Abstract:
Fiscal Policy is defined as the deliberate manipulation of government income and
expenditure to achieve economic and social objectives and sustain growth . Fiscal
policy significantly influences economic growth in both developed and developing economies.
In developed economies, it aims to increase capital formation by reducing consumption and
increasing saving propensity. In developing economies, it focuses on creating an equitable
income distribution and transferring resources from unproductive to productive use. This
study aims to investigate the dynamic effects of fiscal policy and its shocks on economic
performance in Ethiopia using data over the period 1974–1975–2021/22 using the Johonson
co integration and vector error correction models. The Johanson co-integration test result
shows that there is a long-term relationship among the variables. The study found that
current expenditure is positive and statistically significant in both the long and short run. It
indicates that a 1% increase in current expenditure results in 1.42% (0.33%) increases in
economic growth in the long run (short run) on average. The result indicates that capital
expenditure has a negative and statistically significant effect on economic growth in the long
run. The result indicates that a one percent increase in capital expenditure decreases
economic growth by 0.69%, keeping another factor constant. The study explains that both in
the long run and short run, tax revenue has a positive sign but is not statistically significant
in effecting economic growth. This is due to the fact that tax revenue is restricted by factors
like informal economy size, tax evasion, tax structure, fiscal policy effectiveness, and external
influences. The impulse decomposition result shows that the impact of capital and current
expenditure is permanent. The result of the variance decomposition estimates indicates that a
greater proportion of the variation in economic growth tax revenue, current expenditure, and
capital expenditure is also due to their own innovations. Finally, the study recommends that
improved governance, tax reforms, and effective fiscal management and contribute to
economic growth. Fiscal policy is crucial for development and macroeconomic stability, and
in developing countries like Ethiopia, balancing infrastructure investment with social and
human development needs can stimulate economic growth, create employment, reduce
poverty, and improve population well-being.
