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Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa! 65

perfectly rational and perfectly capable, internalize the government’s fiscal choices when
making their consumption decisions. Specifically, for a given pattern of government spending,
increases in government spending (or lowering of taxes) in the current period lead forward-
looking consumers to anticipate future tax increases, thereby leading them to save in the current
period to be able to pay for the future tax increases. As a result, aggregate demand remains
unchanged in the current period (Barro, 1974, 1979). REP, however, breaks down in most
economies because of the failure of the stringent assumptions – including lump-sum taxes –
that are required for it to hold. When REP does not hold, for instance due to proportional taxes,
higher public debt levels (lower public savings) may not be accompanied by increase in private
savings, higher government spending (or lower taxes) in the current period may lead to lower
national savings. This may put upward pressure on the interest rates, resulting in crowding
out of investment and thus negatively impacting the growth rates. This section examines these
mechanisms for India.

Crowding Out?

2.23 The phenomenon of crowding out of private investment is based on the notion that supply
of savings in the economy is fixed. Therefore, higher fiscal spending may increase the demand
for loanable funds and hence exert an upward pressure on interest rates, thereby discouraging
private investment (Blanchard, 2008).
2.24 However, for emerging economies such as India, an increase in public expenditure in
areas that boost private sector’s propensities to save and invest, may enable private investment
rather than crowding it out. In other words, in an economy that has unemployed resources,
an increase in government spending increases the aggregate demand in the economy, which
may induce the private sector to increase their investment in new machinery to cater to the
increased demand, and hence put the unused resources to productive uses. This may have
multiplier effects on aggregate demand, resulting in higher growth rates (Eisner, 1994). In
fact, if the public expenditure is directed to sectors where the fiscal multipliers are large –
for instance for building infrastructure – such spending may significantly crowd in private
investment as well.

2.25 Recent research puts further doubt on the phenomenon of crowding out in rapidly
growing economies by showing that the supply of savings is not fixed but expands with