The Nexus Between Public Debt and Gross Capital Formation in Kenya

Abstract

Governments seek financial resources from domestic as well as external sources to supplement tax revenues in meeting the financial needs. Kenya has been increasingly borrowing to finance expenditures with an increased investment in public infrastructure. This study sought to investigate public debt and gross capital formation nexus in Kenya. It was done against the background of Classical view of public debt, as funds be used appropriated on production and investment rather than consumption by individuals, Keynesian view that high debt levels leads to an upsurge in taxes which leads to a decrease in investment, lowers consumption, reduces employment and reduces the growth rate of the economy and Ricardo economics that lean towards government spending funded from tax revenue rather than public borrowing. These conflicting views present a theoretical issue for investigation. The study relied on time series data for 1980 to 2019 obtained from CBK, KNBS and World Bank Database. VAR was used to estimate the system of equations that link public debt to gross capital formation empirically. Findings are that one year lag in domestic debt positively affects the current year’s gross capital formation. Two year and third year lag in domestic debt were found to have similar results that is a negative effect on the current year’s gross capital formation. Lastly, the four year lag also has a negative effect on current year’s gross capital formation. On the effect of the external debt, the results show that a one year lag in external debt has a positive effect on current year’s gross capital formation. Two year and third year lag in external debt were found to positively affect current year’s gross capital formation. However, the four year lag in domestic debt was found to have a negative effect. On the effect of the total public debt, the results indicate that all the four lag has a negative effect on the gross fixed capital formation. These findings shows that total debt comes with large burden on the country’s development especially in so far as capital formation is concerned. Accumulation of large debt stock comes with reduced fiscal space which culminates into fiscal consolidation on both the recurrent and capital expenditures. Therefore, the study concludes that public debt has a negative effect on the gross capital formation in Kenya. Recommendations are that policy makers should ensure that debt levels are at sustainable levels to avoid the adverse effects the unsustainable debt levels are likely to have on the economic macroeconomic fundamentals, capital formation being one of them. The study recommends further research on to be conducted a cross country analysis in Sub – Saharan Countries.