Exploring the Nexus Between the Composition of Fiscal Deficit and Economic Growth in Indian States

Within a fiscal federal framework, the fiscal performance of state governments constitutes a critical determinant of economic growth (EG) at both the national and subnational levels. Given the substantial contribution of state governments to aggregate fiscal outcomes, understanding the macroeconomic implications of the composition of fiscal deficits (FD) is of considerable policy relevance. Nevertheless, existing research has paid relatively little attention to how the composition of fiscal deficits influences economic growth. This study fills this gap by taking data from 14 Indian states for the period from 1980–1981 to 2022–2023. It disaggregates the FD into the revenue deficit (RD) and the effective fiscal deficit (EFD) to examine their distinct implications for EG. The empirical results reveal that while both RD and EFD adversely affect real income growth in the short run, the adverse effect of RD is considerably more pronounced. However, EFD demonstrates a growth-enhancing effect in the long run, highlighting the importance of the composition of deficits rather than their aggregate size. Moreover, while other fiscal and macroeconomic variables—such as tax and non-tax revenues and inflation—dampen growth, private investment and the implementation of Fiscal Responsibility Legislation (FRLs) have a significant and positive influence on economic performance. These findings underscore the critical importance of sound fiscal management and effective policy execution in promoting sustainable and inclusive economic development. Rather than prioritizing a reduction in the absolute size of the FD, greater emphasis should be placed on its composition, as the quality and structure of the FD play a more decisive role in transforming potentially adverse effects into growth-enhancing outcomes.