This paper examines the Granger causal relation between government revenue and expenditure over the period 1971-2010. The study emphasizes on the idea that the relationship can truly be captured when the relation between anticipated parts and that between unanticipated parts of the variable are studied separately. In-sample one-step ahead ARIMA(3, 1, 1) forecasts for expenditure and ARIMA(2, 1, 0) forecasts for revenue constitute the anticipated parts for expenditure and revenue ( and ) respectively. The respective forecast errors constitute the unanticipated parts of the variables. and , both I(1) variables, are found to be cointegrated. VAR(2, 3) model for these variables testifies to the unidirectional Granger causality from expenditure to revenue. Variance decomposition analysis based on this VAR(2, 3) model supports this finding. White noise unanticipated parts in the VAR(2, 1) model further testify to unidirectional causality from expenditure to revenue. This finding draws large support from the variance decomposition analysis for and . The findings negate the ‘hypothesis of independence’ given forth by the study with observed series on xt and Rt.

The relationship between government revenue and government expenditure has been studied largely on the basis of cointegration between observed time series values of the variables. Stationarity and integrability of these series have been studied which form the basis of the study of cointegration between these observed realizations. In the event of the existence of cointegration, appropriate Vector Error Correction Models (VECMs) are estimated in order to examine the nature of long-run stability and the associated short-run dynamics therein. The nature and direction of Granger causality between these variables are studied through the estimation of an appropriate VAR model where both the variables appear as endogenous variables.

Several empirical studies have been taken up since 1980 with varying conclusions regarding the relationship between expenditure and revenue levels in different countries. These studies differ in the matter of research methodologies, target countries, period of studies, frequencies of dataset, etc. Some of the important studies have been reviewed here.

Manage and Marlow (1986) studied the direction of causality between revenue and expenditure in USA over the period 1929-1982. They concluded that the ‘fiscal synchronization principle’ was operative over the period of study in the USA. Anderson et al. (1986) enquired into the revenue-expenditure relationship in the USA over the period 1946-1983. They argued that the ‘principle of spend and tax’ was valid in the USA over this period (1946-1983). Ram (1988) re-enquired into the relation between revenue and expenditure in the USA over the period 1929-1983. The findings testified to those of Manage and Marlow (1986). Miller and Russek (1990) applied ‘time domain study’ on this issue for the USA over the period 1946-1987. They also reported bidirectional Granger causality between revenue and expenditure over the period of study concerned. So they concluded in favor of the ‘principle of fiscal synchronization’ in the USA during 1946-1987. Baghestani and McNown (1994) re-examined the revenue-expenditure relationship in the USA for the period 1955-1989 with the application of the ‘multivariate cointegration technique’ and the estimation of an appropriate VECM. Joulfaian and Mookerjee (1990) studied the revenue-expenditure relationship in OECD countries during the period 1955-1986. The authors reported ‘unidirectional Granger causality’ from revenue to expenditure and therefore, concluded for the validity of the ‘tax and spend hypothesis’ in the countries concerned over the period of study (1955-1986).

Public Finance journal, Tax Buoyancy, Corporation Tax in Pre- and Post-Liberalization Periods, Economic Policy, Financial Reforms, Corporation Income Taxation, Economic Development, Gross Domestic Product, GDP, Linear Regression Equation, Augmented Dickey-Fuller, Vector Error Correction Mechanism, Domestic Companies, Corporate Development.