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CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The fiscal operations of the Nigerian government have been generally unstable. This is considered to be one of the major causes of macroeconomic instability in the country. The unstable fiscal operations arise partly from fiscal imbalances characterized by inadequacy of financial resources relative to ever increasing need for social and economic infrastructural expenditures. There is a mismatch between the availability of financial resources and the increased cost of running the government and the related inadequacy of resources derive from the heavy post civil war recon structuring efforts (Ariyo, 1993). Budget deficit and external borrowing were resorting to in financing of the resource gaps as the country became increasingly unstable to earn enough foreign exchange to sustain imports. The consequence of unsustainable levels of imports and soaring foreign indebtedness was a precariously weak external economic position. With deteriorating external reserve position, the persistent fiscal deficits and foreign exchange market depended almost entirely on continuously using external borrowing for its financing when continued to exert adverse pressure on the balance of payments conditions (Oluba, 2008).
Inflation is a rise in general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects in the erosion of the purchasing power of money- a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in general price index (normally the Consumer Price Index) overtime; inflation’s effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items overtime, uncertainty over future inflation may discourage investment and savings and hoarding by consumers out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal interest rates and encouraging investment in non-monetary capital projects.
Asogu (1991) was of the view that inflation is generally used to distribute a situation of rapid, persistent and unacceptable high rises in general price level in an economy, resulting in general loss of purchasing power of the currency. According to him, inflation causes serious discomfort for consumers, investors, producers and the government. In the study of some countries, Maynard and Van Ryckeghem(1975) as cited in Masha(2003), found that the long-run trend of rising price levels can be attributed to differences in the rates of growth and productivity in the industrial and service sectors. Other causes of rising prices are differences in the prices and elasticity between the two sectors, uniform growth, nominal wages in both sectors, and price and wage rigidities.
Causes of inflation can however be broadly categorized into the fiscal and balance of payment views. Proponent of the fiscal view has argued that continuous expansion of base money essentially arises from a fiscal disequilibrium. Attempts have been made to show that the economy will be characterized by two inflation equilibria if there is an exogenous real fiscal deficit, a change in cagen semi logarithmic money demand function and rational expectations. The high inflation equilibrium will be stable and low inflation equilibrium unstable (Montel; 1989) as cited in ( Afolalabi and Efunwoye, 1995).
The inflationary trend in Nigeria from 2000 to 2010 goes thus: 12.5%, 6.5%, 14.9%, 14.2%, 13.8%, 16.5%, 13.5%, 10.5%, 5.4%, 11.6%, 11.5% in Consumer Price Index respectively.(Source: CIA WORLD FACTBOOK). This result shows that inflation rate has been fluctuating, we can see that in year 2000, the inflation rate was two-digits while in year 2001, it was a single-digit, which later move to a two-digits rate of inflation until 2008 that fell to one digit inflation rate and so on.
Fiscal imbalance is the term used by government to describe a monetary imbalance between the national government and smaller, subordinate governments, such as those of states or local governments. Fiscal imbalances can be in two forms, they are:
(1)Vertical Fiscal Imbalance occurs when the revenues of different levels of government do not match their expenditure responsibilities. This will necessitate transfer payments from the over endowed party to the under endowed party(Vertical Fiscal Equalization).
(2)Horizontal Fiscal Imbalance occurs when different regions of a country have different abilities to provide services due to different abilities to raise funds. This can occur if regions are able to raise more funds through their tax bases than other regions and / or the cost of provision of services is higher in some regions than in others. This is usually rectified by weighting transfer payment toward the needier regions (Horizontal Fiscal Equalization).
With these forms of fiscal imbalances, Nigeria is said to be vertical. Due to the structure of the Nigerian government as well as the fact that almost all of its revenue comes from the oil industry 80% of a state’s income comes from centrally collected revenues. Thus, Nigerian states have little capacity to raise their own funds and extremely reliant on the federal government.
1.2 STATEMENT OF THE PROBLEM
The growth and persistence of fiscal deficits in both the industrialized and developing countries in recent times have brought the issue of fiscal deficits into sharp focus. The issues surrounding fiscal deficits are certainly not new, but the economic development of the past decade has rekindled the interest in fiscal policy issues. In the advanced countries, the growth of United State Federal deficit provided the impetus for a reassessment of the effect of fiscal deficits on economic activities (Islam and Watzel, 1991). In the less developed countries including Nigeria, Fiscal deficits have been blamed for much of the economic crisis that baset them in the 1980s; over indebtedness and debt crisis, high inflation and poor investment performance, and growth. Attempts to region stability at the macro-level through fiscal adjustment achieved uneven success, raising questions about the macroeconomic consequences of public deficits and fiscal deterioration or fiscal stabilization (Easterly and Schmidt-Hebbel, 1993).
Government expenditure in Nigeria has consistently exceeded revenue for most of the years beginning from 1980. The symptoms of such fiscal imbalances are of course, budget deficits. While budget deficits are nothing new in the country’s history, the recent size of the deficit has been a cause of concern to many people including academics, policy makers and investors. It is, however, pertinent to nobody that much of the debates over the deficits has been more related to the effects unacceptable large deficits rather than with the causes of the deficits. For example, higher interest rates, real exchange rate depreciation, increased public spending are frequently mentioned. Others point the direct relationship between fiscal deficit and inflation, with the causal link generally assumed to be deficit financing by means of credit creation through banking system. Even though convincing empirical evidences pointing to a significant relationship between deficit and other variables are few, there has been renewed interest on the issues that do not address the basic causes of deficit growth will not likely achieved desired results of deficit reduction on a sustainable basis.
1.3 OBJECTIVES OF THE STUDY
The research work broadly examines the relationship between fiscal imbalances/fiscal deficit and inflationary trend in Nigeria. However, the specific objectives of the study are therefore to examine:
(i) The effect of total recurrent expenditure on inflationary trend.
(ii) The effect of total capital expenditure on inflationary trend.
(iii) The effect of company income tax on inflationary trend.