Joanna Siwińska1

Fiscal imbalances and economic growth – an empirical study.

Preliminary, incomplete version.

Introduction.

Persistent fiscal imbalances are regarded by most economists as an undesirable outcome of (imprudent) policymaking. High government deficits and public debts may seriously destabilize the economy – inter alia, they are blamed for causing inflation, triggering currency crises, and decreasing national savings (see, for example Sargent and Wallace 1981; Krugman, 1979; Domenech, Taguas and Varela, 2000).

These concerns have led many countries to adopt fiscal policy rules2 designed to curb fiscal imbalances (for an overview of different kinds of fiscal rules, see for example, Kennedy and Robins, 2001). The EU has also recognized the possible harmful effects of public sector imbalances what has led to the implementation of the controversial fiscal rules of Maastricht Treaty and Stability and Growth Pact.

Although the possible consequences of fiscal imbalances are generally well described (although not uncontroversial, see, for example, Elmendorf and Mankiw, 1998), surprisingly, the influence of public deficit and debt on one crucial variable - economic growth - has not, as of yet, attracted much empirical work.

The main goal of this paper is to fill this gap. This paper adopts the Extreme Bound Analysis (EBA) developed by Levine and Renelt (1992) and Sala-i-Martin (1997) to empirically assess the impact of fiscal imbalances on the rate of economic growth.

The paper is structured as follows: the first part lists theoretical models that discuss the possible impact of fiscal imbalances on economic growth and reviews the existing empirical

1 Dr Joanna Siwińska, Warsaw University, Faculty of Economic Sciences, Chair of Public Sector Economics. 2 “A fiscal policy rule is defined (...) as a permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance. The rules under consideration cover summary fiscal indicators, such as the government budget deficit, debt (...) often expressed as a numerical ceiling or target, in proportion to GDP)” (Kopits, Symansky, 1998, p. 2).

1 evidence. The second part outlines the estimation method and present regression results and the third part concludes.

1. Short overview of existing theoretical and empirical work.

According to neoclassical growth models, the long-run steady-state growth rate of output per worker depends only on technological progress, which is however an exogenous variable, left unexplained by these models. Therefore, as it is well known, within neoclassical framework, fiscal imbalances may only influence the long-run level of output and the transition to steady- state, but not long-run economic growth rate. “Because of that, the conventional wisdom based on the neoclassical model has been that differences in tax systems and in debt (…) can be important determinants of the level of output but are unlikely to have an important effect on the rate of growth” (Easterly, Rebelo, 1993 p. 420)

The inability of neoclassical growth models to explain the long-run growth process has led economists to develop new models that deviate from neoclassical framework. These “endogenous growth” models allow for the determination of the growth rate of output within the model and provide a theoretical framework that enables the researcher to analyze the possible consequences of fiscal policy and fiscal imbalances (as well as other policy variables) for economic growth. An example of a framework that discusses the aftermath of fiscal imbalances is Turnovsky (2000). He assumes a production function similar to Romer (1986) “learning by doing” model, where an increase in private capital stock leads also to an increase of the stock of knowledge (knowledge is a public good). Such production function, together with additional assumptions concerning private returns to capital3, is enough to generate endogenous growth. Turnovsky (2000) shows that fiscal imbalances imply a change in the composition and the ratio of government expenditure and taxation and that these changes influence the private return from capital and hence the long run growth. In a framework of Ak production function, it is easy to show (see Barro, 1990) that taxation, which decreases private returns to capital will decrease economic growth, while government expenditures that increase private return to capital (productive government expenditures) might increase the rate of growth4. Consequently, Turnovsky (2000) shows that keeping government spending fixed, an increase in debt which allows to decrease taxation (of capital) will raise the rate of economic growth. Similarly, if government spending is productive, its

3 Private return to capital cannot be too small 4 Provided that the ratio of productive expenditure to GDP does not exceed a given threshold level, that depends on parameters of the production function.

2 increase financed by an increase in debt (as opposed to an increase in taxation) can be also growth-enhancing. However, if government spending is not productive, an increase in debt caused by increased public expenditure will not change the rate of economic growth. However, if the government is to remain solvent, policy leading to accumulation of debt, might have to be reversed.

Hence, Turnovsky (2000) shows that the accumulation of government debt might be growth neutral or growth enhancing, while a decrease in government debt might be growth neutral or growth-decreasing. However, following this line, it can also be easily shown that an increase in government debt might imply an increase in interest expenditures that might crowd out productive expenditures or cause an increase in taxation, which in turn will reduce the growth rate. It is worth stressing that according to Turnovsky, it’s not the fiscal imbalances per se that influence growth but the change in public expenditure and taxation that they imply.

Saint-Paul (1992) has a different approach. He assumes a simple AK production function and additionally assumes that economic agents have a constant probability of death. This implies that contrary to Barro (1978) government bonds increase net wealth (i.e. financial wealth) of households. This means that government debt increases households’ wealth thus stimulating private consumption, decreasing savings and growth. It is also worth noting that in his model, taxation doesn’t affect the rate of growth of output. Hence a bigger government debt is associated with reduced growth, not because of change in patter of public spending or taxation but because it changes household’s behavior and reduces savings.

Another model, due to Riera (2003) uses similar reasoning and stresses that fiscal imbalances can increase interest rates and discourage investment in physical and also in human capital and hence depress growth.

There is also another line of theoretical (as well as empirical research), which might be placed under the heading of “debt overhang hypothesis”. It doesn’t directly concentrate on the issues of economic growth, but rather on the influence of debt - public as well as private - on the ratio of investment. The proponents of this hypothesis argue that excessive debt will discourage investment. There are several explanations for that. Krugman (1998) argues that if a country is unable to meet its external debt service obligations then the remaining required payments might be conditioned on the country’s performance. This might discourage the “effort” made by this country to improve its situation, i.e. discourage domestic, as well as

3 foreign investment. As Krugman (1988 p.1) puts it: “the benefits of good performance go largely to creditors rather then (to the country) itself”

Agenor (1999) and Pattillo, Poirson and Ricci (2002) argue that a high debt burden increases uncertainty concerning for example future government policies (taxes, inflation, etc), increasing the uncertainty of future payoffs from investments. As Serven (1997) shows, this will discourage long-term, irreversible investments. Serven (1997) argues that in case of many investment projects, their costs are partly or completely a sunk cost - they cannot be recovered. This implies that if future return from investment is uncertain, investors will choose not to invest, as long as current profit from investment is smaller than the costs of possible irreversible loss. Hence high debt that increases uncertainty, will decrease investments, and consequently - growth.

The empirical research on public sector imbalances, investment and economic growth is limited and most researchers concentrate not on public debt, but rather on external debt. The latter is also relevant for the discussion of public debt, as in developing countries most of external borrowing has been made by the government sector.

Some empirical papers concentrate only on the impact of external debt on the ratio of investment. Deshpande (1995) and Greene and Villanueva (1991) estimate a regression for developing countries and find that external debt has a negative impact on investments. On the other hand, Cohen (1993) using data for developing countries in 1980’s doesn’t find a statistically significant relationship between external indebtedness and investment ratio and concludes that a large stock of debt cannot be an “unconditional predictor of a low investment rate in 1980’s” (Cohen, 1993 p. 441). However, his estimations indicate that investments are crowded out by the debt service expenditures.

Another line of research concentrates directly on economic growth. Patillo, Poirson, and Ricci (2002) estimate a panel regression for 93 developing countries over the period 1969-1998, which indicates that the impact of external debt on growth is non-linear – positive, when debt is low and negative, when debt ratio exceeds a certain critical value. They estimate that this critical value is around 160-170 percent of exports and 35-40 percent of income.

Clements, Bhattacharya and Nguyen (2003) estimate a panel regression for 55 poor economies over the period 1970-99 and also find a non-linear relationship between external

4 debt and growth: according to their calculations an external debt higher than 30-37% of GDP reduces the GDP growth rate. They also find that the debt service expenditures crowd out public investment.

Chowdhury (2001) studies the impact of foreign indebtedness on the rate of economic growth using two samples of developing countries. He uses the Levine and Renelt’s (1992) „extreme bound analysis” and proves that the impact of external debt on growth is negative and robust.

The paper by Smyth and Hsing (1995) examines explicitly the impact of public debt on the rate of growth. They estimate a regression using data on US economy and find that the impact of debt on growth it is non-linear – positive for smaller debt ratio and negative for larger values. They estimate the threshold value at 48,9% of GDP.

Another paper concentrating only on public debt is Lin and Sosin (2001). They examine the relationship between government external indebtedness and economic growth. Their cross- section regression analysis is based on different samples: industrial countries, African countries, Latin American countries, Asian and other countries and a wide sample incorporating all of the listed countries. The impact of debt on growth is negative, but insignificant in most regressions. It remains significant only in the African sub sample.

Eastrely and Rebelo (1993) also estimate a number of cross-country growth regressions and include, among other fiscal variables, a measure of government surplus and find that its relation to growth rate and investment rate is positive and robust.

2. Empirical analysis of the impact of fiscal imbalances on growth.

The existing work on the influence of total public debt on growth is limited and inconclusive. The empirical analysis of this paper is intended to fill this gap and to verify the impact of public sector imbalances on economic growth. However, empirical analysis of growth is not straightforward. As Levine and Renelt (1992) stress, over 50 variables have been found to be significantly correlated with rate of output growth. Of course, it is impossible to include all of the in a single regression, hence most researchers in attempt to find a relationship between growth and a given variable of interest consider only a small number of other explanatory variables. This puts into question the reliability of these studies. The solution to this problem proposed by Levine and Renelt (1992) is to use the so called “extreme bound analysis”

5 (EBA). This paper utilizes two versions of EBA: as developed by Levine and Renelt (1992) and by Sala-i-Martin (1997).

In short, Levine and Renelt (1992) propose to estimate regressions of the following form:

y = βi I + βmM + βzZ + u, where:

 y is the per capital growth rate,  I is a set of “basic” variables, always included in regressions  M is the variable of interest  Z is a subset of variables that have been identified by previous studies as being correlated with growth.

The Levine and Renelt methodology calls for estimations of a number of regressions, starting with the base regression, without the subset of Z variables. The following estimated regressions are more extended and contain combinations of up to three different Z variables. This procedure allows the researcher “to find the widest range of coefficient estimates for the variable of interest” (Levine and Renelt, 1992, p. 944). The last step is to calculate the extreme bounds of βm - the coefficient on the variable of interest - which is done by finding the highest and lowest value of βm and then adding two standard deviations to the highest value and subtracting two standard deviations from the lowest value. If the coefficient at the extreme bound remains significant and of the same value “then one can maintain a fair amount of confidence in that partial correlation” (Levine and Renelt, 1992, p. 944).

However, Sala-i-Martin (1997) criticizes this approach as too extreme and proposes a less stringent method. He proposes to move away from the binary “robust” “not robust” classification and instead to look at the whole distribution of coefficient estimates and to assign some “level of confidence” to the coefficient. Hence, Sala-i-Martin (1997) also starts with estimating a number of regressions, similar to Levine and Renelt (1992). Then he calculates the cumulative distribution function of coefficient βm.. If the probability that βm is either greater than or less then zero is 95% or higher, he considers the variable as robust.

6 Since Levine and Renelt’s (1992) and Sala-i-Martin’s (1997) work, both variants of EBA have been utilized by numerous researchers, but according to my knowledge, none of them had addressed the issue of fiscal imbalances.

Following Levine and Renelt (1992) and Sala-i-Martin (1997), the set of base “I” variables that appear in the base regression and all following regressions encompasses:

 Log of initial GDP per capita (GDP),  Log of investment share in GDP (inv) and  Log of population growth (pop).

The “M” variable of interest is log of government debt to GDP ratio (debt).

From the set of basic “I” variables, I omit the fourth variable included by Levine and Renelt – secondary school enrolment rate, as several authors question the influence of this variable on economic growth (see, for example Pritchett, 1996)5.

The set of “Z” variables includes log of: secondary school enrolment rate, tertiary school enrolment rate, consumption of general government as percentage of GDP, international trade as percentage of GDP, share of manufactures in exports and rate of inflation (measured by CPI).

I estimate the cross-section regressions for two sub samples - a broad sample encompassing developing and developed countries (a detailed list is included in the Appendix) and a sample of 25 EU countries. The regressions are estimated by OLS, with White Heteroskedasticity- Consistent Standard Errors & Covariance. For the broad sample, the data on GDP per capita growth and level were taken from Summers-Heston Penn World Tables; for the EU-25 sample, this data comes from Eurostat. The remaining variables are from World Bank World Development Indicators, except for public debt for the EU-25, which is also taken from Eurostat. In case of broad sample all the data, except initial GDP per capital, is averaged over 1990-2000. Initial GDP is an average over 1986-1988. For the EU-25 sample, series were

5 As De la Fuente and Domenech (2001) argue, the lack of robust relationship between data on human capital and economic growth may be due to poor quality of the easily accessible data on human capital. As shown by authors, using better quality data will generally give positive and robust relationship measures of human capital and growth.

7 available up to 2003, hence, the data, except for the level of initial GDP is averaged over 1996-20036. Initial GDP per capita is for 1994.

Following Levine and Renelt (1992), I estimate a number of regressions, with different linear combinations of up to three Z variables. Table 1 below gives the results for the basic regression with the “I” variables and ratio of debt to GDP. Table 2 includes the upper and lower bound for the public debt coefficient (βm), average value of this coefficient and its standard error computed for the values from all regressions, fraction of significant coefficients at the 5% and 10% level and the fraction of the density function of βm lying to the left of zero.

Table 1. Results of the base regression. Broad sample EU sample Variable Coefficient Coefficient Debt -0.626** -0.886*** (-2.13) (-4.72) GDP -0.716** -0.293 (-2.97) (-0.92) Inv 3.540*** 3.010*** (5.054) (3.01) pop -1.126*** -0.338 (-3.39) (-0.28) R-squared 0.447 0.412 Adjusted R-squared 0.4192 0.329 No of obs. 63 25 Source: Own calculations t-statistics are in parenthesis, * indicates significance at 10% level, ** indicates significance at 5% level, *** indicates significance at 1% level

All the coefficients have the expected sign, however in case of EU-25 sample, surprisingly, neither population growth nor initial level of GDP per capita are statistically significant. In both samples the coefficient on debt ratio is negative and highly significant.

Table 2 Extreme bounds and cumulative distribution function (CDF) of the coefficient on debt ratio. Upper Lower Average Standard Percentage Percentage CDF

6 I include a shorter time period than in the broad sample in order to exclude the first half f 1990’s which in case of New Member States was a period of turbulences associated with the initial transformation period.

8 bound bound value of error of significant significant

βm βm at 5% at 10% Broad -1,214*** 0,116 -0,424 0,228 27% 90% 0,968 sample (-2,13) (-1,45) EU-25 -2,447*** 0,056* -1,124 0,319 90% 100% 0,999

(-3,93) (-1,82) Source: Own calculations t-statistics are in parenthesis, * indicates significance at 10% level, ** indicates significance at 5% level, *** indicates significance at 1% level,

In case of both samples the value of βm changes sign at the extreme bounds, thus according to EBA of Levine and Renelt (1992) the ratio of public debt turns out to be a variable that is not robustly correlated to growth. However according to the less stringent Sala-i-Martin’s (1997) EBA, in both samples (and very strongly in the EU-25 sample) the public debt ratio is a robust variable, which impact on economic growth is negative.

3. Conclusions

The theoretical models that discuss the impact of fiscal imbalances on long-run economic growth do not yield uniform conclusions. While some models show that public debt will lower the rate of economic growth, some argue that this impact is ambivalent, depending largely on the implied change in level and composition of public expenditure and taxation.

Empirical research on the influence of budget deficits and public debt on economic growth is limited. Some authors report a negative correlation between indicators of fiscal imbalances and economic growth, but most of the existing research concentrates only on the impact of external debt (public and private). The goal of this paper was to fill this gap in empirical literature. I have used the extreme bound analysis of Levine and Renelt (1992) and Sala-i- Martin (1997) to assess the possible influence of public debt on growth.

While the coefficient on public debt doesn’t pass the very stringent EBA of Levine and Renelt (1992), it does pass the less rigorous EBA of Sala-i-Martin (1997). These results indicate that prolonged fiscal imbalances seem to be detrimental to the rate of economic growth.

9 References Agénor P., Montiel P., 1999, Development Macroeconomic,. Princeton University Press, Princeton, New Jersey. Barro R., 1974, “Are Government Bonds Net Wealth?” Journal of Political Economy vol. 82. Barro R., 1990, “Government Spending in a Simple Model of Endogenous Growth”. Journal of Political Economy vol. 98(5). Chowdhury A., 2001, Foreign Debt and Growth in Developing Countries, paper presented at WIDER Conference on Debt Relief (Helsinki: United Nations University) (August). Clements B., Bhattacharya R., Nguyen T. 2003, “External Debt, Public Investment, and Growth in Low-Income Countries”, IMF Working Paper, IMF WP 03/249, International Monetary Fund, Washington, Cohen D., 1993, “Low Investment and Large LDC Debt in the 1980s,” American Economic Review, Vol. 83 (3). de la Fuente A., Domenech R., 2001, “Schooling Data, Technological Diffusion, and the Neoclassical Model.” American Economic Review vol. 91 Deshpande A., 1995, “The Debt Overhang and the Disincentive to Invest.” Journal of Development Economics, vol. 52(1), Domenech R., Taugas, D., Varela, J., 2000, “The effects of budget deficit on national saving in OECD” Economic Letters, vol. 69, Eastrely W., Rebelo S., 1993, “Fiscal policy and economic growth” Journal of Monetary Economics, vol. 32 Elmendorf D., Mankiw G., 1998, “Government Debt.” NBER Working Paper 6470 National Bureau of Economic Research, Cambridge. Greene J. , Villanueva D., 1991, “Private Investment in Developing Countries.” IMF Staff Papers, vol. 38, International Monetary Fund, Washington, Kennedy S., Robbins J., 2001, “The Role of Fiscal Rules in Determining Fiscal Performance” Department of Finance Working Paper No. 2001/16, Ministere des Finances du Canada, Kopits G., Symansky S., 1998, “Fiscal Policy Rules.” IMF Occasional Paper 162, International Monetary Fund, Washington,

10 Krugman P., 1979, “A Model of Balance-of-Payment Crises.” Journal of Money, Credit and Banking, vol 11, Krugman, P., 1988, “Financing vs. forgiving a debt overhang: Some analytical issues,” NBER Working Paper No. 2486, National Bureau of Economic Research, Cambridge Levine R., Renelt D., 1992, “A Sensitivity Analysis of Cross-Country Growth Regressions” The American Economic Review, vol. 82 (4) Lin S., Sosin, K., 2001, “Foreign debt and economic growth” Economics of Transition, vol. 9(3) Pattillo, C., Poirson H., Ricci L, 2002, “External Debt and Growth,” IMF Working Paper 02/69, International Monetary Fund, Washington Pattillo, C., Poirson H., Ricci L, 2002, “External Debt and Growth,” IMF Working Paper 02/69, International Monetary Fund, Washington,. Pritchett L., 1996, “Where has all the education gone?” World Bank Policy Research Working Paper 1581, World Bank Riera i Prunera M., 2003, “Deficit, human capital and economic growth dynamics.” Documents de Treball de la Divisio de Ciencies Juridiques Economiques I Socials Saint-Paul G., 1992, “Fiscal Policy in an Endogenous Growth Model” The Quarterly Journal of Economics, vol. 107, Sala-i-Martin X., 1997, “I Just Ran Two Million Regressions” The American Economic Review, vol. 87 (2) Sargent T.,Wallace N., 1981, “Some Unpleasant Monetarist Arithmetic.” Federal Reserve Bank Minneapolis Quarterly Review vol. 5. Serven, L., 1997, “Uncertainty, Instability, and Irreversible Investment: Theory, Evidence and Lessons for Africa,” World Bank Policy Research Working Paper No. 1722, Washington: World Bank. Smyth D.,Hsing, Y., 1995, “In search of optimal debt ratio for economic growth” Contemporary Economic Policy, vol. 13. Turnovsky S., 2000, Methods of Macroeconomic Dynamics, The MIT Press, Cambridge Massachusetts, London, England.

Appendix. Sample of countries used in the analysis:

11 Algeria, Australia, Belgium, Belize, Botswana, Burundi, Cameroon, Canada, Chile, China, Colombia, Congo, Rep., Costa Rica, Cote d'Ivoire, Cyprus, Dominican Republic, Egypt, Arab Rep., Ethiopia, Fiji, Finland, Germany, Greece, Guatemala, Iceland, India, Indonesia, Israel, Jamaica, Japan, Jordan, Kenya, Korea, Rep., Lebanon, Madagascar, Malaysia, Malta, Mauritius, Mexico, Morocco, Nepal, Netherlands, Norway, Pakistan, Papua New Guinea, Paraguay, Peru, Philippines, Portugal, Rwanda, Senegal, Sierra Leone, Singapore, South Africa, Spain, Sri Lanka, St. Vincent and the Grenadines, Swaziland, Switzerland, Trinidad and Tobago, Tunisia, Turkey, Uganda, United Kingdom, Uruguay, Zambia, Zimbabwe

List of data and sources: GPD per capita growth rate Heston A., Summers R., Aten B., Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP), October 2002; EUROSTAT (for the EU -25 sample) GDp per capita: Heston A., Summers R., Aten B., Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP), October 2002 EUROSTAT (for the EU -25 sample) Central government debt, in % of GDP - World Bank, World Development Indicators (WDI), 2005 General government debt, in % of GDP EUROSTAT (available only for EU- 25 sample) General government final consumption World Bank, WDI, 2005 expenditure (% of GDP) Gross fixed capital formation (% of GDP) World Bank, WDI, 2005 School enrollment, secondary (% gross) World Bank, WDI, 2005 School enrollment, tertiary (% gross) World Bank, WDI, 2005 Population growth (annual %) World Bank, WDI, 2005 Inflation, consumer prices (annual %) World Bank, WDI, 2005 Manufactures exports (% of merchandise World Bank, WDI, 2005 exports) Trade (% of GDP) World Bank, WDI, 2005

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