Economic Research and Perspectives

Economic Research and Perspectives

An Examination of Fiscal Crowding-Out in Iran’s Economy and Its Impact on Investment and Gross Domestic Product

Document Type : Original Research

Authors
Hossein Asgharpour 1
Saman Hatamrad 2
Mansour Heydari 3
Sadeq Rezaei 4
1 Professor, Department of Economics, Faculty of Economics and Management, University of Tabriz, Tabriz, Iran
2 Assistant Professor, Department of Economics, Faculty of Humanities, University of Zanjan, Zanjan, Iran.
3 PhD Candidate in Monetary Economics, Faculty of Economics and Management, University of Tabriz, Tabriz, Iran
4 Assistant Professor of Economics, Faculty of Entrepreneurship, University of Tehran, Tehran, Iran
10.48311/ecor.2026.28402
Abstract
Abstract
This study investigates the phenomenon of fiscal crowding-out in the Iranian economy over the period 1990–2022. Employing quarterly data and a time-varying parameter vector autoregression (TVP-VAR) model, the study analyzes the impact of government budget deficits on private sector access to banking resources and investment. The model incorporates four key variables: the budget deficit, the ratio of government debt to the banking system, the ratio of credit to the non-governmental sector, and the ratio of investment to gross domestic product (GDP). The findings reveal that, in most years, government budget deficits have reduced the volume of banking credit available to the private sector, ultimately leading to lower levels of investment. The intensity of fiscal crowding-out has varied over time, with periods of relative moderation. Furthermore, using the Mixed Data Sampling (MIDAS) approach, the study evaluates the effect of this phenomenon on annual economic growth and confirms its negative impact. Overall, the results underscore that fiscal sustainability and reduced reliance on banking resources are essential prerequisites for strengthening the role of the private sector and achieving sustainable economic growth in Iran
Purpose/Aims:
The interaction between government expenditure and private sector economic activity has long been a central topic in macroeconomic debate, characterized by two contrasting perspectives. One view contends that fiscal expansion stimulates aggregate demand, thereby enhancing output growth and encouraging private investment. In contrast, an opposing perspective argues that excessive government spending absorbs scarce resources—particularly financial resources—thereby restricting private sector access to credit and ultimately suppressing private investment through a mechanism known as financial crowding out. This theoretical controversy originates in classical economics and has evolved through Keynesian and neoclassical frameworks. Contemporary analyses increasingly emphasize more sophisticated transmission channels, including the bank balance sheet channel. During periods of contractionary monetary policy, banks typically reduce lending volumes and favor larger firms, which exacerbates credit constraints for smaller enterprises.
In Iran, the government’s superior creditworthiness incentivizes banks to allocate resources preferentially to the public sector, consequently limiting financing available to private firms. Additionally, rising government expenditures and persistent budget deficits intensify concerns regarding fiscal sustainability, further undermining investor confidence. Given the critical role of private investment in driving economic growth in Iran—particularly in the context of international sanctions and severe financial constraints—identifying the determinants of private sector investment and evaluating the effects of government expenditure on it are essential. Historical evidence suggests that periods characterized by lower budget deficits and reduced government borrowing from the banking system coincide with larger shares of credit allocated to the private sector. Accordingly, the primary research question guiding this study is whether government spending in Iran predominantly acts as a demand-side stimulus that supports private sector development or whether it primarily crowds out private investment by preempting financial resources. Addressing this question constitutes the core objective of the present investigation.
Methodology & Framework:
Iran’s distinctive political and economic circumstances have imposed several structural distortions on the national economy. Failure to account for these distortions may lead to misleading inferences regarding key economic relationships. Given the presence of structural breaks, regime shifts, and cyclical fluctuations in time-series data, it is therefore appropriate to employ an econometric framework capable of accommodating such features. The time-varying parameter (TVP) approach addresses these challenges by allowing coefficient estimates to evolve over time, thereby capturing period-specific economic conditions. The resulting time-varying coefficients not only indicate the direction (positive or negative) of the effects of explanatory variables on the dependent variable but also reveal the magnitude of these effects in each period.
Findings:
The empirical results indicate that, in most years, budget deficits have contributed to a contraction in banking facilities extended to the private sector, which has ultimately resulted in reduced private investment. The intensity of this financial crowding-out effect has varied over time, diminishing during certain periods. Subsequently, employing the MIDAS approach, the study assesses the implications of this crowding-out phenomenon for annual economic growth and confirms its adverse impact. The findings demonstrate that greater financial crowding-out is associated with weaker GDP growth.
Discussion:
The government’s heavy reliance on banking resources to finance budget deficits has led to a contraction in credit facilities available to the private sector, a subsequent decline in productive investment, and subdued economic growth. These results provide strong evidence of a pronounced financial crowding-out effect in the Iranian economy.
Conclusion & Implications:
To mitigate these adverse outcomes, comprehensive reforms to the government’s fiscal structure are imperative. Such reforms should include the liberalization of prices for goods and services, the elimination of implicit subsidies, an overhaul of the tax system, and strict control over recurrent expenditures. In addition, the accumulation of government debt in the banking system has immobilized credit resources, disrupted bank balance sheets, and increased financial vulnerabilities. It is therefore recommended that policymakers devise a transparent roadmap to halt further debt accumulation and gradually repay existing obligations through mechanisms such as debt offsets, the divestiture of surplus public assets, and the prudent issuance of bonds. Ultimately, the adoption of disciplined fiscal policies, combined with targeted allocation of resources toward developmental projects, would lay the foundation for enhanced private investment and sustainable economic growth. Complementing these measures, strengthening the capacity of the banking sector to support productive activities and improving the overall business environment would further reinforce these policy objectives.
Keywords
Budget Deficit
Economic Growth
Financial Crowding Out
Investment
Private Sector Credit
Subjects
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