Contemporary Issues and Ideas in Social Sciences

August 2008

The Revenue-Expenditure Nexus: Evidence For India

Swati Raju1

Abstract

This paper seeks to analyse whether a nexus exists between central gov-
ernment revenues and expenditures for 1950-51 to 2003-04 by studying the
relationship between total receipts and an array of expenditure measures so
as to determine whether the spend and tax or tax and spend hypotheses
hold for government finances in India. The empirical exercise of the paper
provides us with mixed results. Significant uni-directional causal movements
from expenditures to revenues for three of the seven revenue-expenditure
pairs viz. total expenditures-total receipts, adjusted profile of expenditures-
total receipts and total expenditures-tax receipts indicate that expenditures
lead and revenues follow (spend and tax hypothesis). However, significant
uni-directional causal effects from receipts to expenditures are also seen for
two of the seven revenue-expenditure pairs namely, revenue expenditures-
1
Department of Economics, University of Mumbai.
Email: swatiraju@hotmail.com
2 CIISS August 2008

revenue receipts and non-developmental expenditures and total receipts (tax

and spend hypothesis,) which could be taken to reflect Milton Friedman’s
view that governments spend what it receives and as much as they can get
away with. Significant feedback relation is observed between development ex-
penditure and total receipts and causal independence between the structural
components of total revenues and total expenditures. The paper thus finds
support for both the expenditures lead revenues (spend and tax hypothesis)
and revenues lead expenditures (tax and spend hypothesis) between total re-
ceipts/tax receipts and different categories of expenditures at the level of the
central government for India.
JEL Code: E62
Keywords: revenues, expenditures, causality

1 Introduction
Government deficits are one of the important indicators of fiscal health. In-
dia has seen deficits in central government accounts on almost all indicators
– fiscal deficit, primary deficit, revenue deficit - since the 1970s and this
situation worsened in the mid-1980s. The latter half of the 1980s saw fis-
cal deficits in the range of 7-8% of GDP and the gross primary deficit and
revenue deficit were also in the ranges of 4-5% of GDP and 2-3% of GDP re-
spectively. Fiscal consolidation, therefore, was the major focus of the reform
process introduced in 1991-92. The 1990s have seen varied performance on
the deficit indicators. The period 1991-92 to 1996-97 with the exception of
1993-94 had seen improvement in the situation with a decline in the fiscal
Raju: Revenue-Expenditure Nexus - Indian Evidence 3

deficit as well as other deficit indicators as a percentage of GDP. However,

the later 1990s and early 2000s have seen a reversal of this trend and the
major deficit indicators climbed back to near-about their early 1991-92 levels
with revenue deficit showing continued deterioration. Consequently, greater
attention is being focused on the size of these deficits and efforts undertaken
towards better deficit management - the Fiscal Responsibility and Budget
Management Act (2003) being one measure for the purpose. Besides, fiscal
reforms at the level of the central government focused on both tax reforms
which aimed at augmenting revenues and removing anomalies, inadequacies
and inefficiencies in the tax structure and expenditure reforms that aimed at
curtailing government expenditure.
The Government appointed several committees to look into various as-
pects of tax reform viz. the Tax Reforms Committee, 1991, the Advisory
Group on Tax Policy and Tax Administration for the Tenth Plan, 2001, Task
Force on Direct Taxes and Indirect Taxes, 2002. Tax reforms have focused
on the simplification and rationalization of direct as well as indirect taxes.
Besides, most of these committees have recommended the withdrawal of a
number of exemptions and deductions. Further, since the rates were high
and the structure of indirect taxes was highly complex, the Tax Reforms
Committee recommended the adoption of small number of simple broad-
based taxes with moderate and limited number of rates and with very few
exemptions and deductions. Some of the major tax reforms that have been
undertaken are: lowering of the maximum marginal personal income tax rate
from 60 percent in 1980-81 to the present level of 33 percent; widening of
the tax base through the introduction of presumptive taxes and adoption of
4 CIISS August 2008

a set of economic criteria for identification of potential tax payers in urban

areas which stands abolished from the Budget 2006-07; taxation of services;
reduction of the corporate tax rate on both domestic and foreign companies;
reduction in the peak rate of customs duties on non-agricultural products;
introduction of a uniform 16 percent CENVAT; introduction of VAT by the
states; improvement in tax administration through the better use of informa-
tion technology.
On the expenditure front, measures were taken to curb the built-in growth
in expenditure by subjecting all ongoing schemes to zero based budgeting and
assessment of manpower requirements of all government departments. The
government also appointed the Expenditure Reforms Commission to look
into areas of expenditure correction. Some important expenditure reform
measures undertaken were – optimising government staff strength through a
ban on the creation of new posts for a period of two years; introduction of the
Voluntary Retirement Scheme and the redeployment of surplus staff in various
government departments and autonomous institutions which have budgetary
support through grants; restrictions were imposed on fresh recruitments to
1 percent of the total civilian staff strength over the four years beginning
the fiscal year 2002-03; the creation of a national food security buffer stock
and minimisation of cost of buffer stock operations, and rationalisation of
fertiliser subsidies through dismantling of controls in a phased manner. Other
important measures of expenditure reform undertaken were the dismantling of
the Administered Price Mechanism in the petroleum sector and the Oil Pool
Account which became effective from April 2002. A Guarantee Redemption
fund was set up so as to promote transparency and to control the growth of
Raju: Revenue-Expenditure Nexus - Indian Evidence 5

contingent government liabilities.

It is pertinent to note here that deficits at the level of the state-governments
in India have led to concerns regarding the sustainability of state level govern-
ment finances in India. State finances have shown a progressive deterioration
since the late 1990s, though revenue deficits emerged at the state level in
the later half of the 1980s and have been persistent since them. Several
factors can be attributed to worsening state finances, namely, growing rev-
enue expenditure, particularly wages, salaries and pensions arising out of the
implementation of the Fifth Pay Commission award which saw salaries and
pensions rising by about 60 percent over three years; losses of state public
sector enterprises (especially State Electricity Boards) and declining transfers
from the central government. Besides, states were competing with each other
in ‘exemption proliferating tax competition’ resulting in a fall in the level
of states’ Own Tax revenue relative to GDP. Further, subsidies provided by
states are largely implicit and inadequate user charges have contributed to
the deterioration in state fiscal health. The widening gap between revenues
and expenditures saw states, consequently, resorting to borrowing at high
nominal interest rates resulting in rising debt servicing costs which further
exacerbated the worsening fiscal imbalance.
Fiscal reform measures have been initiated at the state level as well so
as to address the fiscal imbalance at the state level, viz. the creation of a
Fiscal Reform Facility (2000-01 to 2004-05) to provide incentives to states
to undertake Medium Term Fiscal Reform; the introduction of a debt swap
scheme over 2002-03 to 2004-05 and enactment of institutional measures such
as adoption of a rule-based fiscal policy through the enactment of Fiscal Re-
6 CIISS August 2008

sponsibility Legislations (23 states have enacted Fiscal Responsibility Leg-

islations till date); setting up of consolidated sinking funds and guarantee
redemption funds. The Twelfth Finance Commission has also prescribed a
time bound plan for fiscal restructuring of states’ finances - elimination of
revenue deficits by 2008-09 and a gross fiscal deficit target of 3% of GDP by
2009-10 - offer hope for achieving successful fiscal consolidation. Apart from
these measures, states have also focused on revenue augmentation through
broadening and rationalizing their tax systems, improving the efficiency of
their tax administration, simplification of their tax laws and focusing on bet-
ter compliance. Simultaneously, states are also involved in expenditure con-
tainment by trying to reduce administrative expenditure, non-plan revenue
expenditure, non-development expenditure and growing pension liabilities.
Further, the awards of Twelfth Finance Commission which see larger devolu-
tion of resources to states through an increase in shareable central taxes and
grants may help ease the fiscal situation of the states. These various reform
measures seem to have had a favourable impact on the fiscal situation as can
be observed from the improvement seen on the different deficit parameters
since 2004-05 (Reserve Bank of India, 2006; Reserve Bank of India, 2007)
Usually, the focus of any discussion on government finances is centred
around the level of government deficits and its consequences for important
macroeconomic variables viz. inflation, interest rates, exchange rates. How-
ever, an interesting aspect in the study of government finances would be to
focus on the nexus, if any, that exists between the two major components
of deficits viz. revenues and expenditures. That is, to address the issue of
whether revenues lead expenditures or expenditures lead revenues. Inter-
Raju: Revenue-Expenditure Nexus - Indian Evidence 7

dependence between these two components (expenditures and revenues) can

have an impact on the levels of deficits and provide an insight to the strategy
that could be adopted towards deficit management. This paper seeks to con-
tribute to the discussion of government finances in India by examining the
issue of the existence if any, of a nexus between revenues and expenditures
and help identify whether expenditures lead or follow revenues. Further, the
nexus between revenues and expenditures is analysed in nominal terms as the
idea to study the inter-dependence, if any, between revenues and expenditures
is to understand better what strategy would help in deficit management viz.
deficit rules and/or expenditure containment or augmenting revenues and
such policy decisions are usually in nominal terms.
A graphical presentation of some of the major expenditure and revenue
measures would help understand the association between these two compo-
nents over the period of study - 1951-2004. Figures 1 to 3 depict the behaviour
of total expenditure and total receipts, total expenditure and tax receipts,
and revenue expenditure and revenue receipts, of the central government in
Rupees crore or in nominal terms, respectively. While both total expendi-
ture and total receipts have shown a rising trend over the entire period, this
increase is more evident from the 1980s. The period since the 1980s has seen
major increases in total expenditure by about 20.70 times from Rs.22768
crore in 1980-81 to Rs.471368 crore in 2003-04. Though the total receipts
of the central government have seen an increase by about 23.37 times, from
Rs.20291 crore in 1980-81 to Rs.474255 crore in 2003-04, the gap between
the tax receipts and total expenditure has widened since the 1980s (Figure
2). Figure 3, likewise, looks at the profiles of revenue expenditure and rev-
8 CIISS August 2008

F i g u r e 1 C e n t r a l G o v e r n m e n t T o t a l E x p e n d i t u r e a n d

R e c e i p t s 1 9 5 1 - 2 0 0 4 ( R s . C r o r e s )

500000 T r e c

T e x p

400000
C r o r e s

300000
R s .

200000

100000

0
1950 1960 1970 1980 1990 2000
Y e a r s

enue receipts and we can observe that both revenue expenditure and revenue
receipts have been showing an increasing trend over the entire period and
the gap between revenue receipts and revenue expenditure which reflects the
extent of saving/dis-saving of the government has widened in the 1990s. Rev-
enue expenditures increased by 4.94 times from Rs.73516 crore in 1990-91 to
Rs.362887 crore in 2003-04 while revenue receipts increased by 4.79 times
from Rs.54954 crore in 1990-91 to Rs. 263027 crore in 2003-04.

The inter-temporal relationship between government expenditures and re-

ceipts could result in any of the following propositions: Proposition (i) tax
and spend hypothesis (revenues lead expenditures). This hypothesis may
Raju: Revenue-Expenditure Nexus - Indian Evidence 9

F i g u r e 2 C e n t r a l G o v e r n m e n t T o t a l E x p e n d i t u r e a n d T a x

R e c e i p t s 1 9 5 1 - 2 0 0 4 ( R s . C r o r e s )

500000
T R

450000 T e x p

400000
C r o r e s

350000

300000

250000
R s .

200000

150000

100000

50000

0
1950 1960 1970 1980 1990 2000
Y e a r s

F i g u r e 3 C e n t r a l G o v e r n m e n t R e v e n u e E x p e n d i t u r e a

R e v e n u e R e c e i p t s 1 9 5 1 - 2 0 0 4 ( R s . C r o r e s
400000

350000 R E X P

R R E C

300000
C r o r e s

250000

200000
R s .

150000

100000

50000

0
1950 1960 1970 1980 1990 2000
Y e a r s
10 CIISS August 2008

represent regimes where incurring budget deficits may not be encouraged.

According to this view, tax changes would lead government expenditures,
implying thereby that only increasing revenues could lead to greater expen-
ditures and has found support with Friedman’s opinion that ‘increasing taxes
will simply lead to more government spending’ and ‘Political Rule Number
One is government spends what government receives plus as much more as
it can get away with’ (Friedman, 1982, Anderson et. al., 1986). Hence, in-
creasing taxes (revenues) would imply as large a deficit but a higher level of
government spending.

Proposition (ii) spend and tax hypothesis (expenditures lead revenues)

indicates that the government revenue constraint adjusts to changes in ex-
penditures with a lag. According to this proposition, the government spends
first and then determines the manner in which these expenditures can be
financed. In such a scenario, the government is really not concerning itself
with the level of deficit. This view of taxes gradually adjusting to expendi-
tures also finds support from the Peacock and Wiseman (1979) study for the
United Kingdom for the periods 1920-38 and 1950-70. Thus, some form of
expenditure compression may help in deficit containment.

Proposition (iii) fiscal synchronization wherein revenues and expenditures

change simultaneously could suggest contemporaneous interdependence be-
tween revenues and expenditures. According to this hypothesis, citizens of a
locality decide on the optimal levels of spending and taxes by comparing the
marginal benefits and costs of government.

This paper, therefore, seeks to examine which of the above mentioned

Raju: Revenue-Expenditure Nexus - Indian Evidence 11

three propositions characterises the inter-relationship between government

revenues and expenditures for the central government in India. We test this
inter-relationship for total receipts vis-à-vis a range of expenditure measures
viz. total expenditure, revenue expenditure, developmental and non develop-
mental expenditure. Since budgetary deficits in India are largely structural
in nature (Report of the Twelfth Finance Commission, Chap 4, p.54), we also
test whether there exists a causal relation between the structural components
of total expenditures and total receipts. Section II of the paper contains a
brief review of literature while Section III discusses the data and methodol-
ogy adopted in this paper. Section IV presents the empirical evidence and
Section V concludes the paper.

2 Literature Review
Most of the studies have examined the inter-relationship between expendi-
tures and revenues using the standard Granger causality tests and concern
the United States economy. Manage and Marlow (1986) study this relation-
ship for the United States over the period 1929-82. They use annual data
and study the finances of the federal government and conclude that causality
is uni-directional from federal taxes (revenues) to federal expenditures. The
study of Anderson, Wallace and Warner (1986) also for the United States us-
ing annual data for 1946-83 and for the federal government finds that causality
proceeds from expenditures to revenues, a finding contrary to that of Man-
age and Marlow. Ram (1988) in his study also for the United States tried
‘to ascertain which of the above conclusions is more reasonable’ (p. 763) and
12 CIISS August 2008

broadened the scope of his study to the relationship between federal receipts
and expenditures as well as that for state and local governments. Further,
it employed annual data for the period 1929-83 and quarterly data for 1947-
83 for both nominal and real measures of receipts and expenditures. Ram’s
study finds that causality runs from revenues to expenditures at the federal
level while at the state and local level causality proceeds from expenditures to
revenues. Von Furstenberg, Green and Jeong (1986) use a VAR model to anal-
yse the relationship between expenditures and revenues in terms of a tax and
spend or a spend and tax hypothesis. Quarterly data for the period 1954-82
is employed and apart from federal expenditures and taxes they include GNP
gap and inflation as additional variables in their model. The paper examines
4, 6 and 9 variable VAR models and finds no support for the tax and spend
hypothesis (revenues cause expenditures) while it finds support for the spend
and tax hypothesis (expenditures cause revenues) a finding akin to that of An-
derson, Wallace and Warner (1986). Miller and Russek (1990) seek to verify
this relationship using cointegration and error-correction models for federal,
state and local levels of government using annual as well as quarterly data
and both nominal and real measures of revenues and expenditures for 1946-
87. This study finds bi-directional causality between government taxes and
spending for all levels of government when quarterly data is employed. For
annual data, the results show at times uni-directional causality from taxes to
spending for the federal government while bi-directional causality is observed
for state and local governments. Jones and Joulfaian (1991) have examined
this interdependence between revenues and expenditures for the early years
of the American Republic using cointegration and error-correction technique
Raju: Revenue-Expenditure Nexus - Indian Evidence 13

and have concluded that the spend and tax hypothesis prevails in the short
run while the existence of a feedback relation between revenues and expen-
ditures is seen in the long run. Joulfaian and Mookerjee (1991) study the
dynamics between revenues and receipts for 22 OECD countries using a bi-
variate VAR model and later augment the VAR model using the output gap
and inflation variables so as to comprehensively model the nexus between
revenues and expenditures. They find greater support for spend and tax
hypothesis as compared to the tax and spend hypothesis. They further con-
clude that reductions in spending are essential to reducing budget deficits and
government size. Mithani and Khon (1999) study the inter-relation between
revenues and expenditures for Malaysia for 1970-94 using quarterly data and
the seasonal error correction model. This paper too finds uni-directional
causality from government expenditures to revenue – a result similar to that
of Anderson, Wallace and Warner (1986) and Von Furstenberg, Green and
Jeong (1986). Fasano and Wang (2002) test this interdependence for the
Gulf Countries Council (GCC) countries in a cointegration and vector error-
correction model (VECM) framework and find support for the tax and spend
hypothesis. They suggest that the GCC countries could ‘enhance the effec-
tiveness of their fiscal policy by making budget expenditure less driven by
revenue availability’ (p.18). Literature, thus, provides mixed evidence on the
nature of interdependence between government revenues and expenditures.

3 Methodology
A. Tests for Unit Roots
14 CIISS August 2008

(i) Augmented Dickey Fuller Test

The initial step would be to test the variables for the presence of a unit
root. All the variables were tested for stationarity using the Augmented
Dickey Fuller (ADF) test which examines the null hypothesis: the series
contains a unit root. The ADF test uses the following three autoregressive
processes to test for the presence of a unit root:

p
X
∆yt = γyt−1 + β∆yt−i+1 + ²t (1)
i=2

p
X
∆yt = a0 + γyt−1 + β∆yt−i+1 + ²t (2)
i=2

p
X
∆yt = a0 + γyt−1 + a2 t + β∆yt−i+1 + ²t (3)
i=2

The sequential testing procedure suggested by Doldado, Jenkinson and

Sosvilla Rivero (1990), when the form of the data generating procedure is not
completely known, is employed in the paper to determine the stationarity of
the variables and is as follows:
Step I Estimate the least restrictive model – which includes both a trend
as well as a drift and is given by equation (3) above and use the τT statistic,
that is, the t statistic for the ADF test in the presence of a constant and drift
term to test the null hypothesis γ= 0. If the null hypothesis is rejected, do
not proceed further and conclude that the yt series does not have a unit root.
Step II If the null hypothesis γ = 0 is not rejected in Step I, then proceed
to determine whether there were too many deterministic regressors included
Raju: Revenue-Expenditure Nexus - Indian Evidence 15

in Step I as the presence of these regressors may have reduced the power of
the test. Hence, in step II test for the significance of the trend term a2 by
testing the hypothesis a2 = γ = 0 using the ϕ3 statistic, that is, the F test in
the ADF test to test a2 = γ = 0 in equation (3) above. If the trend is not
significant proceed to Step III.
Step III Estimate the model without the trend (as given in equation 2
above) and test for the presence of unit root using the τµ statistic, that is,
the t statistic for the ADF test to test if γ = 0 in the presence of a constant
term. If the null of γ = 0 is rejected, conclude that the series does not contain
a unit root. If the null is not rejected, test the hypothesis using a0 = γ = 0
using the ϕ1 statistic, that is, the F test in the ADF test to determine if a
drift exists or test if the restriction a0 = γ= 0 is binding. If the drift is not
significant, proceed to Step IV.
Step IV Estimate the equation without the drift and trend terms (as in
equation 1 above) and test for the presence of unit root using the τ statistic.
If the null hypothesis of γ = 0 is rejected, conclude that the series yt does
not contain a unit root. Else, conclude that yt contains a unit root. (Enders,
2004).
(ii) Zivot and Andrews (ZA) test
The standard ADF test does not take into account the presence of struc-
tural break in the series and this could at times lead to an error when the null
hypothesis is not rejected. Hence, a series could be tested for unit root in the
presence of structural break. A major problem while testing for stationarity
in the presence of structural break is the timing of the break. ZA (1992) pro-
pose a test procedure in which the break point, k, is treated as an outcome
16 CIISS August 2008

of the estimation procedure designed to fit xt to a certain trend stationary

representation rather than exogenously. ZA consider the null hypothesis to
be: a series xt is I(1) without a structural break and the alternative hypothe-
sis is that the series xt can be represented by a trend stationary process with
a single break in trend occurring at an unknown point in time. According
to the ZA procedure the break point k is the one which minimises the ADF∗
unit root test statistic computed from the following regressions:

Model A: Break (intercept)

k−1
X
∆xt = µA
1 + γ1A t + µA
2 DUt (k)
A
+ θ ∆xt−1 + βj ∆xt−j + ²t (4)
j=1

k−1
X
∆xt = µB
1 + γ1B t + γ2B DTt∗ (k) B
+ θ ∆xt−1 + βj ∆xt−j + ²t (5)
j=1

k−1
X
∆xt = µC
1 + γ1C t + γ2C DTt∗ (k) + µC B
2 DUt (k) + θ ∆xt−1 + βj ∆xt−j + ²t (6)
j=1

Where DUt (k) =1 and DT∗t (k) = t-k if t > k, and 0 otherwise with the
regressions being estimated over the range of the sample (0.15T..0.85T), T is
the total number of observations. Model A allows for a change in the level of
the series, Model B allows for a change in the slope of the trend of a series
and Model C estimates for both change in level and the slope of the trend
(Mills, 1999, pp.92-93).

B. Test for Co-integration and Error Correction

Raju: Revenue-Expenditure Nexus - Indian Evidence 17

An important feature of co-integrated variables is that their time paths

are influenced by the extent of any deviation from the long run equilibrium
relationship between or among them. The Johansen procedure depends heav-
ily on the relationship between the rank of the matrix and its characteristic
roots and the rank of the matrix π is used to determine if the two variables
are co-integrated. Further, the procedure is ‘nothing more than a multivari-
ate generalization of the Dickey Fuller test’ (Enders, 2004, p.348-52) and can
be generalized to allow for higher order autoregressive process as:

p−1
X
∆xt = π0 + πxt−1 + Σ πi ∆xt−i + ²t (7)
i=1

where, π0 is an (n x 1) vector of intercept terms with elements πi0 ;

πi are (n x n) coefficient matrices with elements πjk (i);
π is an (n x n) matrix with elements πjk 6= 0; and
²t is an (n x 1) vector with elements ²it .
The rank of the matrix π is equal to the number of independent cointe-
grating vectors If rank (π) = 0, the variables in vector xt are not cointegrated
and equation (7) would be similar to a VAR in first differences. If π is of
rank n, the vector process is stationary. If the rank of π =1, there is a single
cointegrating vector and the term πt−1 is the error correction term (ECT).
When 1 < rank (π) < n, there are multiple cointegrating vectors. The test for
the number of characteristic roots that are insignificantly different from unity
can be determined using the λ trace which tests the null hypothesis that the
number of distinct cointegrating vectors is less than or equal to r against a
general alternative and the λ max statistic which tests the null hypothesis
18 CIISS August 2008

that the number of co-integrating vectors is r against the alternative of r+1

co-integrating vectors. Thus, if all the elements of π equal zero, equation
(7) would be a traditional VAR in first differences and there is no error cor-
rection representation. However, if one or more of the πjk differs from zero,
∆xt responds to the previous period’s deviation from long run equilibrium.
Hence, estimating xt as a VAR in first differences is not appropriate if xt has
an error correction representation. The lag length on the right hand side of
equation (7) could be determined through the use of the variance-covariance
matrix of the restricted and unrestricted systems or by using the multivariate
Akaike Information Criterion (AIC) or Schwartz Bayesian Criterion (SBC).
A block exogeneity test helps determine whether causality exists between
the pairs of variables. If there are three variables, wt , yt and zt , the question
of whether lags of one variable, say wt, improve the prediction of either yt or
zt , that is, whether wt Granger causes either yt or zt is answered through the
block exogeniety test. The block exogeniety test restricts all lags of wt in the
yt and zt equations to be equal to zero and the statistic has a χ2 distribution.
Granger causality in a cointegrated system would need to be interpreted
differently. In a cointegrated system of a vector x comprising two variables y
and z, yt does not Granger cause zt if lagged values of ∆y (i.e. ∆yt−i ) do not
enter the ∆zt equation and if zt does not respond to the deviation from long
run equilibrium. Hence, zt must be weakly exogenous. Also, the coefficient
of the ECT represents the speed of adjustment parameter. Usually, both
the speed of adjustment parameters should be significant in a cointegrated
system but it is possible that one of the parameters is zero. In other words, the
absence of Granger causality for cointegrated variables requires the additional
Raju: Revenue-Expenditure Nexus - Indian Evidence 19

condition that the speed of adjustment co-efficient, that is, the ECT in the
corresponding error correction model be equal to zero (Enders, 2004).

4 Empirical Evidence
The paper employs annual data over the period 1950-51 to 2003-04 and tests
for interdependence between central government revenues and expenditures.
The data for all the revenue and expenditure variables are obtained from
various issues of the Reserve Bank of India’s Report on Currency and Finance
and Handbook of Statistics.
The interdependence was examined for total receipts and an array of ex-
penditure measures. While the profile of total expenditures reveals actual
spending of the government, they also consist of defence expenditure and
interest payments which are usually committed expenditures and hence it
was thought that it would be worthwhile to consider a profile for expenditure
that excludes these two components of expenditure and see if this had any
meaningful impact on the interdependence between revenues and expendi-
tures and is given by TE2. Revenue deficits in India have been persistent
and growing since 1982-83, hence the interdependence between revenue re-
ceipts and revenue expenditures was also analysed. Further, expenditure was
further decomposed into development and non-development expenditure so
as to determine whether there exists a causal relation between these expen-
ditures vis-à-vis total receipts (which in turn may help identify whether it
is increases in development and/or non-development expenditure lead total
receipts (and thereby impact the fiscal deficit). Further, fiscal deficits in In-
20 CIISS August 2008

dia have been largely structural in nature, as stated earlier, and hence the
total revenue and total expenditure series were decomposed into their struc-
tural and cyclical components, using the Hodrick-Prescott filter (with) to
determine the trend and we looked at the structural profile of receipts and
expenditures to examine the existence of interdependence between the two.
All the variables are considered in their logarithmic form and denoted by the
suffix ‘L’ and are explained below.

LTEXP Total Expenditure

LTE2 Total Expenditure exclusive of defence expenditure and interest payments
LTREC Total Receipts
LTR Tax Receipts
LREXP Revenue Expenditure
LRREC Revenue Receipts
LDE Development Expenditure
LNDE Non-development Expenditure
STEXP Structural component of log of Total Expenditure
STREC Structural component of log of Total Receipts

All the variables were tested for the presence of unit roots using the sequential
ADF test and the ZA test which tests for unit roots in presence of a structural
break in the series (tests are detailed in Section III.A above). The lag length
for the tests was determined using the AIC criterion.
Results of the unit root tests are presented in Table1 and the ADF test
(Rows 1-5 indicate results of ADF test for the different variables in levels
Raju: Revenue-Expenditure Nexus - Indian Evidence 21

while Rows 6-7 indicates the results of the ADF test for the different variables
in First Differences) finds all the expenditure and revenue variables to be
difference stationary or I(1) processes except for STEXP and STREC, which
are found to be stationary in levels. Since the drift is significant (Row for
ϕ1 ) and the trend is not significant (Row for ϕ3 ) for most variables in levels,
the first difference ADF statistics (τµ ) reported are those for the presence of
constant, no trend. The Zivot-Andrews (ZA) test (Rows 8-10), with a null
of - series are I(1) without a structural break and a alternative hypothesis
of – series are I(0) with a single structural break, reveals that the variables
LTEXP, LTE2, LTR, LREXP and LRREC reject the null and hence are I(0)
processes with a single structural break while the other variables - LTREC,
LDE, LNDE do not reject the null hypothesis and hence are I(1) processes.
The ZA test indicates a structural break at the end of the 1960s and the
late 1970s and early 1980s. India adopted a model of planned economic
development after independence and accordingly the government played an
active role in economic development and made large investments in areas
it felt private enterprise would not be forthcoming. Public sector outlay
increased by 8.05 times from Rs.1960 crore during the First Five Year Plan
to Rs.15780 crore in the Fourth Five Year Plan and was at Rs.6750 crore
at the end of the three Annual Plans (1966-69). Expenditure increases can
also be attributed during the late 1960s to drought in 1965-66 and 1966-67
and industrial stagnation. Plan expenditures were higher on account of food
subsidies and higher cost of interest on foreign loans due to devaluation. The
drought in 1979 and the oil price shock saw increased expenditures at the end
of the 1970s. The 1980s saw higher growth but was based on excessive internal
22 CIISS August 2008

spending and both internal and external borrowing. In case of STEXP and
STREC since the ADF test itself finds that the variables are I(0) processes
i.e. stationary, we did not proceed to determine if STEXP and STREC were
I(0) processes with a single structural break. Hence the ZA test was not
performed on STEXP and STREC.
23

Table 1 Tests of Stationarity

No Stat LTEXP LTE2 LTREC LTR LREXP LRREC LDE LNDE STEXP@ STREC@
Raju: Revenue-Expenditure Nexus - Indian Evidence

1 τT -2.31 -2.22 -2.78 -3.22 -1.99 -3.20 -1.79 -3.24 -5.47** -8.03**
2 ϕ3 2.70 2.55 4.14 5.19 2.30 5.26 1.74 5.45 – –
3 ϕ1 5.25 10.09 9.07 14.06 21.74 12.66 9.18 10.53 – –
4 τµ -0.27 0.22 -0.85 -0.31 -0.86 -0.61 -0.69 -0.74 – –
5 Lag(s) 5 2 2 1 1 1 1 3 1 1
6 τµ -3.96** -4.73** -12.72** -5.52** -5.57** -4.41** -4.16** -6.89** – –
7 Lag(s) 2 1 1 1 1 3 3 1 – –
8 ZAA -4.19 -3.98 -4.38 -6.15** -4.45 -6.13** -2.52 -4.66 – –
Lag(s) 0 0 0 1 0 1 0 0 – –
Year (1968) (1968) (1969) (1984) (1983) (1963) (1981) (1968) – –
9 ZAB -7.09** -7.23** -3.41 -3.40 -7.06** -6.13** -2.62 -3.86 – –
Lag(s) 0 0 0 0 0 1 0 0 – –
Year (1979) (1976) (1975) (1975) (1976) (1996) (1991) (1975) – –
10 ZAC -7.39** -7.57** -4.78 -4.79 -6.99** -6.24** -3.83 -4.24 – –
Lag(s) 0 0 0 0 0 1 0 0 – –
Year (1969) (1969) (1968) (1968) (1974) (1995) (1981) (1969) – –
24 CIISS August 2008

Critical value for the ADF test @ 5% level of significance: τµ -2.86, τT -

3.41, ϕ3 6.25, ϕ1 4.59
Crtical values of ZA test @ 5% level of significance ZAA − 4.80,ZAB −
4.42,ZAC − 5.08
** indicates rejection of null hypothesis at 5% level of significance
Years in parentheses for the ZA test are the break points using the ZA
procedure
Lag length determined using AIC.
Consequent to the unit root tests causal interdependence between the
revenue-expenditure pairs can be examined using the bivariate VECM model
for the LDE-LTREC and LNDE-LTREC pairs alone as both the variables for
these pairs are I(1) processes and hence it is possible to examine if a coin-
tegrating relationship exists between these revenue-expenditure pairs. As
regards, LREXP-LRREC (the ZA test) and STEXP-STREC (the ADF test)
pairs of revenue and expenditure are found to be stationary and we can
infer causality using the standard Granger causality test while VAR anal-
ysis can be used to infer causality the following revenue-expenditure pairs
viz. LTEXP-LTREC, LTEXP-LTR and LTE2-LTREC. In each of these
revenue-expenditure pairs as can be observed from Table 1 the revenue vari-
ables (LTREC and LTR) are I(1) processes while the expenditure variables
(LTEXP and LTE2) are stationary or I(0) processes. Nevertheless, one
can employ VAR analysis to infer Granger causality between these revenue-
expenditure pairs. Enders (2004) illustrates a bivariate VAR where one vari-
able is an I(1) process and the other is a stationary I(0) process and explains
how one can use the F or t tests to determine Granger causality. To quote
Raju: Revenue-Expenditure Nexus - Indian Evidence 25

from Enders (2004),

‘To take a specific example, consider the following equation from

a two-variable VAR:

y t = a 11 y t−1 + a 12 y t−2 + b 11 z t−1 + b 12 z t−2 + ²t

Consider the case in which y t is I(1) and z t is I(0). Since b 11

and b 12 are coefficients on stationary variables, it is possible to
use a t test to test the hypothesis b 11 =0 or b 12 =0 and a F test
to test the hypothesis b 11 =b 12 =0 . . . .and the test to determine
whether zt Granger causes yt can be performed using the t or F
distributions’.

In Table 3 below which presents the results of causality and where we find
statistically significant causal interdependence for the above specified three
revenue-expenditure pairs satisfy the condition enumerated in Enders (2004)
and hence the results would hold.
Table 2 reports the results of cointegration using the Johansen technique
for the LDE-LTREC and LNDE-LTREC pairs and finds cointegration for
both these revenue-expenditure pairs. The lag length in the cointegrating
regression from which the lag structure for the Error Correction Model (ECM)
model can be inferred was also determined using the AIC. The ECM can be
employed to study long term causal movements only for the LDE-LTREC and
LNDE-LTREC pairs through the error-correction term (see Section III. B).
Table 3 reports the results of causal interdependence between the different
revenue-expenditure pairs.
26 CIISS August 2008

Table 2 Results of Johansen’s Cointegration Test

Variable LDE-LTREC LNDE-LTREC
Trace Stat 16.01** 27.82#
Max. Eigen Stat 14.46** 27.52#
Lags 2 2

Indicates Significance at # 1% and ** 5% level of significance Lag length

determined using AIC.

Table 3 Results of Causality and Error Correction

Null: RevenuesCauseExpenditures Null:ExpendituresCauseRevenues
LDE-LTREC LTREC-LDE
(1) ECTt−1 -0.0058 (0.07) (1) ECTt−1 0.1366# (3.71)
2 # 2 ∗∗
(1a) χ 13.2012 [0.0014] (1a) χ 6.4591 [0.0396]
LNDE-LTREC LTREC-LNDE
#
(2) ECTt−1 -0.5851 (-4.00) ECTt−1 0.0558 (0.59)
(2a) χ2 4.1442 [0.1259] χ2 0.1425 [0.9312]
1 1
LTEXP-LTREC LTREC-LTEXP
(3) χ2 0.3784 [0.5385] (3) χ2 10.6504# [0.0011]
1 1
LTE2-LTREC LTREC-LTE2
(4) χ2 0.3194 [0.5719] (4) χ2 3.6574∗∗ [0.0558]
1 1
LTEXP-LTR LTR-LTEXP
(5) χ2 0.4250 [0.5145] (5) χ2 6.8940# [0.0086]
LREXP-LRREC2 LRREC-LREXP2
(6) F Test 5.3213** [0.0253] (6) F Test 1.1283 [0.2932]
STEXP-STREC2 STREC-STEXP2
(7) F Test 0.4946 [0.4854] (7) F Test 0.8215 [0.3695]

Figures in ( ) parentheses indicate ’t’ values. Figures in [ ] parentheses

indicate probability values
Raju: Revenue-Expenditure Nexus - Indian Evidence 27

Indicates significance at # 1%, ** 5 % and * 10%.

1 2
causality results from VAR model causality results from standard
Grnager causality test.
Since the revenue-expenditure pairs LDE-LTREC and LNDE-LTREC are
cointegrated, the causal relation between revenues and expenditures can be
inferred from bivariate VECM models - Table 3 (Rows 1 to 2a). As de-
scribed in Section III.B, causality in a cointegrated system can be inferred
by looking at the significance of the ECT (Rows 1 and 2) as well as the χ2
statistic (Rows 1a and 2a). Column (1) of Table 3 indicates causality from
revenues to expenditures while Column (2) indicates that causality proceeds
from expenditures to revenues. Significant feedback relation is seen for total
receipts and developmental expenditure (LDE-LTREC) (Row 1a, Table 3).
Further, for total receipts and development expenditure causal effects from
expenditures to revenues are observed through the significance of the ECT
as well (Row 1, Table 3) and hence suggest of a stronger causal effect from
expenditures to revenues. Further, total revenues would adjust rather slowly
– more than 7 years (a coefficient of 0.13 for the ECT in the error correction
model with annual data) to changes in development expenditure. However,
uni-directional causality from receipts to expenditures (Row 2, Table 3) is
observed for non-developmental expenditure-total receipts (LNDE-LTREC).
Further, the coefficient of 0.59 for the ECM term in the error correction model
with annual data would suggest that non-developmental expenditures would
adjust in 1.7 years to increases in total receipts and support for the tax and
spend hypothesis for total receipts and this category of expenditure.
Results of the VAR analysis for the following three revenue-expenditure
28 CIISS August 2008

pairs (i) total expenditure-total receipts (LTEXP-LTREC), (ii) total expendi-

tures exclusive of defence expenditure and interest payments – total receipts
(LTE2-LTREC) and (iii) total expenditure-tax revenues pairs indicates that
causal relation is from expenditures to revenues. In other words, expenditures
lead and total receipts as well as tax receipts follow to adjust for the increased
expenditure and hence these three revenue expenditure pairs support spend
and tax hypothesis. Causal effects, however, for the revenue receipts-revenue
expenditure pair was uni-directional and revenue receipts lead revenue expen-
diture implying thus, that rising revenue/current receipts can influence the
government to have higher revenue/current expenditure. No causal relation
is observed between structural expenditures and structural receipts.
The empirical evidence of the paper is, thus, mixed and finds support for
both the tax and spend hypothesis as well as the spend and tax hypothesis
for different pairs of revenues and expenditures. The evidence in the paper,
however, indicates that there exists a nexus/causal interdependence between
the two major components of deficit viz. expenditures and revenues for gov-
ernment finances in India. However, it is pertinent to note here that the
impact of these causal relations between revenues and expenditures cannot
by themselves explain the impact on deficits as a result of increases in re-
ceipts and/or expenditures. The effect of increases in revenues/expenditures
on deficits can be studied by examining if a uni-directional causal relation ex-
ists between revenues/expenditures and deficits. This paper, however, limits
itself to studying the nexus between revenues and expenditures and identi-
fying whether revenues lead expenditures (tax and spend hypothesis) or ex-
penditures lead revenues (spend and tax hypothesis) persists for government
Raju: Revenue-Expenditure Nexus - Indian Evidence 29

finances in India.

5 Conclusion
The paper seeks to examine whether there exists interdependence between
total receipts/tax receipts and an array of expenditure measures of the cen-
tral government. The empirical evidence in this paper is mixed and finds
the prevalence of causal interdependence between total receipts and different
categories of government expenditures. Support for expenditures lead rev-
enues - spend and tax hypothesis is observed for three of the seven revenue-
expenditure pairs viz. total expenditures-total receipts, adjusted total expen-
ditures (adjusted for defence and interest payments)-total receipts and total
expenditures-tax receipts. whereas revenues lead expenditure – tax and spend
hypothesis is seen for two of the seven revenue-expenditure pairs namely,
revenue expenditure-revenue receipts and for non-development expenditure-
total receipts. Significant bi-directional short run causal effects are observed
between development expenditures and total receipts. However, stronger
support for expenditures lead revenues can be inferred for development ex-
penditure and total receipts, as a causal relation from expenditures to re-
ceipts (implied by the significance of the ECT) is also observed. While no
causal relation is observed between structural expenditures and structural
revenues. Hence it would be safe to conclude that evidence for four of the
seven expenditure- revenue pairs support expenditures lead revenue i.e. the
spend and tax hypothesis. Hence, we could infer that the government pro-
ceeds with its expenditure plans and then finds means by which revenues can
30 CIISS August 2008

be raised to finance these expenditures. Further, a statistically significant

causal relationship is also observed between revenue receipts and revenue ex-
penditures, thus implying that rising revenue/current receipts can influence
the government to have a higher revenue/current expenditure which in turn,
can have an impact on the management of revenue deficits or the extent of
government dis-saving and in a sense support the Friedman hypothesis. While
no causal relation is seen between structural expenditures and structural re-
ceipts. The paper thus, finds evidence towards the prevalence of a causal
relation between revenues and expenditures which in turn could have an im-
pact on deficit management. This impact on deficits of increases in revenues
and expenditures can be conclusively proved by looking at the causal interde-
pendence between revenues/expenditures and the different deficit measures.
However, the evidence which is largely in favour of expenditures lead revenues
(spend and tax hypothesis) one can probably infer that rather than having
deficit rules alone so as to achieve fiscal stability, it would be useful to have
rules for expenditure containment as well in an effort to have some degree of
fiscal stability.
Raju: Revenue-Expenditure Nexus - Indian Evidence 31

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