Document Type : Research Paper
Authors
1 Ph.D. Student, Department of Economics and Management, Shiraz Branch, Islamic Azad University.
2 Associate Professor, Department of Economics and Management, Shiraz Branch, Islamic Azad University, Shiraz, Iran.
3 Assistant Researcher, Department of Economics, Institute for Humanities and Cultural Studies.
Abstract
This paper aims to explain the real-fiscal linkages by identifying the macroeconomic determinants of the operational fiscal deficit in Iran from 1972 to 2020 using the Dynamic Ordinary Least Squares (DOLS) method. The findings indicate that economic growth, inflation, centralization, the size of the government in terms of efficiency, and the relative population of the employed have positive effects on the operational budget deficit in Iran. On the contrary, trade openness has had a negative effect. The common sense in economics regarding the positive effect of the budget deficit on inflation -primarily because it is often financed through money printing-, along with the key finding of this paper regarding the positive effect of inflation on the operational budget deficit, indicates the establishment of a “self-reinforcing vicious cycle” in Iran’s economy. Based on this, the overall policy implication of this paper is in support of the government’s “strict commitment” to budgetary discipline in conjunction with the design and implementation of a growth strategy based on fostering “human-capital-intensive” technological changes, a more open economy, more fiscal decentralization, minimizing government crowding-out and avoiding price distortions in factor markets, allowing the public sector to align with free market relative prices, and implementing comprehensive explicit complete indexation on both the fiscal revenues and expenditures sides.
Introduction
In conventional public sector economics, the Tanzi effect (1978) suggests that real tax revenues will decline as inflation rises, which in turn leads to an increase in the budget deficit during periods of high inflation. On the other hand, the Patinkin effect (1993) operates in the opposite manner. It predicts that at high inflation rates, the Patinkin effect will prevail over the Tanzi effect, resulting in a decrease in real government expenditures compared to a situation of zero inflation. Consequently, when inflation subsides, real government expenditures are expected to rise. This often leads to an underestimation of the fiscal adjustments needed after inflation has ended, which diminishes the incentive for governments to combat inflation and can even contribute to the persistence of high inflation.
Inflation can influence fiscal expenditures, either increasing or decreasing them - known as the Patinkin effect or its inverse - and it can also affect tax revenues in similar ways - referred to as the Tanzi effect or its inverse. As a result, at a given inflation rate, governments of varying sizes may adopt different budget plans. This means that the presence, absence, or reversal of the Tanzi effect, combined with the presence, absence, or reversal of the Patinkin effect, can lead to different and sometimes contradictory fiscal deficit situations across countries, even when their inflation rates are similar. Historically, there has been a consistent non-neutral relationship between inflation and budget deficits. In this context, Cardoso (1998) argues that inflation typically results in an operating budget deficit that is proportional to the amount of real seigniorage the government requires to finance that deficit.
Accordingly, examining whether inflation has been synergistic with the budget deficit in Iran’s economy or whether the government has used inflation to reduce its real budget deficit is of particular importance in analyzing the economics of government in Iran and providing political economy interpretations of government behavior.
This paper answers these questions: What is the effect of inflation on the operating budget deficit in Iran? In addition, how have other macroeconomic determinants affected the government's operating budget deficit in Iran?
Methods and Material
The research model is specified as follows:
(1)
where:
: represents the government operating budget deficit,
: is the GDP at current prices, at market prices,
: indicates the consumer price index.
Additionally, : is a vector of determinants affecting the government’s relative operating budget deficit. This vector will be added step by step to the initial specification and includes the following indicators:
Open: trade openness.
PD: Population density, serving as a proxy for fiscal preferences.
WPP: The ratio of the working-age population to the total population, which acts as a proxy for the demographic effects on the budget.
RPPG: the ratio of the government consumption-adjusted price index to the private consumption-adjusted price index, and indicative of government size.
The paper empirically identifies the macroeconomic determinants of Iran’s government’s operating budget deficit from 1972 to 2020 using the Dynamic Ordinary Least Squares (DOLS) method and adopts a specific-to-general modeling approach.
Results and Discussion
The key findings of this paper are:
a) Iran’s economic growth has resulted in a government budget deficit. Therefore, achieving fiscal discipline requires a growth strategy that is independent of government influence.
b) The positive effect of inflation on the operating budget deficit indicates the lack of full indexation in Iran's economy. Non-explicit incomplete indexation of revenues and expenses in the government's fiscal regulations has led to varying rates of indexing, with some items not indexed at all or over-indexed due to political pressures.
c) In a more open economy, government assessments will better reflect cost-benefit analyses that consider social benefits and global prices, improving budget efficiency and reducing fiscal imbalances - which is not observed in Iran’s relatively closed economy.
d) Decentralization can shift functions from the central government to local governments, particularly in infrastructure development. This reduces central government expenditures and enhances efficiency while easing budget pressures through balanced regional growth.
e) The government has worsened its budget imbalance by trying to create public sector jobs via financing or subsidizing job creation. This approach crowds out the private sector and encourages the use of capital-intensive technologies over human-capital-intensive ones, leading to higher unemployment among educated youth. As a result, there is increased pressure on the government to create jobs, further straining Iran’s operating budget deficit.
f) The positive effect of the ratio of the government consumption-adjusted price index to the private consumption-adjusted price index suggests that as the difference in prices of goods supplied by the government increases compared to those supplied by the private sector, government inefficiency also rises. This, in turn, worsens the operating budget deficit. In Iran’s economy, the primary reason for the persistent and widening imbalance in the government’s operating budget is the public sector’s failure to align with relative market prices.
Conclusion
On one hand, Political economy motives are widely recognized as a contributing factor to government budget deficits, which in turn can lead to inflation. These motives create a strong incentive for governments to finance budget shortfalls in the simplest way possible, often by printing money (cf. Friedman, 1971; Aghevli, 1977). On the other hand, based on our findings, increasing inflation also leads to increasing budget deficits. The two have created a self-reinforcing vicious circle in Iran’s economy that cannot be broken without identifying and analyzing the political economy motives that reinforce it.
The overall policy implication of the findings of this study is to support the design and implementation of a coherent economic growth strategy in conjunction with greater fiscal discipline and the establishment and maintenance of a balanced budget to which the government has a “tight commitment”.
Keywords
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