An empirical investigation of the relationship between budget deficits and economic growth in Kenya (1975-2012)

Abstract

Budget deficit has become a striking and institutionalized feature of most economies of the world. The Kenyan government has continued to reduce inflation (below 10%) and to develop sound fiscal policy that spurs growth. However, from 1970s to 2012, the government continued to experience high and unsustainable budget deficits and dwindling economic growth. Past empirical studies on the relationship between budget deficits and economic growth have come up with mixed results, being either positive or negative. The purpose of this study was to determine the relationship between budget deficits and economic growth in Kenya. The specific objectives were to: determine the impact of budget deficits on private sector investment in Kenya; examine the main determinants of Kenya’s budget deficits; and establish the relevance of Ricardian Equivalence Hypothesis for Kenya. Underpinning theories of the research anchored on the Keynesian, Neoclassical and Ricardian propositions. Correlation research design was used. Saturated sample of time series secondary data for a period of 38 years (1975-2012), purposively selected were used. Modeling technique that incorporates co-integration and error correction method was adopted to validate the models for policy formulation. The models were estimated using Ordinary Least Squares method. The results indicated a positive and significant relationship between lagged budget deficits and economic growth at 1% level with elasticity coefficient of 0.00146 (p= 0.007) and R2 of 96%, congruent with the Keynesian’s assertion that government expenditure spurs economic growth. There was a positive relationship between budget deficits and private investment with elasticity coefficient of 0.0083 (p=0.0000). This supports the crowding-in hypothesis. The main determinants of budget deficits were foreign exchange rate and lagged inflation (positive relationship) as well as terms of trade (negative relationship). In testing the relevance of Ricardian Equivalence Hypothesis, a significant negative relationship was established between national savings and budget deficits with elasticity coefficient of -0.0087 (p=0.0177), hence non relevance of Ricardian Equivalence Hypothesis for Kenya. The study concludes that budget deficits spur economic growth when lagged one period. It is recommended that the government should incur budget deficits over one period lag to increase economic growth and private investment. The government should also pursue stable macroeconomic policies that would influence budget deficits. The government should encourage the culture of savings. The study findings may be useful to government policy makers and also be a source of information to academicians and potential investors. Further research should examine specific expenditures that affect budget deficits in Kenya.