1.6. Scope of the study .............................................................................................................................. 4

1.7. Significance of study.......................................................................................................................... 5

1.8. Limitation of the study ....................................................................................................................... 5

1.9. Organization of the study ................................................................................................................... 5

I
CHAPTER TWO .......................................................................................................................................... 5

THEORETICAL AND EMPIRICAL LITERATURE REVIEW ................................................................. 6

2.1. Theoretical literature review .............................................................................................................. 6

2.1.1. Government budget deficit.......................................................................................................... 6

2.1.2. Concept of budget deficit ............................................................................................................ 6

2.1.2.1. Current account deficit ......................................................................................................... 7

2.1.2.2. Cyclically adjusted/trend deficit .......................................................................................... 7

2.1.2.3. Primary and operational deficit ............................................................................................ 8

2.1.3. Causes of budget deficit .............................................................................................................. 8

2.1.4. The effect of budget deficit on macroeconomic variables .......................................................... 8

2.1.5. Methods of deficit financing ....................................................................................................... 9

2.1.5.1. Foreign reserve reduction..................................................................................................... 9

2.1.5.2. Domestic borrowing ............................................................................................................. 9

2.1.5.3. External borrowing ............................................................................................................ 10

2.1.5.4. Money printing................................................................................................................... 10

2.1.6. Determinant of budget deficit ................................................................................................... 10

2.1.6.1. Level of economic development ........................................................................................ 11

2.1.6.2. Growth in government revenue.......................................................................................... 11

2.1.6.3. Size of government participation in the economy .............................................................. 11

2.1.6.4. Inflation rate ....................................................................................................................... 11

2.1.6.5. Foreign exchange rate ........................................................................................................ 11

2.1.6.6. Interest rate......................................................................................................................... 12

2.2. Empirical literature reviews ............................................................................................................. 12

CHAPTER THREE .................................................................................................................................... 13

METHODOLOGY AND DATA ................................................................................................................ 13

3.1. Data Sources .................................................................................................................................... 14

3.2. Data Analysis ................................................................................................................................... 14

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 3.3. Specification of the model ............................................................................................................... 14

3.3.1 .Theoretical justification of the model ....................................................................................... 14

3.3.2. Specification of the model ........................................................................................................ 15

3.4. Description of variables ................................................................................................................... 16

3. 5. Estimation techniques .................................................................................................................... 18

3.5.1. Co-integration test ..................................................................................................................... 19

3.5.2. Error correction model (ECM) .................................................................................................. 20

3.5.3. Heteroscedasticity Test ............................................................................................................. 21

3.5.4. Autocorrelation Test ................................................................................................................. 21

3.5.5. Multicollinearity Test ................................................................................................................ 22

3.5.6. Unit root test of stationary ........................................................................................................ 22

CHAPTER FOUR................................................................................................................................... 23

4. DESCREPTIVE AND ECONOMETRIC ANALYSIS .......................................................................... 23

4.1. Descriptive Analysis ........................................................................................................................ 23

4.1.1 Introduction ................................................................................................................................ 23

4.1.2 Government revenue .................................................................................................................. 23

4.1.2.1 Foreign trade tax ................................................................................................................. 25

4.1.2.2 Indirect tax .......................................................................................................................... 25

4.1.2.3 Direct tax ............................................................................................................................. 25

4.1.2.4 Non-tax revenue .................................................................................................................. 25

4.1.2 Government expenditure ............................................................................................................ 26

4.1.2.1 Current expenditure............................................................................................................. 28

4.1.2.2 Capital expenditure ............................................................................................................. 29

4.1.2.3. Government budget deficit................................................................................................. 30

4.2. ECONOMETRIC ANALYSIS ........................................................................................................ 32

4.2.1 Test of stationary........................................................................................................................ 32

4.2.2. Test Model Specification .......................................................................................................... 33

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 4.2.3. Autocorrelation test ................................................................................................................... 35

4.2.4. Hetroscedasticity test ................................................................................................................ 36

4.2.5. Multi-collienarity test ................................................................................................................ 36

4.2.6. Co-integration test ..................................................................................................................... 37

4.2.7. Long Run Model Estimation ..................................................................................................... 38

4.2.8. The short Run Model (Dynamics) ............................................................................................ 39

Chapter Five ................................................................................................................................................ 41

5. Conclusion and policy Implication ......................................................................................................... 41

5.1. Conclusion ....................................................................................................................................... 41

5.2. Policy implication ............................................................................................................................ 43

5.2.1. Policy implication for determinant of budget deficit ................................................................ 43

5.2.2. Policy implication for financing it ............................................................................................ 43

References:.................................................................................................................................................. 45

IV
 ACKNOWLEDGEMENT
First of all I would like to thank the almighty God (and his mother Saint Virgin Mary) for his
guidance and love and for giving me the opportunity to follow my study. Next I would like to
forward the deepest of my appreciation and gratitude to my advisor DerejeYohannes (Msc) for
his patience and constructive advice throughout the course of the thesis. Not only did his help me
with invaluable advice, I have also learned a lot from him. Special thanks would go to my
families specifically for my mam and father I will always love you, you are always in my mind.
My Special thanks would be also extended to my friend Roberto Firmino and my big brother
YnwaMulugeta will not be forgotten for their ample financial, technical and material support.
Lastly to those companies or institutions who help me a lot and without whom this would have
been a rough road to me. Thanks you all, God bless you.

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 List of Figures
Figure 4.1 Trend of Government Revenue Excluding Grant………………………………….24

Figure 4.2 Total Government Expenditure…………………………………………………….27

Figure 4.3 Trend of Current Expenditure from 1981 2017……………………………………29

Figure 4.4 Trend of Capital Expenditure from 1981-2017…………………………………....30

Figure 4.5 Trend of budget Deficit from 1981-2017………………………………………….31

List of Tables
Tables 4.1 Unit Root Test Results…………………………………………………………….34

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 List of ACRONYMS
ADF Augmented Dickey-Fuller
BD Budget Deficit

CAB Cyclically Adjusted Budget

CLRM Classical Linear Regression Model

DCs Developed countries
ECA Economic Commission for Africa
ECM Error Correction Model
FDRE Federal Democratic Republic of Ethiopia
GDP Gross Domestic Product
GTP Growth and Transformation Plan
IMF International Monetary Fund
LDCs Least Developed Countries
MLFIs Multilateral Financial Institutions
MoFEC Ministry of Finance and Economic cooperation
NBE National Bank of Ethiopia
OLS Ordinary Least Square
PCI per Capita Income
SAPs Structural Adjustment Polices
VIF Variance Inflation Factors

VII
ABSTRACT
Budget deficit means government spending is persistently exceeds its revenue. If expenditure
continue to mount up throughout the years whereas revenues especially taxes are poorly
collected, it widens the budget deficit. A deficit policy plays a vital role in assisting countries to
achieve macroeconomic stability, poverty reduction income redistribution and sustainable
growth. For this reason, most governments use the budget as effective tool in achieving their
economic objectives. Attaining a macroeconomic balance has become a priority of developed
and developing countries’ economies in the measurement of government success.

This research aims to investigate determinant of budget deficit. For the sake of achieving the
objectives of the study, researcher employed only secondary data in quantitative term and the
data was collected from annual reports and collected data.

Time series method of data regression and analysis were employed to analyze and regressing the
collected data. The data collected were presented in tabular form, graphical form and result of
regression. Finally, based on the findings of the study, policy implication and conclusion was
forwarded to the concerned body.

VIII
 CHAPTER ONE
INTRODUCTION

1.1. Introduction

Ethiopia shows some growth in past decade and in particular in second half of the decade has
been appreciated by international observers including the economic institution such as
economic commission for Africa (ECA, 2007). The government has begun to openly argue that
successful rejection of neo-liberal economic policy which refers to structural adjustment
policies (SAPs). In addition government, accept the idea of development state which later
refers to public sector intervention in economy through policy and investment. Budget deficit is
when the government expenditures exceed its revenue. In other words, when the level of public
saving is negative that leads to affect the economic growth of the country. Budget deficit is
caused when government spending more than collected taxes.

During the economic downturns the deficit increase government attempts to stimulate
economic growth with spending (Todaro, 2011). But the issue of budget deficit is not recent
things, while economic development faces spending greater than revenue. Government deficit
is the area of debate among of policy makers. This view concludes that government debt put
burden on future generation, while Ricardians view of government deficit stress that budget
deficit merely represent a substitution of future taxes for currents taxes (mankiw 7th edition).

In recent years government spending of least developed countries (LDCs) has increase
significantly. This due to the government of least developed countries(LDCs) involved in
social, political and economic affairs while the revenue do not grow rapidly in the same
proportion as expenditure due to inefficient tax collection system that result in budget deficit.
In developed countries, too market failure mechanism in 1930’s (during great depression) that
leads to government intervention in economy paving the way increase in government
expenditure in countries. The high budget deficit and variable inflation with crowding out of
investment and growth, while in some countries moderate budget deficit not to generate

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imbalance at all. This consequence of budget deficit different government adopts different
techniques of financing this deficit (mankiw, 2007).

Ethiopia faces big budget deficit due to combine effect of very rapid increase in expenditure
and lower increase in revenue. The fast increase in budget deficit started in 1997/98 when
doubled from its previous years from 1billiopn to 2.1billion birr again to 4.5billion in 1999/00
(Befekadudegefe, getahuntafesse2007). As structural reform agreed with multilateral financial
institution (MLFIs) the government of Ethiopia commit to decrease or over abandon domestic
borrowing to financial deficit. This considers as prudent strategy to curb inflation and even
more importantly to avoid crowding out of private investment.

On monetary policy, the government accepts persuasion of multilateral financial institutions

(MIFIs) and practice of tight monetary policy until 1996/97 where money supply increasing
less than nominal policy changed, but starting with conflict and money supply begins to
increase rather considerably. In 1997/98 narrow money supply by 10.7% and broad money
supply by 12.7%, while the rate of nominal GDP 8.1 %(Befekadudegefe, getahuntafesse 2007).

1.2.Statement of problem
Ethiopia is the one of the poorest countries in the world. The performance of the Ethiopian
economy has been due to distorted economic policies. The performance of macro-economic
balance has been the priority of government and developing countries’ economies in the
measurement of success of economic growth.

Ethiopia has along-history economic imbalance characterized by mismatch between

government spending and revenue. The large budget deficit always characterized by more
expansionary fiscal policy. But this not true, because during economic boom GDP will falls,
the contribution of revenue growth become decline because people pay lower taxes when earn
less (Mankiw 7th edition 2007).

It is true that similar studies were conducted before. However, they are not adequate. The
overwhelming majority of them focused on some determinants of budget deficit (such as real

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 exchange rate, money supply real interest rates, Real GDP and share of agriculture in the
GDP).Ignoring other relevant variables, such a Broad money supply.It is this consideration that
induced this study. The Study also analyzes the significances of each determinant of budget
deficit and their implication on the Ethiopian Economy. Finally the study attempts to find out
the significant determinants of budget deficit in Ethiopia and solution to finance that deficit.

1.3.Objective of the study

1.3.1. General objective

The main objective of this study is to examine the main determinant factors of the budget
deficit in Ethiopia.

1.3.2. Specific objective

 To assess the effects of budget deficit in Ethiopia.
 To analysis the determinant of budget deficit.
 Examine the means of financing the deficit and its implication.

1.4. Research question

The study will be addressed the following question:

I. what are the major determinants of Budget deficit?

II. What is the effect of budget deficit on economic growth?

III. What are the means of financing the budget deficit and what are the implications?

1.5.Sources of data and methods of analysis

1.5.1. Sources of data
The studies will be entirely depends on secondary sources of data collect from different sources
such as National Bank of Ethiopia(NBE), Minister of Finance and Economic cooperation
(MoFEC).

1.5.2. Methodology of analysis

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 To meet the objectives of the study the descriptive and econometric methods of analysis will
use. Ordinary least square (OLS) will be undertaken to clearly see the determinants relationship
with budget deficit in Ethiopia. The descriptive methods such as graphs, percentage will use to
show the trend of budget deficit, revenue and expenditure. In general study uses both
descriptive and econometric methods of data analysis.

1.5.3. Specification of the model

The budget deficit model of this study is going to be specified by using: real exchange rate, share
of agriculture in the GDP, Real GDP, real interest rate and Broad money supplyas explanatory
variables and budget deficit as dependent variable.

The model specification is as follows:

BD=f (LNRER, LNAGRI, LNRGDP, RIR, LNLM2)

The linear form of the above model is:

BDt= β0 +β1LNRERt + β2LNAGRIt + β3LNRGDPt + β4RIRt + β5LNLM2t+𝜺𝒕

Where t denotes time
BDt= Budget deficit at time t
LNRERt=Real exchange rate at time t
LNAGRIt= Share of agriculture of the GDP at time t
LNRGDPt=Real GDP at time t
RIRt=Real interest rate at time t
LNLM2t =Broad Money supply at time t
𝜺𝒕 = error term and β constitutes parameter estimators.

1.6.Scope of the study

In this study, the determinant of budget deficit will be study. The study covers the time periods
from 1980/81 up to2016/17. It will select because to explains the budgetary deficit trend
experience in Ethiopia. It also gives an emphasis on the trend and condition of budget deficit
during two regimes, the dergue regime and present (FDRE) regime.

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 1.7.Significance of study
The study will conduct on the determinant of budget deficit as country level. The study will be
significant in the context of the following:
 It gives information on determinant of budget deficit.
 To display the proper methods (technique) uses to finance budget deficit.
 To shows the policy implication on determinant of budget deficit.
In generally, this study may also give the way for further study on determinant of budget deficit.

1.8.Limitation of the study

As asses to these studies, budget deficit is one of the big problems of economic growth. The
some apparent limitation of the studies concentrates on macroeconomic factors which are
broader to cover in this study. This means that there are other important factors, other than
macro-economic factors that explain the relative good economic growth in Ethiopia. The topic
itself, for further research and it may/may not address in this study. A study will seek to explain
budget deficit which may be arrive at different results.

1.9.Organization of the study

The study will organize into five chapters. The first chapter of the study deals with background
of study, statement of problem, the objective of the study, hypotheses, significance of the study,
scope of the study, methods of data collection and analysis, limitation of the study and
organization of the study. The second chapter includes the discusses on the theoretical literature
on budget deficit, means of financing budget deficit. On other hand the deals with the empirical
review of the literature. The third chapter will also deals with description of analysis of budget
deficit and it includes component such as government revenue, government expenditures
during Dergue and the present government. The fourth chapter will deals with the discussion
and review of econometric issues. Econometric issues includes such as specification of models,
tests and interpretation of the results. Finally, the conclusion remarks and policy implication for
the study will be discussed in chapter five.

CHAPTER TWO
5
THEORETICAL AND EMPIRICAL LITERATURE REVIEW

2.1. Theoretical literature review

2.1.1. Government budget deficit

Analysis of budget deficit in most literature on public finance. Most of the literature prior to the
1950`s focused on separate discussion of the revenue and expenditure side of government
budget where the occupation of the analysis is to explain the role of fiscal policies in resource
allocation, stabilization, income distribution and economic growth and devoted little
explanation for budget deficit. Most of literature of that period was based on developed
countries and merely discussion of budget deficit to financial markets which made deficit
financing easily with little impact on macroeconomic variables.

Moreover, Keynesian conception of budget deficit is that of an average balanced deficit our
business cycle, i.e. surplus during boom and deficit during recession as a norm of fiscal
behavior, hence fiscal deficit accordingly was not much of the problem over a period. Even if
analysis of budget deficit got consideration since the 1960`s, a significant numbers of studies
that models the determinant of budget explicit were still limited (mankiw, 2007).

Budget deficit is related to activities of the government. The early mercantilist school of
thought support active government participation. This view was supposed by classical
economist who believed that market mechanism itself can regulate the economy and therefore
government should limit its intervention on economic sphere. However, in 1930`s (due to great
depression) economist started to question the working of the market mechanism. So, on other
hand large government intervention it leads to increase in government expenditure.

2.1.2. Concept of budget deficit

Any attempts to assess budgetary impact on macroeconomic variables such as money supply,
balance of payment, public debt and aggregate economic activity requires a specific measure of
the budget deficit. Fiscal deficit as conventional defined on a cash basis, measure the difference
between total government cash outlay, including interest outlay, but excluding amortization
payment on the outstanding stock of public debt and total cash receipt including tax and non-
tax revenue and grant but excluding borrowing proceeds. The most widely used purpose
oriented deficit, the structurally adjusted deficit, the primary deficit and the operational deficit.

6
2.1.2.1. Current account deficit
The current account deficit of the government is the excess of non-capital expenditures over
non-capital revenue. The treatment of depreciation in enterprise account on accrual basis which
contradict public sector accounts that tends to be available on the basis. Finally in the context
of economic adjustment, the difficulty of separating adjustment induced effects on the budget
from those introduced by external shocks limits the use of the current account deficit as a
measurement of fiscal stance.

2.1.2.2. Cyclically adjusted/trend deficit

Cyclically adjusted deficit cleans the budget from the effect of business cycle. It used by
practitioners as a tool to calculate the adequacy of the stance of fiscal policy. There are three
steps to practice assessment of fiscal policy. First, definition of the cyclically adjusted budget
(CAB). This involves developing a budget profile that allow for the impact of the economy on
the budget. It should be noted that the choice of base year when the budgetary position was
consistent with a satisfactory level of economic performance is central to the CAB. CAB can
formalize as follows

CAB=g*PGDP-t*AGDP……………………………… (1)

CAB= cyclically adjusted budget AGDP= actual GDP

PGDP= potential GDP g*= base year ratio of government expenditure to GDP

t*= base year ratio of revenue to actual GDP

Note that relating expenditure and taxes to potential GDP and actual GDP respectively allow
the budget vary with the cyclical position of the economy, I.e. deficit will be during and fall
during boom. Second, comparing the actual budget deficit with the cyclically neutral budget.

CEB= (G-T) –CAB………………………………… (2)

Where CEB= cyclical effect of the budget G=government expenditure

T= government taxes

7
 Fiscal policy can be expansionary or contractionaryis indicated by the sign of the CEB.
Appositive CEB points to the former while a negative one indicate the latter. Third, assessing
stance of fiscal policy. The appropriateness of fiscal policy is evaluated buy company the CEB
with the cyclical situation.

2.1.2.3. Primary and operational deficit

The primary deficit (non-interest deficit) is a measure of the fiscal deficit adjusted for interest
payments. It computed by subtracting net payment by government from total government
expenditure. The implication is that the primary balance should eventually turns surplus to
provide at least in part where with for interest on current debt. One basic deficit with the
primary deficit is that it does not exclude the part of interest payment including inflation. This
is particularly important in high inflation situations. To alleviate this problem the effect of
inflation on interest payment should be getting an inflation corrected deficit known as
operational deficit.

2.1.3. Causes of budget deficit

In current period, government spending increases in LDCs dramatically. This due government
of LDCs involved in social, economic and political affairs. Meanwhile, the revenue of the
government do not grow rapidly as proportion of expenditure due to narrow tax base and
inefficient tax collection result in budget deficit. However, DCs too market failure mechanism
due to 1930’s (great depression) led to government intervention in economy paves the ways for
to increase in government expenditure in the countries. The fluctuation in general price level,
income distribution, and population size determine growth of government spending while
change tax administration, and income determine growth of government revenue and
imbalances growth of the two leads to budget deficit (GTP).

2.1.4. The effect of budget deficit on macroeconomic variables

We now turn to the discussion of macro effect of deficit financing on variables such as, current
account, private saving and investment. The open economy national income identity provides a
useful guide for the discussion.

Y= C +I + G + (X-M)………………………………………………………….. (3)

Y= national x= export earning C= private consumption spending

8
 I= private investment spending G= government expenditure M= import consumption

Subtracting tax (T) from both sides of equation (3) then we obtain the disposable income (Yd.)

Y- T = C + I + G –T + (X- M)…………………………………………………. (4)

Yd. = C + I + G – T + (X –M)…………………………………………………… (5)

Because the disposable income (Yd.) can either be saved or consumed (C + S) = Yd.

C + S = C + I + (G – T) + (X –M)……………………………………………….. (6)

Rearranging equation (6) then (T – G) = (I –S) + (X –M)……………………… (7)

The equation shows the government deficit has counter balance in investment crowd out or
current account deficit or combination of the two. This implies that there is a crowd out to
budget deficit. For a give level of saving, the deficit implies either a reduction in investment or
an increase in current account deficit or both.

2.1.5. Methods of deficit financing

In general, the problem of deficit financing is one of the disagreement issues in economic
which do not conclusive theoretical analysis. The methods of financing are also an important
factor determining its deficit. There are four sources of deficit financing such as drawing
reserves, domestic borrowing, external borrowing and money printing (todaro, 2011).

2.1.5.1. Foreign reserve reduction

One of the methods of financing government budget deficit is to run down the foreign
exchange reserves. These methods of financing can be used to play for import bills. It has two
merit of reducing inflationary in the domestic economy and reduces the risk of external debt
crises. However, it tends to appreciate the domestic current by increasing the supply foreign
currency. In turn, this will deteriorate the current account by making import attractive and
discouraging export. Moreover, there are limits imposed by international organizations like the
IMF to its use in financing budget deficit.

2.1.5.2. Domestic borrowing

9
 Government can obtain domestic borrowing from banking system or the private sector. Funds
can be obtained by selling securities (government bonds and treasury bills). It is non-
inflationary and reduces the risk of external debt crisis. Nevertheless, domestic borrowing from
the banking system (excluding the central bank) requires a relative well developed financial
intermediation system. Moreover, the government’s recourse to domestic financing reduces the
supply of loan able funds.

2.1.5.3. External borrowing

External borrowing often appears too attractive because of the crowd out effect on private
investment and its being non-inflationary. It allows government to carry-out expansionary
domestic policies without drawing upon domestic saving. Although, government external
borrowing does not directly affect domestic interest rates and the supply of loan able fund, it
may also crowd out private investment through its impact on prices or the nominal exchange
rate in flexible or managed exchange rate regimes. When the budget deficit stems from
expenditure on locally produced goods, external borrowing brings about an appreciation of the
real exchange rate under a fixed or managed exchange rate regime. This has crowd out effect
on certain local producers (mankiw, 2007).

2.1.5.4. Money printing

The budget deficit can be covered directly through money creation by the central bank or more
generally by increasing credit of the banking system. However, excessive use of monetary
financing results in exceeds overall demand, which in turn translate into inflation or under fixed
exchange rate on the balance of payment. However, the relationship between the monetary
financing of budget and inflation is neither direct nor linear especially in the short-run
(Clayton, 1995).

2.1.6. Determinant of budget deficit

Budget deficit is as a result of increasing government activities in the economy, developing
theorizing problems related to the structure of the economy and political pressure to spend
more than what government collects as revenue. The size of government in the economy is also
an important determinant which may be included in the structural determinants of budget
deficits. Early work on the issue at hand tried to explain why government’s involvement in the
economy increases overtime.

10
2.1.6.1. Level of economic development
For countries with low level of economic development (measured by PCI) the initial level of
investment in infrastructure and expenditures as a percentage of the GDP, requires expanding
the infrastructure. On other hand, the revenue of government grows at very slow rate. The
system of taxes collection in most low income countries incur considerable time lags. Private
saving ratios are positively correlated to the level of economic development. Saving is
considered as the mobilization and diversion of the money incomes through deficit financing
that would otherwise be spent for consumption.

2.1.6.2. Growth in government revenue

The needs to deficit financing decreases when revenue grows rapidly while expenditure grows at
a lesser pace or decrease. However, inadequate growth of revenue leads to deficit financing.
Moreover, governments with slowly growing revenues are likely to resort to financing to support
expenditure than government whose revenues are growing at significant rates.

2.1.6.3. Size of government participation in the economy

The government’s ability to control expenditure is influenced by institutional, ideological and
structure factors. Among the factors which put upward pressure on spending are lacks of
coordination between financial and physical plans, development theorizing high share of
recurrent expenditure and revenue instabilities. The relative size of government sectors tends to
be highly correlated with increasing government role in production, consumption and
distribution of goods and services.

2.1.6.4. Inflation rate

Inflation is a sustainable increase in general price of goods and services while purchasing
power is decreasing. Inflation is the sign of economic growing. On other hand, low inflation
can have the same effect as high inflation, but goodness or badness of inflation depends on the
overall economy as well as individual situation (Salvatore 3rd edition).

2.1.6.5. Foreign exchange rate

11
Foreign exchange rate is the rate at which one currency exchange for one another. However,
depends on agreement of different countries, exchange can be fixed or floating i.e. determined
solely by free market forces. The central bank is intervening in the market when there is
currency fluctuation in the country (Salvatore 3rd edition).
2.1.6.6. Interest rate
Interest rate is a rate at which interest paid by borrowers (debtors) for the use of loan that
borrow from lenders (creditors).

2.2. Empirical literature reviews

Fiscal deficit adversely affect the economic structure and this impact depends on the ways of
financing. The study concludes that the simple correlation between fiscal deficit and individual
indicators of macro-economic imbalances (interest, inflation, price instability etc.) are weak to
non-existent. This clearly due to different mechanism that each country rely to finance its
deficit. However, the study found negative correlations between deficit and growth. The study
also examine the degree to which deficit are affected by external shocks(foreign exchange,
balance of payment, commodity price fluctuation, foreign interest rate or by domestic
macroeconomic variables(inflation, domestic interest rates, real exchange rates). The 50% of
the variation in deficit was explained by foreign shock does not seem to explains the deficit
variation (Salvatore 3rd edition).

According to this study, high fiscal deficit are significantly associated with high negative
interest rate in Ghana, Mexico, and Zimbabwe. These countries relied on financial repression as
means of financing their deficit and all control their nominal interest which resulted in negative
real rates. <<Recardian equivalence theory>> which propose that deficit and taxes are equal in
their effect on private consumption and the private sector save more in anticipation of high
future tax obligation during high fiscal deficit, was found to be true in the case study in
Argentina, morocco, and Zimbabwe. The study has confirmed that fiscal deficit appreciate real
exchange rate and the existence of close association between fiscal and internal balance (ibid).

The high fiscal deficit in 1970sin the country was caused by boom in coffee price. During this
time the government relied on foreign exchange reserves and faced appreciated real exchange

12
rate which damaged the non-traditional export sector. During these periods the government
used external debt to finance it and faced appreciated real exchange rate. Evidence from the
country shows the government adopted non-inflationary means of deficit financing more
relaying on domestic borrowing through bonds. The evidence also shows that there is no clear
relationship between inflation and seignorage in the country.

CHAPTER THREE
METHODOLOGY AND DATA
13
 3.1. Data Sources
The necessary data for the paper collected from various sources such as national bank of
Ethiopia (NBE), ministry of finance and economic cooperation (MoFEC), and other related
journals related with budget deficit.

3.2. Data Analysis

This paper is based on both descriptive and empirical study that applies econometrics techniques
using secondary data. In this paper the study uses time series data from 1980/81up to 2016/17.
As the data use time series, various tests such as testing for stationary (unit root test) and co
integration tests are performed. The study uses error correction model (ECM model) by using
ordinary least square method (OLS).

3.3. Specification of the model

3.3.1 .Theoretical justification of the model

In measuring the relationship between budget deficit, government expenditure and economic
growth, NurHayatiAbdrahman (2012) uses the model below:

𝑌 = 𝑓(𝐿𝑅𝑆𝐶𝑃t, 𝐿𝑅𝐷𝑆𝑃𝑡, 𝐿𝑅𝐾𝑆𝑃t, 𝐿𝑅𝐷𝐸𝐹𝑡, 𝐿𝐷/𝐹𝐹𝐼𝑁)

𝐿𝑅𝑆𝐶𝑃t= Log of real current spending

𝐿𝑅𝐷𝑆𝑃𝑡= Log of real defense spending

𝐿𝑅𝐾𝑆𝑃t= Log of real current spending

𝐿𝑅𝐷𝐸𝐹𝑡 = Log of real budget deficit

𝐿𝐷/𝐹𝐹𝐼𝑁= Log of domestic to foreign financing ratio

The objective of the model is to investigate the relationship between budget deficit, government
expenditure and economic growth and the way of its financing. Finally, the research use
economic growth as dependent variables.

14
Another work by Roubini and Sachs (1989) use the same model with the exception of budget
deficit but in this study the objective is solely to investigate the relationship between government
expenditure and economic growth.

Additionally, Cambes and Seadi-Sedik (2006) used simple theoretical model of budget deficit
determination. The main objective of this study is to find the determinant of budget deficit during
the period of 1995 to 2006.

Cambes and Seadi-Sedik specify the following model:

𝐵. 𝐷 = 𝑓(𝐶𝐵𝐼, LRGDPi, GRGDPi, URBi, AGRIi, ILLYi, OPENi)

𝐵. 𝐷 = Government budget deficit

𝐶𝐵𝐼 = Central bank independence

LRGDPi= Log of real per capita GDP

GRGDPi= The real GDP annual growth rate

URBi= The degree of urbanization

AGRIi= The share of agriculture in the GDP

ILLYi= The ratio liquid liability of the financial system to the GDP

OPENi= The trade of openness

Financial system to the GDP (ILLYi) include as a sub independent variable real exchange rate,
interest rate and real inflation rate are included.

3.3.2. Specification of the model

In fact overwhelming researchers did in Budget deficit by different models. As I try to
summarize some of them above, I will select my determinants of budget deficit based on the
following criteria. (1)Availability of data (2) selection from theoretical justification and add a
new variable to full fill the past study gap. It is true that why I am doing in the determinants of
budget deficit, which is why I believed that overwhelming researchers were, missed some

15
important determinant variables. That is why I cannot include all of the variables from
theoretical justifications.

To pick out the determinant of budget deficit, I will use multivariate time series model with the
available data. For this purpose the study start with the specification of the model with the
selection from theoretical justification and add a new variable to full fill the past study gap.

The reason for the selection of independent variable from the model is there is not generally
accepted theory and variable to shed light on only some determinant of budget deficit. Therefore,
there is no common set of variable to be included in the study. Another, reason for the selection
process is the existence and problem of availability and consistency of data that is used in the
model.

Besides, the objective of this paper tries to address the selection of the variable to be used in the
study with consideration of the availability and accurate of the data. The specified model is;

BDt= β0 +β1LNRERt + β2LNAGRIt + β3LNRGDPt + β4RIRt + β5LNLM2t+𝜺𝒕

Where t denotes time
BDt= Budget deficit at time t
LNRERt=Real exchange rate at time t
LNAGRIt= Share of agriculture of the GDP at time t
LNRGDPt=Real GDP at time t
RIRt=Real interest rate at time t
LNLM2t =Broad Money supply at time t
𝜺𝒕 = error term and β constitutes parameter estimators.

3.4. Description of variables

𝟏. Real exchange rate (𝑹𝑬𝑹): The appreciation and depreciation of domestic currency with
respect to foreign currency specifically with a measurement of USD. Because USD has a
property of vehicle currency, it dominates international transaction.

During appreciation of domestic currency export supply of the country decrease then it leads to
aggravate the growth of public fiscal deficit. This appreciation of domestic currency leads to

16
current account deficit that was seen more detail in literature review as a one source of budget
deficit. The data source gets from national bank of Ethiopia (NBE). The expected sign will be
negative.

2. Real interest rate (RIR): According to Keynesian economics lower real interest rate will lead
both the consumer and business capital spending both of which increases equilibrium national
income. This is because lower interest rates induce investment which in turn increases output and
hence increases revenue. Higher interest rate inhibits investment; lowers output and hence
reduces revenue. Source comes from national Bank of Ethiopia (NBE). The expected sign will be
positive.

𝟑. Real GDP(𝑳𝑵𝑹𝑮𝑫𝑷): Is included in the model as a proxy for economic activity because
government budget balance is sensitive to economic fluctuation. Indeed , when the level of
economic activities low or moderate the amount of tax revenues collected by the government
decreases while social expenditure increase, that lead to a deterioration of budget balance.
Conversely, a higher economic growth generates an improvement of budget balance (automatic
stabilizers). However, some authors (Talvi and Vegh, 2000) have suggested that fiscal policy can
be procyclical in developing countries with weak governments, because political pressures to
increase public spending go hand in hand with the growing tax revenue due to higher economic
growth. The strong increase in the fiscal demands during economic boom is called “voracity
effect” (lane and tornell, 1999).

The data source obtained from MOFEC and with some adjustment changed to real and use for
the study. And the expected sign will be negative.

𝟒. Share of agriculture in the GDP (LNAGRI): According to Tanzi (1992) country’s

economic structure is an important factor that could influence the level of taxation. The expected
sign of AGRI is uncertain because the theory distinguishes two opposite effects of the share of
agriculture in GDP on the tax share.

On the supply side the share of agriculture in GDP: is expected to have a negative effect on tax
revenues because political constraints could encourage the government to cut taxation in this
sector, often heavily taxed in many implicit ways through import quotas, tariffs, collected prices
of output or overt valued exchange rates.

17
Conversely on the demand side, the share of agriculture in GDP is expected to have a positive
effect on budget surplus because many public sector activities being city oriented, the demand
for public goods and services and so the public expenditures are theoretically reduced (Teere,
2003).

Agricultural sector in LDC’s is mainly characterized by subsistence farming and the

predominance of small farmers and so, it appears difficult for a government to tax the main foods
that are used for subsistence (Stotsky and Wolde Miriam, 1997). As over all there is difficult to
collect tax from agriculture sector in LDC’s but there is a little contribution to the tax revenue.

The data source obtained from ministry of finance and economic cooperation (MoFEC) change
to real data. And the expected sign will be positive.

5. Broad Money supply (LNLM2): (Woo, 2003) included as a process for the financial market
development level, the so called “financial depth”. According to Woo (2003) “countries with
higher developed financial markets can more easily finance the budget deficit by issuing bond,
without having resort to inflationary finance. And the expected sign will be negative.

6. Error term ( 𝜺𝒕 ): it includes the determinantsof Budgetdeficit that arenot included in

themodel.

3. 5. Estimation techniques
To address the relationship econometrically, a simple ordinary least square (OLS) is applied on
the model. According to Gujarati (2007), the coefficient derived by OLS best approximate the
true coefficient since it adopted the criteria of minimizing the summation of the error term.
However, this method heavily relies on the assumptions of; absence of serial correlation between
the error terms, absence of linear association among explanatory variables. Thus to drive a viable
link appropriate care will be undertaken to avoid these statistical shortcoming. Since the study
employ time series data, it is mandatory that stationary of data to be tested. A stochastic process
is said to be stationary if the mean and variance are constant regardless of the time taken.
Stationary test makes sure that there will not exist a spurious result which often found in non-
stationary time series. If the data is non-stationary forecasting the result of the other time period
may not have a practical significant (Gujarati, 2004). For the purpose of this study, the researcher
used annual time series data. Time series data are often strongly correlated over time. The notion
18
of stationary process is an important one when we consider econometric analysis of time series
data. A time series is called stationary, if its statistical properties remain constant over time. A
stochastic process is said to be stationary if its mean and variance are constant over time, i.e.
time invariant (along with its auto covariance). Such a time series will tend to return to its mean
(mean reversion) and fluctuations around this mean will have broadly constant amplitude. More
precisely, a time series let’s 𝒚𝒕 is called stationary if the following conditions are satisfied:

(1) 𝑬[𝒚𝒕] = 𝞵(Constant mean for all t)

(2) 𝑬[(𝒚𝒕 − 𝝁)𝟐] = 𝜸𝒐(Constant variance for all t)
(3) 𝑬[(𝒚𝒕 − 𝝁)(𝒚𝒕 + 𝒌 − 𝝁)] = 𝜸𝒌(Constant covariance for all t)
Where; µ, γ0, and γk are finite-valued numbers that do not depend on time t. So the mean has to
be constant over time, and, if the series has a trend, this should be removed. Also the variance
has to be constant, and, if the series contains seasonal fluctuations or changing variance, this
should also be removed. Finally, the co-variances are constant over time. If a time series is not
stationary (fails to satisfy the above requirement), it is called non-stationary time series which
contains time varying mean or time varying variance or both.
If the variables are non-stationary, the consequence leads to inaccurate results or so called
spurious (false) regression problem. Spurious regressions in a sense means that two variables are
trending over time, a regression of one on the other could have a high R2even if the two are
totally unrelated or although there is no meaningful relationship between the variables (Gujarati,
2004). So, the researcher uses different tests to check whether the data is stationary or non-
stationary.

3.5.1. Co-integration test

Co integration means that despite being individually non-stationary, a linear combination of two
or more time series can be stationary. Co integration among the variables reflects the presence of
long run relationship among non-stationary variables in the system. Testing for co integration is
important because differencing the variables to attain stationary generates a model that does not
show long run behavior of the variables. When estimating regression models using time series
data it is necessary to know whether the variables are stationary or not (either around a level or a

19
deterministic linear trend) in order to avoid spurious regression problems. This analysis can be
performed by using the unit root and stationary tests.
If the time series variables are non-stationary in their level, they can be integrated with
integration order 1, when their first differences are stationary. These variables can be co-
integrated as well if there are one or more linear combinations among the variables that are
stationary. If these variables are being co-integrated then there is a constant long-run linear
relationship among them or long term equilibrium between them.
It is well known that if two series are integrated to different orders, linear combinations of them
will be integrated to the higher of the two orders. Thus, for instance, if two economic
variables(𝑦𝑡, 𝑥𝑡) are I (1) the linear combination of them, (𝑧𝑡) will be generally I(1). But it is
possible that certain combinations of those non-stationary series are stationary. Then it is said
that the pair (𝑦𝑡, 𝑥𝑡) is co-integrated. Co-integration is important to the analysis of long-run
relationships between economic time series. It implies that these pairs of variables have similar
stochastic trends. Test for co-integration can be checked by Engle-Granger (EG) test on the
residual estimating from the co-integrating regression. If the variables are individually non-
stationary, there is a possibility that this regression becomes spurious. But when we performed a
unit root test on the residual, if the absolute value of calculated Engle-Granger (EG) value is
greater than the absolute value of critical (tabulated) Engle-Granger (EG) value our conclusion
is that the estimated residual is stationary (i.e. the co-integrating regression is not spurious even
individually they are non-stationary).

3.5.2. Error correction model (ECM)

An error correction model is the short run model which reflects the current error in achieving the
long run equilibrium relationship among variables. ECM is used to estimate the short run
economic growth function and allows us to study the short run relationship among variable under
consideration. An important theorem known as the Granger representation theorem, states that if
two variables X and Y are co-integrated, then the relationship between the two can be expressed
as ECM (Gujarati, 2004).
Generally, since ECM is a short run model, the coefficients of the independent variable show the
short run relationship of them with the dependent variable. For example, if we consider a
consumption function with consumption as dependent variable and income as independent
variable, the coefficient of income shows the short run marginal propensity to consume. The

20
ECM developed by Engle and Granger is a means of reconciling the short run behavior of an
economic variable with its long run behavior.

3.5.3. Heteroscedasticity Test

An important assumption of the classical linear regression model is that the disturbance ui
appearing in the population regression function is homoscedasticity i.e. they all have the same
variance. But when there exist an outlying observation in relation to the observation in the
sample the assumption of constant variance is violated and this violation is referred as
heteroscedasticity. The problem would lead the least square estimators to be inefficient and the
estimates of the variance are also biased which invalidates the test of significance. Weisberg test
for heteroscadasticity is used with the null hypothesis of constant variance and it is possible to
reject this hypothesis when p value is greater than the 5% significance level. The remedies
suggested to correct the problem of heteroscedasticity are transforming the data to the logs and
deflating the variables by some measures of size (Madala, 1992).

3.5.4. Autocorrelation Test

Autocorrelation occurs when covariance of errors are not zero, 𝑐𝑜𝑣𝑎𝑟 (Ԑ𝑡, Ԑ𝑡 − 1) ≠ 0
covariance of errors are nonnegative. This is mainly a problem observed in time series data.
There are several causes which gives rise to autocorrelation. These are; 1. Omitted explanatory
variables: We know in economics one variable is affected by so many variables. The error term
represents the influence of omitted variables and because of that an error term in one period
many have a relation with the error terms in successive periods. 2. Misspecification of the
mathematical form of the model: It we have adopted a mathematical form which differs from the
true form of the relationship, then the disturbance term is the must be show serial correlation.
The consequences of autocorrelation are the property (minimum variance property) is not
satisfied. If the disturbance terms are auto correlated then the OLS variance is greater than the
variances of estimate calculated by other method therefore the usual are no longer valid. The
variance of random term u may be seriously underestimated if the u`s are auto correlated. Durbin
Watson d statistic: is the most usable test detecting autocorrelation between the errors in different
time periods (Maddala, 1992).

21
3.5.5. Multicollinearity Test
One of the assumptions of classical linear regression model (CLRM) is that there is no perfect
co-linearity among some or all explanatory variable. Multi-co linearity (also co linearity) is a
phenomenon in which two or more predictor variables in a multiple regression model are highly
correlated, meaning that one can be linearly predicted from the others with a substantial degree
of accuracy that provide redundant information about the response. So, detecting Multi co-
linearity by using Variance inflation factors (VIF), which measure how much the variance of the
estimated regression coefficients are inflated as compared to when the predictor variables are not
linearly related, is important. If VIF≥10, then there is a problem of multi-co linearity (Gujarati,
2004).

3.5.6. Unit root test of stationary

Augmented Dickey Fuller (ADF) test is useful to know whether or not there exist a unit root of
time series data is stationary at level, it is integrated of order zero or I (0) which means it is not
spurious. In conducting the dickey fuller test t assumed that the error term 𝑒𝑡 was uncorrelated.
But in case of 𝑒𝑡 are correlated, dickey and fuller have developed a test known as the augmented
Duckey-Fullr (ADF) test. This test is conducted by augmenting the equation by adding the
lagged values of the dependent variables. The number of lagged difference terms to include is
often determined empirically, the idea being to include enough terms so that the error term is
serially uncorrelated. If the data is not stationary at level, we take first difference, second
difference and so on until it became stationary. A time series data is said to be stationary if the
calculated ADF is greater than the critical ADF at a given level (Gujarati, 2004).
The early and pioneering work on testing for a unit root in time series was done by Dickey and
Fuller which we call Augmented Dickey-Fuller (ADF) test. It is also known as tau (τ) test. So, a
time series data is said to be stationary if the computed ADF or τ-value is more negative than
critical ADF value or when we take absolute value, a time series data to be a stationary it must
fulfill that calculated ADF or τ-value is greater than the critical ADF value at a given level
(calculated τ > critical τ) (Gujarati, 2004).

22
 CHAPTER FOUR

4. DESCREPTIVE AND ECONOMETRIC ANALYSIS

4.1. Descriptive Analysis

4.1.1 Introduction
In the review of the literature, the paper has seen that both the size and the composition of public
expenditure as important factor in affecting the depth and existence of budget deficit. Using fiscal
instrument of taxation, expenditure and borrowing governments mobilizing resources to the provision of
publicly provided good and service, with higher objective of attaining better economic growth manipulate
the economy. As stated by Mahduri (1984), public expenditure is becoming a growing concern in almost
all developing countries.

Moreover, the general trend for government expenditure has been increasing through the world relative to
GNP in almost all over the state despite its role and importance in the national economies in the area of
government expenditure remains relatively unexplored. (ibed).

It is to be inferred from the fourth coming analysis that the general trend for public expenditure is
increasing in Ethiopia through the study period. In similar pattern the government revenue also increasing
in the study period but it fails to catch up with the growth of government expenditure that deficit start to
crop up in 1984/85 and has been growing ever seen.

In this section the study review the trend of government revenue and expenditure and focus on the
structure and trend of budget deficit.

4.1.2 Government revenue

The government of Ethiopia classified the revenue schedule in to ordinary revenues, external assistance
and capital receipts. Ordinary revenues are further classified in to direct tax; indict ax, and foreign trade
tax and non-tax revenue.

23
 Fig 4.1 Trend of government revenue excluding grant
300000
200000
100000

1980 1990 2000 2010 2020

year

Source NBE but own computation, Revenues are in million

As we can see from the graph Fig 4.1 beginning from 1984 government revenue is increasing in lower
pace until 1992/93. Then the trend of government revenue is sharply increasing at a higher pace up from
the beginning of 2002/03 to 2018. The reason for the fast increase was;

During 1981-1985, significant major changes on the rate and structure of all types of taxes were made.
These involved widening the land tax base, introducing capital and surplus transfers from nationalized
firms, as well as certain minor arrangements on other taxes, (Ministry of Finance, 1997; Geda and Abebe,
2005).

After the fall of Derg regime there is a tax reform in Ethiopia. There are internal and external factor for
the tax reforms. The major internal driving factors for the tax system were the transition of the economic
system of the country from the planned economic development strategy to market based economic
resource allocation on one hand and poverty eradication strategy of developmental program on the other
hand. While the external driving factors were the requirement of International Financial Institutions (IFIs)
to meet the standard of loan and aid. This leads to a certain increase in the government revenue up to the
pre reform period 1992/93 to 2001/02.

In the post reform 2002/03 the Revenue is trending upwards thanks to tax reforms and enhanced tax
administration. More recent efforts to broaden the tax base and strengthen tax administration through
automation, tax education and enforcement measures drove the increase in revenues on profits and VAT.

24
VAT and income tax performed well compared to foreign trade tax and non-tax revenue in recently but
the overall is foreign trade tax is contributed the largest share of the total government revenue were
44.29%, 42.61% and 40.16% during the year 1986/87 to 1988/89 and in recent period 34 percent from the
overall revenue that means Ethiopian government get 13,912,885,311 ETB from the foreign trade tax.

Furthermore, the recently passed income tax law simplifies procedure, update tax bracket and improve the
tax appeals process. Also the newly introduced invoice based taxation is an important factor in increasing
the tax revenue.

4.1.2.1 Foreign trade tax

Foreign trade tax which include export duties and taxes, import duties and taxes and transaction tax on
exported as well as imported goods constituted a major part of government revenue.

As shown in fig.3.1 above foreign trade tax have been the most important source of government revenue.
Until 1988/89 their shares from the total government revenue were 44.29%, 42.61% and 40.16% during
the year 1980/81 to 1982/83. Its contribution to total government revenue decreased after 1984/85. In the
year 1988/89 its contribution was only 13.45% from the total government revenue. After this period the
trend of foreign trade tax contribution to total government revenue increased.

4.1.2.2 Indirect tax

The other component of government revenue is indirect tax. These taxes constitute excise and transaction
taxes on locally manufactured goods and turn over tax on stamp duties. The relative importance of this tax
has been declining although the absolute amount has been increased.

4.1.2.3 Direct tax

Direct taxes have remained stable contribution to total government revenue. They have shown relatively
less fluctuation in their contribution to total government revenue. Direct tax includes personal income tax,
tax on business and profit, agricultural income tax and land use fee. Of these taxes tax on business is the
most important one followed by personal income tax.

4.1.2.4 Non-tax revenue

A component of government revenue which has shown constant increase in terms of contribution to the
total government revenue is non-tax revenue categories. The important components of non-tax category
are charges and fees, sales of goods and services, surplus and capital charges.

As can been seen from fig 4.1 above starting from 1980/81 the total government revenue increase
constantly until 1993/94. Then the trend for government sharply declined until 1995/96. The reason for

25
the sharp decline of the trends in the last two years of the Dergue regime were political and economic
crisis faced by the governments which have eroded the tax basis and consequently decline the government
tax revenue. However, various reforms were introduced by the post 1990/91 government of Ethiopia that
increased government revenue. As a result the trend for government revenue show a sharp rise and
increased constantly then after.

4.1.2 Government expenditure

Government expenditure in a modern government finance is regarded a means of securing social ends
rather than just being mere finance mechanisms, government expenditure is significant in modern
economy because it produce money directly and indirectly to socio-economic effect.(Mankiw, 2000)

The growths of government expenditure are measured by total government expenditure as a ratio of GDP.

In Ethiopia before and after the 1991 the government participates in the economy but the reason and
severity of the participation have a difference. In pre 1991 the governments follow socialist economic
policy. According to Teshome (1994) views the socialist economic policy, the nationalization of private
property, the expansion of bureaucracy and series of campaign conducted during the Derg regime as
being a major contributor to the rapid growth of government expenditure.

In 1988, 1989 and 1990 government expenditure growth rate is 23%, 22.8% and 24.9% respectively, this
is the highest growth Ethiopia face before 1980’s. During this period Ethiopia face a crisis and war in
most of the country.

During the period of 1989 and 1990 the country face a huge public expenditure growth rate that are never
appear in the countries experience, it count 30.1 and 33.9 respectively. The government of that time
directed its resource to the war effort because the civil war is reached at a climax level, so that the budget
had been strongly in favor of defense outlay.

According to peacock and wise man analysis public expenditure, also partly explain the rise of public
expenditure in Ethiopia during 1980’s and 1990’s. Their analysis suggests that the growth of public
expenditure tends to show up ward shift, at a time of crisis such as war and famine.

After 1991, the growth rate of government expenditure is decreasing until 1993 and it account 19.6% the
lowest in the decade. In 1998, 1999 and 2000 are the highest growth of government expenditure25.4%,
26.04% and 23.39% respectively, due to the reason of Ethiopia Eritrean war for the purpose of border
demarcation and the place of Badme. The lowest is accounted during 2008 13.21%.

26
 In 2014/15-2015/16 the expected government expenditure is higher from the previous 2014 the reason for
the increasing of this government expenditure is different according to Ethiopian government and the
international observer. According to Ethiopian government the reason is blame to the drought that can
raises from the Elliono effect only but based on the evidence and international observer the effect of
Elliono is not the only cause for the slightly increase in government expenditure growth but also political
unrest have a significant effect. And according to BBC news December 14, 2016 states that the country
economic growth is decline to 8% from a previous annual average of 10% based the above reason.

Fig 4.2 Total government expenditure

400000
300000
200000
100000

1980 1990 2000 2010 2020

year

Source NBE but own computation, in million

Convectional to classify government expenditure in to various economic categories. Classification of the

government expenditure means that, the manner or the structure format in which items of different
government expenditure are categorized and personated.

The purpose and requirement of budgetary, expenditure classification are facilitation of analysis in order
to distinguish between the nature and effect of different parts of government expenditure (Aklilu, 1995).
Various authors give different ways of classification of government expenditure. According to Bhatia
classified government expenditure is based on three things. These are accounting classification,
classification by productivity and classification by transferability.

27
 In Ethiopia government expenditure is categorized in to recurrent and capital expenditure. Recurrent
expenditure refers to outlays for running government administration and other social and economic
services. On the other hand, capital expenditure refers to investment outlays on developing project.

4.1.2.1 Current expenditure

In Ethiopia, government expenditure is more concerned with those expenditure that do not render returns
in the long run, i.e. why the current expenditure takes the major proportion of total expenditure. From the
figure 4.3, the government expenditure shows the growth of government expenditure through time.
During the pre-reform, the highest government expenditure occurs in 1982/83, which was 20.4% of GDP,
and in 1988/89 was about 23.4% of GDP. However, post reform period the highest government
expenditure occurs in 200/02 which was about 29% of GDP and after this time it showed decreasing
trends.

In general the share of current expenditure to total government expenditure during pre-reform period on
average was 73.8% while it was 64.3% in post reform period. During pre and post reform period annual
growth rate of current expenditure to overall expenditure has dominated government expenditure for
whole period of the study.

Fig 4.3 Trend of current expenditure from 1981-2017

200000
150000
100000
50000

1980 1990 2000 2010 2020

year

Source NBE but own computation, expenditure in million

28
4.1.2.2 Capital expenditure
Capital expenditure is broadly defined as an outlay on development project that result in the acquisition
on fixed and there by enhance the capacity of the economy for the production of the goods and services.
Such outlays include spending on construction and purchase of machine and equipment. It also includes
payment for project study and design, management provision and direct labor costs.

Significant increases have been witnessed in the capital expenditure during the post reform period. It
grew by 26.5% and 29.2% in nominal terms successively been 1992/93 and 1995/96. This was triggered
by an all out effort for rehabilitation and reconstruction of war devastated infrastructure and up lifting the
status of neglected regions. Such a significant annual increase lifted the share of capital expenditure in
total expenditure from 22.63% in1994/95 to 45.24 in 1995/96. Annual average growth rate of capital
expenditure was 13.8% during pre reform period while it increased to 22.93% on average during post
reform period. On average, capital expenditure was34.77% of the total government expenditure in the
post reform period while it was 26.52% during pre-reform period.

Since 1980/81 the government expenditure as a whole shows an increasing path. Its annual growth rates
which was 7.79% and 5.43% during the year 1982/83 and 1933/1984 shoot to 41.12 on 1984/85. After
1984/85 the government expenditure shows a sharp rise. The major reason for the sharp increase after
1984/85 was the increase in the public sector economy. During the Dergue regime, the economy was put
under the state control with considerable socialist transformation. As a result, the whole production and
distribution processes were mainly carried out by the public sector.

The government expenditure sharply declined from 1989/90 to 1991/92 annual growth rate during those
periods -7.73, -8.12 and -13.37. The reason for the sharp decline was a cut in government expenditure as a
result of a huge decrease in tax revenue.

The sharp declined trend was reversed after 1992/93. Annual growth rate of government expenditure were
24.11% and 35.91% during the year 1992/93.

29
 Fig 4.4 Trend of capital expenditure from 1981-2017
150000
100000
50000

1980 1990 2000 2010 2020

year

Source NBE but own computation, expenditure are in milliom

4.1.2.3. Government budget deficit

A major consequence of fast growth of public sector economy is the existence of persistence structural
deficit in the economic system. As the literatures describe that a major factor behind the trend of
increasing government budget deficit has been relatively high growth of expenditure than revenue.

Fig 4.5 Trend of budget deficit from 1981-2017

60000
Budget deficit

40000
20000

1980 1990 2000 2010 2020

year

Source NBE but own computation excluding grant

30
As the literature described that the major factor behind the trend of increasing government budget deficit
has been the relatively high growth expenditure than revenue.

Budget deficit has followed on increasing trend over the long-term. As indicated by Teshome (1994) in
1950-1955 budget surplus were recorded in Ethiopia. During the following period balance budget were
maintained more or less, and during the period of 1965-1974, the practice of fiscal conservatism kept the
deficit small.

Fig 4.6 shows the trend and budget deficit is increasing over time and government participation on the
economy is increasing. When comparing the two governments (Derg regime and FDRE) the trend is
increasing. In pre 1991 the government uses their budget on non-return activity like defense purpose,
campaign and introduction and promotion of new ideology this activity is no effect to the economic
growth.

During the Derg and it’s to 17 year governance, the budget deficit increase from 321.381 million in
1984/85 to 1611.66 billion in 1981/82 and increase significantly to 2147.9 billion Ethiopian birr in
1989/90.

Post 1991 the budget deficit is increasing in high growth rate comparing to Regimes, more specifically on
the beginning of 2000. The budget deficit is increasing by 2318.28 billion ETB on the previous year
1999.

The deficit in absolute terms moves from Birr 2,028.2 billion in 1992/93 to birr 7,243.3 million in
2001/2002 However, the substantial and increasing flow of external grants significantly reduced the
deficit amount to Birr 1,648.3 million and Birr 4,818.3 million for the above mentioned year.

A major reason for the rise of budget deficit in post 1991, Ethiopian government is still the main investor
and will remain some time to come. This is basically the apparent problem of infrastructure especially on
road, social service like heath care center, schooling and so on. Currently these sectors are less attractive
for the private sector with the exception of some sector like road.

The other reason is economic growth, there is an improvement in national income and people have more
disposable income to consume good but domestic producer cannot meet domestic demand and
government try to fill this gap by importing goods from abroad it create current account deficit, as one
part of budget deficit and seen more detail in literature review.

Currently, on the report of NBE 14.4 billion ETB deficit, the revenue is 80.6 billion birr but the
government expenditure is 95 billion ETB in the first six month of 2017.

31
4.2. ECONOMETRIC ANALYSIS

4.2.1 Test of stationary

The estimation of more specific relationship between budget deficit and its determinants, we have to sure
that the time series data is stationary. Most research’s and its economic data are non-stationary (random
walk). There exists a trend element in which both the independent variables and dependent variables grow
up ward or decreases down ward continuously together.

Running the regression on this data give higher R2 which seems as the explanatory variables well explain
the regressed. However, the higher magnitude of the multiple coefficient of determination (R2) arises
from spurious (false) relationship between the dependent and independent variables (Thomas, 1993).

If the time series data are found to be non-stationary most of classical assumption for econometric
estimation will be violated clearly, if available data mean and variances will change over time. In such
cases econometric results may not be ideal for policy making because the OLS estimation gives
inconsistent estimates (Gujarati, 1995).

The common tests used are Dickey Fuller (DF) and Augment Dickey Fuller (ADF) tests. These tests are
basically required to ascertain a number of times variables have to be differenced to arrive at stationary. A
time series data are said to be differenced of ordered ‘p’ if it became stationary after differencing it ‘p’
times. Economic variables stationary from the outset are I (0) series and a variable that requires to be
differenced once to be stationary is I (1) series (Gujarat, 1995).

H0; There is all has a unit root test (there is non-stationary)

H1; There is no unit root test (there is stationary)

According to the Augment Dicky fuller test there is two ways of test in the stationery. One is by
computing the P-value less than 0.05 or not. If the first one is appear the model is stationary and accept
the alternative hypothesis, but the second one directly use lag and try to full fill the above requirement.

The other is by comparing the calculated or test statics with the critical value. This means the test statics
must be greater than from the whole critical value (1%, 5% and 10%) in this case the variable has not a
unit root and stationary, which means reject the null hypothesis and accept the alternative one. if it is not,
the model will not be stationary.

32
Table 4.1 unit root test results

Variable Test statistic 1% critical value 5%critical value 10% critical

(ADF-test) value
BD -2.695 -3.682 -2.972 -2.618
RER -5.439 -3.682 -2.972 -2.618
LNRGDP -5.031 -3.682 -2.972 -2.618
LNAGRI -5.532 -3.682 -2.972 -2.618
LNLM2 -6.196 -3.675 -2969 -2.617
RIR -4.996 -3.675 -2.969 -2.617
Source: stata12 results

Using the augment dickey fuller (ADF) test broad money, real interest rates are stationary without
differencing the values or with (0) lags. The remaining variables are not stationary and take the lag at one
to be stationary. Budget deficit, real exchange rate, Share of agriculture to the GDP and real GDP are
non-stationary without lag.

4.2.2. Test Model Specification

A model specification error can occur when one or more relevant variables are omitted from the model or
one or more irrelevant variables are included in the model. There are several methods to test model
specification. Mostly used for test of model specification is link test and ovtest is available for the
stationary data.

But they have a little difference when they are apply in the specified model. The main difference is
linktest performs a link test for model specification whereas ovtest performs regression specification error
test (RESET) for omitted variables.

The linktest command also performs a model specification link test for a given equation models. If our
model really is specified correctly, then if we were to regress budget deficit on the prediction and the
prediction squared, the prediction squared would have no explanatory power. This is what linktest does. If
we find that the prediction squared does have explanatory power, so our specification is not as good as we
thought. Although linktest is formally a test of the specification of the dependent variable, it is often
interpreted as a test that, conditional on the specification, the independent variables are specified
incorrectly.

33
But the paper is applied linktest because mostly it used to know there is omitted value or not in the
specified model. Hypothesis test is:

H0= Model has no omitted variable

H1= the model has omitted variable

. linktest

Source SS df MS Number of obs = 37

F( 2, 34) = 89.04
Model 4.2942e+09 2 2.1471e+09 Prob > F = 0.0000
Residual 819867464 34 24113748.9 R-squared = 0.8397
Adj R-squared = 0.8303
Total 5.1141e+09 36 142058802 Root MSE = 4910.6

bd Coef. Std. Err. t P>|t| [95% Conf. Interval]

_hat .6763363 .2044059 3.31 0.002 .2609335 1.091739

_hatsq -8.45e-06 4.96e-06 -1.70 0.097 -.0000185 1.63e-06
_cons -889.6364 1097.608 -0.81 0.423 -3120.244 1340.971

On the above the measurement the model specification hatsq is -1.7 and insignificant these imply
rejection of the alternative value and accept the null hypothesis. The result of linktest indicates there is no
omitted variable in the specified model.

In most case to get the model specification we use the regression result and see the R2.

. reg bd reer rir lnlm2 lnrgdp lnagri

Source SS df MS Number of obs = 37

F( 5, 31) = 29.43
Model 4.2242e+09 5 844844460 Prob > F = 0.0000
Residual 889894583 31 28706276.9 R-squared = 0.8260
Adj R-squared = 0.7979
Total 5.1141e+09 36 142058802 Root MSE = 5357.8

34
The statistical values that measure the goodness of fit and significance of the model show that the model
fits reasonably well. To be specific the R2 value shows that about 82.6% of the variations in budget deficit
are explained by the explanatory variables.

4.2.3. Autocorrelation test

In the regression estimation the most important assumption is that the consecutive error terms are not
correlated or there is no autocorrelation. Running regression estimation by disregarding autocorrelation
will result in inefficiency on the estimated result and its standard errors are estimated in the wrong way.

The paper use for test autocorrelation by Durbin Waston test and the hypothesis is specified bellow:

H0= no autocorrelation in the model

H1=autocorrelation in the model

. estat dwatson

Durbin-Watson d-statistic( 6, 37) = 1.917975

From the estimation of Durbin Waston test the result is 1.917. The Range of Durbin Watson is between
zero and four.

If the calculated’ value is much smaller (close to zero) or much longer than two (close to four) we will
reject our null hypothesis which indicate that there is autocorrelation. However, if the value of d-stastics
is approximately two to be about two there is no serial autocorrelation.

On the above Durbin-Waston test approximately close to two this indicates reject the null hypothesis and
there is no serial-correlation in the model.

The other method of testing the presence or not of autocorrelation is Breusch-Godfrey LM test and the
hypothesis is the same to Durbin Wsten test. The result is:

35
Breusch-Godfrey LM test for autocorrelation

lags(p) chi2 df Prob > chi2

1 0.325 1 0.5684

H0: no serial correlation

If the p value is less than 0.05 or 5% there will be autocorrelation in the model. If there is not absence of
autocorrelation is indicated.

Based on the above estimation the p-value is greater than 0.05 and it account 0.5684 this implies accept
the null hypothesis which, means there is no autocorrelation or no serial correlation on the model.

4.2.4.Hetroscedasticity test
The existence of heteroscedasticity is a major concern in the application of regression analysis, including
the analysis of variance, as it can invalidate statistical tests of significance that assume that the modeling
errors are uncorrelated and uniform—hence that their variances do not vary with the effects being
modeled.

But if there is hetroscedasticity in the specified model the variance are vary and there is also correlation in
the model.

The paper use ARCH effects in the residuals test for testing the presence or not of hetroscedasticity in the
model. The hypothesis is specified bellow:

H0= There is homosedacticity in the model

H1=There is hetroscedasticity in the model

On the result of Breusch-Pagan / Cook-Weisberg test the alternative hypothesis is accept and the null
hypothesis is reject. This implies that the model is hetrosedacticity and have correlation in the variables.

To detect the problem of hetrosedacticity the paper use robust as the remedial solution of this problem
and detect it.

4.2.5. Multi-collienarity test

Multi-collinearity refers to case which two or more explanatory variables in the regression model are
highly correlated and making it difficult to isolate their individual effects on the dependent variable.

36
The existence of the problem of multi-colleniarity is tested using correlation coefficient test and variance
inflation factor (VIF). Correlation above 0.8 between independent variables indicates the existence of
problem of multi-colleniarity. Furthermore VIF above 10 shows the existence of multi-colleniarity
(Guajarati, 2007).

The hypothesis is as follow:

H0=there is no multi-collineality problem

H1=there is a multi-collinearity problems

. vif

Variable VIF 1/VIF

lnagri 19.35 0.051677

lnrgdp 17.58 0.056897
lnlm2 2.77 0.361322
reer 1.77 0.564997
rir 1.12 0.894706

Mean VIF 8.52

Using VIF test since the mean of variance inflation factor is below ten in order to say the model has not
multi-collineality problem. But the mean of VIF is greater than ten the model have a multi-colliniality
problems.

The estimated result gives the VIF mean is 8.52 this result is less than ten, so the paper accept the null
hypothesis, which indicates as there is no multi-collinearity problem in the specified model as seen from
the above.

4.2.6. Co-integration test

A linear combination of a time series variable becomes stationary, if there is co-integration between the
variables. The variables are said to be stationary if the residual is co-integrated (stationary) even if the
variables are not stationary at level independently. The residual is stationary at 1% level of significant as

37
shown in the following table. Therefore, the variables are co-integrated and there is long run relationship
between them.

. dfuller r

Dickey-Fuller test for unit root Number of obs = 36

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -5.632 -3.675 -2.969 -2.617

The residual is stationary at 1% significant level. Since ADF test result is -5.632, it is stationary at 1%
level I (0), which means the variables are stationary. This shows the existence of long run relationship
among the variables.

4.2.7. Long Run Model Estimation

In regression analysis, we predict the values of the unknown dependent variables based on the known
values of the independent variable(s). The model specified for estimation purpose has been the following
as listed in chapter three under the equation movies. The estimated results were used for long run analysis
for the determinant of budget deficit and ways of financing it.

. reg bd reer rir lnagri lnrgdp lnlm2

Source SS df MS Number of obs = 37

F( 5, 31) = 29.43
Model 4.2242e+09 5 844844460 Prob > F = 0.0000
Residual 889894583 31 28706276.9 R-squared = 0.8260
Adj R-squared = 0.7979
Total 5.1141e+09 36 142058802 Root MSE = 5357.8

bd Coef. Std. Err. t P>|t| [95% Conf. Interval]

reer -21.73482 24.11217 -0.90 0.374 -70.91192 27.44228

rir -63.85709 65.59045 -0.97 0.338 -197.6297 69.91552
lnagri 26645.92 8793.306 3.03 0.005 8711.856 44579.99
lnrgdp -31526.5 5133.542 -6.14 0.000 -41996.42 -21056.57
lnlm2 2455.626 2514.145 0.98 0.336 -2672.007 7583.259
_cons 52780.39 43219.16 1.22 0.231 -35365.66 140926.4

Y=52780.4-21.7RER-63.8RIR+26645.9LNAGRI-31526.5LNRGDP+2455.6LNLM2

38
As the regression result shows the model with the dependent variable is explained by 82.6% of R 2.
Budget deficit is well defined by the dependent variable incorporated in the model based on the long run
analysis.

The real GDP per capita have a negative relationship with budget deficit. Holding other variable constant
budget deficit is decrease by -31526.5, when the real GDP per capital is increase. Theory say that higher
level of income per capita leads to higher level of development which indicates greater capacity to levy
and collect taxes, this leads to decrease the budget deficit and their relation is significant.

The value of the constant term 52780.4 shows that BD will have a value of 52780.4 units if all the
explanatory variables (included in the model) are zero. It may also imply the impact of excluded variables
on BD, other variables kept constant. The other variables which are not included in the model are
positively affecting the budget deficit.

4.2.8. The short Run Model (Dynamics)

To analysis the short run regression the study consider error correction model which has both the long run
and short run information. It has been shown previously in chapter three from the test of co-integration on
the error term that the variable in the long run has equilibrium relationship.

Interpretation of the model and interpretation the result are the main part of the study. The model that
specified in chapter three and the dependent variables budget deficit determine by Real exchange rate
(RER), real interest rate(RIR), Agriculture share to GDP (Agri), real GDP and broad money are the
specified determinant variable of budget deficit.

The interpretation is based on the short run analysis and regression:

. reg dbd dreer drir dlnagri dlnrgdp dlnlm2 r

Source SS df MS Number of obs = 36

F( 6, 29) = 6.03
Model 626877977 6 104479663 Prob > F = 0.0003
Residual 502303087 29 17320796.1 R-squared = 0.5552
Adj R-squared = 0.4631
Total 1.1292e+09 35 32262316.1 Root MSE = 4161.8

dbd Coef. Std. Err. t P>|t| [95% Conf. Interval]

dreer -21.99885 25.28552 -0.87 0.391 -73.71355 29.71586

drir -12.52819 40.3258 -0.31 0.758 -95.00371 69.94733
dlnagri 8650.934 9495.167 0.91 0.370 -10768.86 28070.73
dlnrgdp -14663.28 7005.431 -2.09 0.045 -28991 -335.5706
dlnlm2 20386.01 11046.84 1.85 0.075 -2207.312 42979.33
r .9149181 .1610701 5.68 0.000 .5854928 1.244343
_cons -1923.106 1104.895 -1.74 0.092 -4182.869 336.6582

39
Y = β0+β1RER+β2RIR+β3LNAGRI+β4LNRGDP+β5LNLM2+µi

Y= -1923-21.9RER-12.5RIR+8650.9LNAGRI-14663LNRGDP+20386LNLM2+0.95

In the short run regression result 55.5% the variation of budget deficit due to the variation of dependent
variables that include in the model. As the study show from the regression result the short run impact of
broad money supply has significant and negative influence on the Ethiopia budget deficit. As the study
show in long run analysis like short run the effect of broad money supply on the budget deficit is
significant, this shows that the change in have significant influence on the budget deficit in the study
period.

In general the short run analysis of budget deficit differently determines by different variables than the
long run analysis. This means in long run RER, real interest rate and broad money supply have significant
impact on Ethiopian economy but, in short run broad money supply has insignificant impact on the
determinant of budget deficit.

There is also a sign difference between the variable in the short run and long run, RER has negative and
significant in the long run, i.e. when real exchange rate depreciates the budget deficit will decrease by
16366 literature implies if there is an economic development the government revenue and non-tax
revenue is increasing and it decrease the budget deficit. But in the short run when the realexchange rate
depreciates it increases export supply increase the per capital income and the economy is able to cover the
desires of people and the government measurement is import consumer or other product this leads to
current account surplus and it affect budget deficit negatively.

40
 Chapter Five
5. Conclusion and policy Implication

5.1. Conclusion
The main objective of this study is in order to know the determinant of budget deficit and the
way of financing it in the case of Ethiopia. In this analysis the secondary document is used from
the Derg regime to the previous year (1981-2017) and the study use both descriptive and
econometrics analysis. On the regression analysis the independent variables is real exchange rate,
real interest rate, real GDP, broad money supply and agriculture share to the GDP with the
dependent variables budget deficit.

It was attempted to achieve objectives of the study with the data obtained from NBE using two
techniques of analysis. This chapter aims to link the objectives of the study with the result
obtained and draw some policy implications. It has been stated that fiscal deficit are at the
forefront of macroeconomic problems after the 1980s and 1990s in both developing and
developed countries. The result of works on deficit has been mixed that some empirical work
have resulted positive relationship while other have found clear cut negative relationship
between budget deficit and its financing.

The descriptive analysis has revealed that expenditure has been persistently growing due to the
growth of the public sector economy. In turn, this has created budget deficit since it was not
followed by equally proportionate growth revenue. Since 1984, large and rapid expansion of
state activity in the economy has led to the growth of both government revenue and spending
with the dominance of the latter. As a result, budget deficit have been growing over time.

As to the causes of rising budget deficits, it has been argued that it was mainly caused by the
growth of expenditure over revenue. Apart from this, there were four reasons discussed in the
literature as to why government may open to high fiscal deficit level; political reasons, that
governments may deliberately favor high spending levels and low tax rates to make their
government legitimate; structural reasons; which makes the economy inflexible in the short term;
inflation, that reduces the real balance of tax revenue as a result of the existence of collection
lags and finally development theorizing.

41
As stated in the literature review, during wartime, the need to rapidly increase military spending
results in government expenditures rising faster than tax revenues. The desire of the government
to reduce taxes in the face of a continued high level of spending may be lead to large budget
deficits.

The econometrics result on determinant of budget deficit indicates that real exchange rate; real
GDP and broad money supply is negatively related to the budget deficit. The above mentioned
variables affect budget deficit inversely in many ways, but the one and the major ways of effect
is through taxation. If those variable are increasing the tax base also increase and also the amount
of tax collected, this result decrease budget deficit.

The descriptive analysis for financing the deficit shows that the way of finance is shifted from
domestic resource to the foreign one. This enable the government free from crowding out effect
and inflation problem. This appreciate the economic growth due to decreasing the effect
crowding out effect and provoke investors invest in the domestic economy and result decrease
budget deficit through taxation and aggravate the domestic economy.

This does not mean the foreign source of financing does not have effect on the economy. But the
finance get from the foreign source are wisely and utilize use the benefit get from it is highly
significant than the cost that we lose or sacrifice’s.

For much reliable conclusion econometric analysis was employed to examine the empirical
relationship between budget deficit and it’s financing. To this effect, the model specified in
chapter four is estimated using the available data and the time series analysis.

In the econometric analysis, the attempt has been made to test the hypothesis that financing
budget deficit through money creation leads to high inflation, domestic borrowing to finance
budget deficit leads to crowding out effect and excessive resort to foreign borrowing for
financing budget deficit leads to high external debt a service burdening.

The regression analysis of this study resulted that inflation is positively related and significant to
the budget deficit. This indicates that financing deficit from the domestic source specially on
printing money leads to the existence of higher budget deficit and the share of agriculture to the
GDP is positively related to budget deficit.

42
5.2. Policy implication
The paper results have some policy implication with respect to determinant of budget deficit and
way of finance. The policy implication is based on descriptive and econometrics analysis for the
determinant of budget deficit but for the way of finance the study only used descriptive analysis
and result.

5.2.1. Policy implication for determinant of budget deficit

To reduce budget deficit the government should restructure its budgeting system and mode of
financing. To this end, the policy implication that emanates from the study is the following;

 To increase tax revenue and decreases the deficit problems, fundamental reform of tax
structures should be made and the reform should focus on broadening the tax bases (as
opposed to mounting high tax rates), minimize tax exemption and improve the tax
administration system which would affect the tax collecting systems.
 The fact that GDP growth in the country follows agricultural growth trend implies that
agriculture is the key to economic growth in the country. Since the sector is subjected to
several of the nature which are beyond policy measures and control, due emphasis should
be given to this sector of the economy. Apart from policies directed towards improving
productivity in agriculture.
 Finally, the government should, not only formulate, but also implement appropriate
policies to further encouraging private sector investment and saving which should gear
the country to the pace of rapid economic growth.

5.2.2. Policy implication for financing it

Based the results from descriptive analysis the following recommendations are forwarded as an
alternative to finance budget deficit.

 The government should be increases the tax base and develop capital markets so as to use
treasury bills, bonds and stocks or open market operation (OMO) for financing of budget
deficit. Reform the national bank of Ethiopia and its operation in order to reduce its
subordination to the ministry of finance and economic development to increase its
independence. This would allow the banking system credit to the government and thus
forming the government to strength its fiscal discipline.

43
 The government should motivate the private investment, in order to reduce the
government expenditure.

 The government should also exercise control over its expenditures and its financing
techniques especially through limiting its domestic borrowings from banks.
 If the government budget deficit exists in country, the government must use appropriate
ways of financing such as selling Treasury bill, levy tax on informal sectors etc. by we
mean that to reduce impact on the level of inflation the government has to use.
 The Ethiopia government should change political system. Especially the Ethiopia
economic policy based on politics, due to frightened of politics, the government does not
impose tax properly.

44
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Befekadudegefe, getahuntafesse, 2000/01,second annual report on the Ethiopia economy;

Cambes and Seadi-Sedik.(2006) Theoretical model of Budget deficit Determination.

Clayton, 1995,economics principles and practices,

Dominick Salvatore3rdedition, 1994, microeconomic theory, managerial economics and

statically and econometric authored principles of economics and development economics.

Ethiopia GTP, 2011, fiscal policy;

Geda and Abebe (2005), stracture of Ethiopian Revenue

Gujarati, D.N. (1995). Basic Econometrics (3rd Ed.). McGraw-Hill International Editions.New
York

Gujarati, D. (2004) Basic Econometrics, Fourth Edition, the McGraw−Hill Companies.

Gujarati, D. (2007) Basic Econometrics, Seventh Edition, McGRAW-Hill Companies.

Madala.(1992) The Logistic Regression Model with a modified Weight Function in Survival
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Mahduri (1984), public expenditure in developing country

Mankiw (2007) ,macro-economic 7th edition;

Michael P.Todaro,(2011)economic development 11th edition;

Ministry of finance (1997), Ethiopian revenue report,

NurhayatiAbdrahman. (2012) Relationship between Budget deficit, Government expenditure

and Economic Growth.

N.GregoryMankiw. (2000) Economic Fluctuations and Growth, Monetary Economics

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Roubini and sachs.(1989) Economic Interaction between Government Expenditure and
Economic Growth.

Teshome ,(1994) Trend of the Budget deficit in Ethiopia,

Thomas (1993), Basic Econometrics analysis

46