Public debt and the limits of fiscal policy to increase economic growth

Abstract

Research that seeks to estimate the effects of fiscal policies on economic growth has ignored therole of public debt in this relationship. This study proposes a theoretical model of endogenous growth,which demonstrates that the level of the public debt-to-gross domestic product (GDP) ratio shouldnegatively impact the effect of fiscal policy on growth. This occurs because government indebtednessextracts part of the savings of the young to pay interest on the debts of the older generation, who are nolonger saving. Therefore, the payment of debt interest assumes an allocation exchange role betweengenerations that is similar to a pay-as-you-go pension system, which results in changes in the savingsrate of the economy. The major conclusions of the theoretical model were tested using an econometricmodel to provide evidence for the validity of this conclusion. Our empirical analysis controls for timeinvariant,country-specific heterogeneity in the growth rates. We also address endogeneity issues andallow for heterogeneity across countries in the model parameters and for cross-sectional dependence.