Dynamic causal relationship between government expenditure and government revenue in Sri Lanka

Abstract

Introduction

An opposite fiscal policy is a vital ingredient for sustainable economic development. Sri Lanka is often suffering from a persistent fiscal deficit one that has been increasing in an exponential way in nominal as well as real values.

Many scholars have drawn their attention to comprehend the budgetary movements and the causal relationship between government revenue and government expenditure since, it is essential to address unsustainable fiscal deficit and evaluate the government’s role in the management of resources. Moreover, such evaluation clears the way for sound fiscal policy formulation and implementation to achieve rapid and sustainable socio-economic growth (Obioma & Ozughalu, 2010). Persistent behavior of budget deficit raises many unanswered questions in existing literature. The direction of causality between the government revenue and government expenditure is still a puzzle.

Theoretical literature explains the causal relationship between government revenue and government expenditure by considering four hypotheses. The tax-and-spend hypothesis, proposed by Friedman (1978) explains that raising taxes will simply lead to more spending. The spend-and-tax hypothesis, proposed by Peacock and Wiseman (1961, 1979) postulates that government expenditure causes government revenue. The third school, fiscal synchronization hypothesis argues that government may take revenue and expenditure decisions simultaneously, because the two variables interact interdependently (Meltzer & Richard, 1981; Musgrave, 1966). Finally, fiscal neutrality school or institutional separation hypothesis which was introduced by Baghestani and McNown (1994) is based on the perspective that government revenue and expenditure decisions are independent of one another.

Using bounds testing approach for Sri Lanka Narayan (2005) identified government revenue Granger cause government spending in the short run. In the long run, government spending Granger causes government revenue. Using Engle Granger Co-integration approach and Error Correction Model (ECM) for Sri Lankan Ravinthirakumaran (2011) found bidirectional causality between revenue and expenditure which supported the fiscal synchronization hypothesis. According to the existing literature, it proves that only limited numbers of studies have concentrated on this issue in Sri Lanka and no one has extended their analysis to identify the short run and long run dynamics and budgetary movement. By considering these research gaps, this study investigates the direction of causality between government expenditure and government revenue for Sri Lanka.