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THE LONG – RUN EFFECTS OF FISCAL DEFICIT ON ECONOMIC GROWTH IN GHANA 1970 – 2000 BY BERNICE SERWAH DUODU

THE LONG – RUN EFFECTS OF FISCAL DEFICIT ON ECONOMIC GROWTH IN GHANA 1970 – 2000 BY BERNICE SERWAH DUODU. INTRODUCTION. Conceptually, we can think of fiscal deficits as a measure of the extent to which a government is spending beyond its means.

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THE LONG – RUN EFFECTS OF FISCAL DEFICIT ON ECONOMIC GROWTH IN GHANA 1970 – 2000 BY BERNICE SERWAH DUODU

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  1. THE LONG – RUN EFFECTS OF FISCAL DEFICIT ON ECONOMIC GROWTH IN GHANA 1970 – 2000 BY BERNICE SERWAH DUODU

  2. INTRODUCTION Conceptually, we can think of fiscal deficits as a measure of the extent to which a government is spending beyond its means. Precisely, fiscal deficits is the difference between the total expenditure of the government, and the sum of all its “revenue receipts” as well as those “capital receipts”, which do not create any payment obligations for the future.

  3. INTRODUCTION cond. • Macro – instability in Ghana has been fuelled to a large extent bygovernment policies that have resulted in a persistent overshooting of the budget deficits and also by the measures employed to finance the growing deficits. • Key factors that have accounted for government’s tendency to overshoot the deficits includes: • weak revenue mobilization mechanisms, • anticipatory spending (i.e. spending in anticipation of donor inflows) • high-flying among such measures are debt monetization and the sale of treasury bills.

  4. INTRODUCTION cond • One of the principal objectives of Ghana’s Fiscal Policy is to stabilize and reduce domestic debt with a view to stemming the increase in interest payments and to achieve the desired easing in real interest rates. • The main elements of the strategy to achieve fiscal policy objectives are improved resource mobilization.

  5. INTRODUCTION cond • Strategies adopted to improve fiscal resource mobilization includes: • minimizing revenue leakages in all revenue collection agencies (IRS, CEPS and VAT) • reviewing and revising existing taxes by instituting measures that widen the tax base • fees and user charges • strengthening the revenue collecting institutions • strengthening the District Assemblies for improved tax collection.

  6. Statement of the Problem • Huge budget deficits and associated hikes in inflation can heighten uncertainty about government policies. • This can increase the risk premium in Ghana, resulting in domestic and foreign investors not having confidence in the economy. • Huge fiscal deficits can also lead to an explosion in domestic debt that can crowd out credit to the private sector, further constraining financing options to firms.

  7. Statement of the Problem • The government has acted to reduce deficits and debt in 2001 by introducing new taxes and curtailing expenditures, but could not prevent a further accumulation of domestic arrears and recourse to domestic financing. • The 2002 budget outturn did not reduce the government’s recourse to domestic financing either, due to unbudgeted increases in the wages of health and education staff, inadequate control of wage expenditure in some ministries, new shortfalls in official assistance, and higher-than-budgeted subsidies to utilities.

  8. Statement of the Problem cond. • These have raised certain issues: • What has been the trend in fiscal deficits in Ghana over the period 1970 to 2000? • What has been the trend in economic growth over the same period? And • What has been the relationship between fiscal deficits and economic growth over the period 1970 to 2000? This study seeks to address the questions above.

  9. Objective of the Study • The main objective of the study is to examine the effect of fiscal deficits on output growth in Ghana over the period 1970 to 2000. Specifically, the study seeks: • To establish the causal relationship between output growth and fiscal deficits if any • To establish the trends in fiscal deficits over the 1970 to 2000 period • To establish the trends in economic growth over the same period • Make recommendations with regards to the outcome of the study.

  10. Significance of the Study • The effect of fiscal deficits on growth in Ghana is very important for policy decisions especially in achieving the goals of the Ghana Poverty Reduction Strategy (GPRS) and the Millennium Development Goals (MDGs) so that the economy will be managed effectively to enable wealth creation for the benefit of all Ghanaians. • The implications of fiscal deficits is that, it contributes to a low level of national savings, which in turn reduces domestic investment and increases borrowing from abroad. • The reduction in national savings raises domestic interest rates, which crowds out private investments, reduces the rate of employment and attracts capital from abroad. Therefore, the estimation of fiscal deficit and growth has more than academic motivation.

  11. Theoretical Literature • At a theoretical level, Some of these studies, such as Premchand (1984), assert that financing the budget deficit by borrowing from the public implies an increase in the supply of government bonds. • In order to improve the attractiveness of these bonds the government offers them at a lower price, which leads to higher interest rates. • The increase in interest rates discourages the issue of private bonds, private investment, and private spending. • In turn, this contributes to the financial crowding out of the private sector.

  12. Theoretical Literature • Miller (1983) argues that government deficits are necessarily inflationary irrespective of whether the deficits are monetized or not. • For instance, as argued by Sargent and Wallace (1981), the Central Bank would be forced into monetary accommodation of the deficits. • Nevertheless, even if the Central Bank does not monetize the deficits, deficits are still inflationary through crowding out of private investment, and hence reduce the rate of growth of real output.

  13. Theoretical Literature cond. • To sum up, economic theory suggests that an increase in fiscal deficits lead to an increase in the interest rate. An increase in the interest rate appreciates the exchange rate. • In turn, exports become relatively expensive and imports cheaper, thus generating a trade deficit. Therefore, there is a link between the so-called twin deficits in open economies. • Hence, empirical evidence of a relationship between the two (deficit and growth) would be very important to enable economists and policymakers to better understand whether there is a causal relationship or merely a correlation between deficit – growth relationship.

  14. Trends in Fiscal Deficits in Ghana • Before the ERP, reliance on external borrowing to finance Ghana’s fiscal deficit was very neglible Nkrumah’s pride of place as the champion in the fight against neo- colonialism prevented his government from seeking budgetary support from the Bretton Woods institutions whose activities he viewed as imperialistic. • During the governments of the National Liberation council (NLC, 1966-69) and the Progress Party (PP, 1969-72), an IMF-sponsored adjustment programme opened the door to external borrowing for financing the deficits. • In 1970, the deficits was almost fully financed from external borrowing.

  15. Trends in Economic Growth in Ghana The performance of the economy and economic growth has been characterized by the non attainment of macroeconomic targets. In particular, whereas the GDP was expected to grow between 7.1% and 8.3% in the period 1996-2000, actual growth was between 4.2% and 5.0%. The recent growth record is deemed inadequate for the desired transformation of the economy in order to achieve the Millennium Development Goals (MDGs) by the year 2015. The significant deviation between targets and the actual, is translated into low per capita GDP growth and poor sectoral growth.

  16. Model Formulation and Specification • In this study, we adopt the growth accounting model of Lin (1994), which was also adapted by Kweka and Morrissey (1999) where output (Y) is assumed to be a function of productive inputs, capital (K) and labour (L). • There are two sectors, government (g) and private (p) and both possess each of the two factors of production.

  17. Model Formulation and Specification • In this setting, output is a function of the two factors of production and government expenditure (G). • It is assumed that government services affect the efficiency of productive units of capital and labour, but this could be in a positive or a negative manner. • In the context of developing countries, exports (X) and foreign capital (F) are potential determinants of growth, and can be included.

  18. Model Formulation and Specification cond. Furthermore, we can express change in capital (ΔK)as Investment (I). Government expenditure can be decomposed into productive (Ig) and unproductive (Cg) components, and where Ip is private investment (I = Ig + Ip): Functionally, Where α1, α2, . . . . ., α6 are elasticities and subscripts p and g refer to private and government respectively. • As we have no suitable time series measure of L it is assumed that labour inputs can be proxied by public expenditure on Human capital (Hg). • Thus, expressing variables in natural logarithms, the base regression is: Where ε = error term

  19. Model Formulation and Specification cond. • For the purpose of this study, we will adopt this model with slight modifications due to data problem. Since the objective of the study is to investigate the effects of fiscal deficits on growth, deficits becomes an important explanatory variable of interest and was thus, included. • Foreign capital is a component of foreign direct investment, therefore, we proxied foreign capital with foreign direct investment to look at the totality of foreign inflows in to the country either in the form of capital or technology. • Also, most growth models include other macroeconomic variables that have effect on growth. Hence, the study included inflation and the level of money stock as part of the explanatory variables by the fact that they have the tendency to distort economic stabilization.

  20. Model Formulation and Specification cond • A dummy variable to capture the Political environment of the economy was also included. Where D = 1 for democratic era and, zero for military regime. • Finally, the model to be used for the Regression Analysis is specified as: • In RGDP =In a + 1In PVTINV + 2In MGRO+ 3 In DEFT + 4 In EXPT +5 In FDI + INFL + PDUM + ε

  21. Summary and Definitions of the Variables used

  22. Test of Hypotheses • In order to achieve the stated objectives, the followinghypotheses shall be tested. Ho : Fiscal deficits exert no effect on economic growth in Ghana. Ho: 3 = 0 H1 : Fiscal deficits exert effect on economic growth in Ghana. H1: 3 ≠ 0 • The null hypothesis states that fiscal deficit have effect on economic growth and not significantly different from zero. That is, the variable cannot explain the variation on growth. • The alternative hypothesis (H1) on the other hand implies that fiscal deficit is significantly different from zero. In other words the explanatory variable have effect on explaining the changes in economic growth in Ghana.

  23. Data Sources • The study rely heavily on secondary (time series) data obtained from various issues of Ghana Statistical Service Publications, information obtained from World Tables, International Financial Statistics Year Book (various issues), World Development Indicators 2003 and Internet to carry out the study. • Annual data for the period 1970 – 2000 is utilized to estimate the model specified.

  24. Estimation Procedure Test for Stationarity • As a preliminary data analysis, data are first checked for stationarity. If the series are nonstationary, using standard econometric techniques can lead to misleading results. • Standard economic theory requires the variables to be stationary. However, a group series test was conducted to find the extent of correlation among the variables.

  25. Test for Stationarity cond. • The econometric methodology firstly examines the stationarity using the Augmented Dickey-Fuller or ADF (p) test (Dickey and Fuller, 1979 and 1981). • The test was applied to each individual series. This consists of running the variables at their level, first difference of series with series lagged once and the option of intercept and trend. • We first report the characteristics of the data by showing the unit root test results of the variables in the model. • Table 1 contains the results of the unit root tests of the individual variable.

  26. Unit root tests for the variables of deficit – growth relationship in Ghana (sample: 1970-2000)

  27. Test for Stationarity cond. • The table gives the test statistic and the probability values (in bracket). The L (.) and DL (.) are the log levels and the first difference respectively. • The Tests were performed using Eviews Software (version 3.1), which was used to compute both T-ADF statistics and their critical values. • As the table indicates, LRGDP, LPVTINV, LMGRO, INFL, LFDI were stationary at their levels and significant as their critical values were less than the ADF Statistics at 1%, 5%, and 10% level of significance. • The retained Residual of the equation was also stationary at 1% 5% and 10% level of significance.

  28. Test for Stationarity cond. • The results in the table shows that not all the variables were stationary at the levels. This is because the T-ADF Statistic were less than their critical values and thus we accept the null hypotheses that the variables are not significantly different from zero. • However, they were stationary at the first difference as presented in table 4.3.

  29. Table 4.3: Unit root test of first difference of the variables

  30. Test for Stationarity cond. • The result also suggests that GDP depends on the change in the level of the variables stationary at their first difference. • That is, GDP depends on the change in the level of deficit and more also, on the change in the level of exports in Ghana. • Combining the results of table 4.2 and 4.3, we conclude that, the variables LRGDP, LPVTINV LMGRO, LFDI, INFL, are integrated of order zero: Xt I(0) where Xt is a vector of these variables, whilst DLDEFT, DLEXPT, are integrated of order one: Xt I(1), where Xt is a vector of the variables mentioned.

  31. Granger Causality Test • The detection of causal relationships among a set of variables is one of the objectives of empirical research. A degree of correlation between two variables does not necessarily mean the existence of a causal relationship between them; it may simply be attributable to the common association of a third variable. • According to Granger (1969), Y is said to “Granger-cause” X if and only if X is better predicted by using the past values of Y than by not doing so with the past values of X being used in either case. • In short, if a scalar Y can help to forecast another scalar X, then we say that Y Granger causes X.

  32. Granger Causality Test cond • The Granger (1969) approach to the question of whether deficit causes Growth is to see how much of the current growth can be explained by past values of growth. • Growth is said to Granger-caused by deficit if deficit helps in the prediction of growth. • To investigate the causality between GDP and deficit, we perform a simple Granger causality test. • The outcome of the Granger causality tests is shown in Table 4.4

  33. Granger Causality Test cond Table 4.4: Granger causality test results

  34. Granger Causality Test cond • Two lags of each variable were used and the test also considers the reverse causation. • Given the low F – Statistics and high probability values reported for Ho, we reject the null hypotheses for the test. • This result indicates that there is a causal relationship between fiscal deficit and output growth.

  35. Test for Co integration • Co integration is the statistical implication of the existence of a long – run relationship between economic variables. • The test stipulates that if variables are integrated of the same order, a linear combination of the variables will also be integrated of that same order. • The idea behind co integration analysis is that although macro variables may tend to trend up and down over time, groups of variables may drift together. • If there is some tendency for some linear relationships to hold amongst a set of variables over long periods of time, then co integration analysis helps us to discover it.

  36. Test for Co integration • Generally, if a linear combination of variables of different order of integration is formed, this linear combination will take on the high order of integration. • However, if the variables are integrated of different order, there is some linear combination of the two series, which is stationary. That is instead of being I(1), the linear combination is I(0). • A unit root test was then applied to the retained residuals (Er) to determine its stationarity excluding trend and intercept. The ADF test revealed that the retained residual is stationary at its level i.e. of I(0) series, and significant at the conventional level of significance of 1% 5% and 10%.

  37. Test for Co integration cond. • This implies that, output growth is co integrated with the other variables, and that there exist a linear combination of the variables, which is stationary. • This leads to a conclusion that there exist long run equilibrium relationships among the variables. • The long - run equation to be estimated is specified below as: LRGDP = C + LPVTINV +LMGRO + LFDI +INFL + DLDEFT + DLEXPT + ER (4.4)

  38. Empirical Results Long Run Regression Results • In an attempt to work towards a more parsimonious equation, the study adopted a general to specific modeling approach in the estimation process. • This process is where we impose lag structures of all the variables in the co-integrated equation 4.4. • Moreover, this technique makes it possible to deal with irrelevant variables rather than omission of relevant ones. Using the Akaike Information Criterion, the significance of the individual variable, and the Adjusted R- squared as a guide, the estimated equation was reduced to a more parsimonious model (see table 4.5).

  39. Table 4.6: Preferred Deficit – Growth Model

  40. Table 4.6: Preferred Deficit – Growth Model cond.

  41. Empirical Results cond. • The estimate shows that the coefficients of all the regressors (explanatory variables) have the expected signs. • The R-squared value of 0.944579 shows that all variations in output growth can be explained by the explanatory variables. In otherwords, about 94.44% of the changes in output growth can be explained by the parameter. • The high F – statistic (22.72513) illustrates that the parameters (explanatory variables) are jointly significant and that the explanatory variables are capable of explaining the variation in output growth, the dependent variable. • Also, the Durbin Watson (2.0) indicates that there is no serial autocorrelation.

  42. Empirical Results cond. • It is evident from the result that changes in Deficits; the variable of interest is significant at 1% level of significance and has a negative effect on growth, and that the coefficient suggests that a percentage increase in deficits will result in a decline of about 12 percent in growth. • The implication is that the more the government overspends beyond its revenue or income, the more deficits accumulate which must be financed. And financing the deficit by borrowing from the public leads to higher interest rates.

  43. Empirical Results cond. • The increase in interest rates discourages private investment, and private spending. These in turn, contribute to the financial crowding out of the private sector, and consequently exert a negative effect on growth. • This evidence is consistent with Arora and Dua (1993) results. Their study suggests that, higher fiscal deficits crowd out domestic investment and increase trade deficits. • This is also in line with Karras (1994) findings, who concluded that deficits are negatively correlated with the rate of growth of real output, and moreover, increased deficits do appear to retard investment.

  44. Empirical Results cond. • The estimate also reported a positive relationship between changes in exports and growth and this is significant at 5% level of significance. This means that a percentage increase in exports will boost growth by 6 percent. • This relation is in line with Little, Scitovsky, and Scott (1970) results. They contend that by encouraging exports, including agricultural exports, a country would benefit from more efficient resource utilization, more equalization of income distribution, and more employment in both agriculture and the industry sectors of the economy. • Kravis (1970) also recognized in his study the tendency towards more growth in countries that have been more successful exporters.

  45. Empirical Results cond • It is apparent from the estimation that the level of foreign direct investment in the past two years have a positive relation with growth and significant at 1% level of significance, and that a percent increase in foreign direct investment will lead to an increase in growth by 35 percent. Moreover, the estimate implies that foreign direct investment in a current year do not have any effect on growth, rather that of the past two years do have a positive effect on growth.

  46. Empirical Results cond. • From the results, the coefficient of inflation rate suggests that a unit change in inflation is associated with a 2 percent drop in growth. Inflation is statistically significant at I% level. The result also indicates that, inflation is negatively related to growth. • This is in line with Darrat (1985) who suggested that both monetary growth and government deficits significantly influenced inflation. • Also, Ahking and Miller (1985) concluded that government deficits appear to be inflationary in their study.

  47. Empirical Results cond. • The results also suggest that the level of money stock in the current year is positively related with growth and that a percentage change in the level of money stock will result in a 30 percent increase in output growth. • A percentage change in the level of money stock in the previous year will result in 45 percent increase in output growth, and is significant at 5% level of significance. • However, money stock in the previous two years is negatively related with economic growth and that a percentage change in the level of money stock in the past two years will result in 27 percent decrease in output growth

  48. Empirical Results cond. • The dummy variable, PDUM introduced to capture the political environment of the economy was statistically significant at I% level and reported a negative relationship with growth over the period. • This might be as a result of so many years of the economy under military regimes. • A theoretical investigation suggests that in economies where political power changes frequently, each administration is likely to spend a lot when it is in power, and thus leave a high public debt to its successor. Sachs and Larrain (page 206).

  49. Empirical Results cond. • A percent increase in Private Investment in the past two years will boost output growth by 38 percent and is statistically significant at 5% level. • The results, also, shows that private investment in a current year does not have any effect on growth. Hence much more would be needed to spark sustainable growth in output, income and employment. • And this cannot be achieved without efficient financial sector to increase the mobility of resources in terms of credit to the private sector in order to survive and be competitive

  50. Summary and Conclusion • The Study attempted to highlight and examines the effects of fiscal deficit on output growth in Ghana for the period 1970 to 2000. • Addressing the questions raised in the problem statement as to what has been the relationship between fiscal deficits and economic growth over the period 1970 to 2000, it was evident that deficits impedes growth in Ghana. • Furthermore, the theoretical exposition buttress that deficits have a negative effect on growth. • A time series analysis was conducted with particular attention paid to the causal relationship between deficits and growth in the context of Granger Causality Test.

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