The effectiveness of fiscal policy contributions from institutions and external debts

In addition, this paper finds interesting evidences that the external debt has linear effects on economic growth, whereas the heterogeneous effects of fiscal policy on economic growth as

University of Economics Ho Chi Minh City Journal of Economic Development

THE EFFECTIVENESS OF FISCAL POLICY: CONTRIBUTIONS FROM INSTITUTIONS

AND EXTERNAL DEBTS

CS- 2017- 01TĐ-03

Contents

CHAPTER 1: INTRODUCTION 3

1.1 Abstract 3

1.2 Motivations 3

1.3 Methodology 5

CHAPTER 2: LITERATURE REVIEWS 7

2.1 The effectiveness of fiscal policy 7

2.1.1 The theoretical framework of fiscal policy’s effectiveness 7

2.1.2 The empirical works 9

2.2 The institutions and the effectiveness of fiscal policy 13

2.3 The external debt burden and the effectiveness of fiscal policy 17

CHAPTER 3: METHODOLOGY AND DATA 21

3.1 Methodology 21

3.2 Data 25

CHAPTER 4: RESULTS AND DISCUSSIONS 29

4.1 The institutions and the effectiveness of fiscal policy 29

4.2 The external debt and the effectiveness of fiscal policy 32

4.3 Robustness check 34

CHAPTER 5: CONCOLUSIONS 39

Acknowledgement 41

References 42

CHAPTER 1: INTRODUCTION

1.1 Abstract

The effectiveness of fiscal policy is an interesting field in literature of macroeconomics In this paper, we use panel data from 2002 to 2014 from 20 emerging markets to investigate the effects of fiscal policy on economic growth under contributions from the differences in institutions and external debt levels By using GMM estimators for unbalanced panel data, our results show positive effects of fiscal policy on economic growth across emerging markets in the examined periods Notably, the improvement in institutions promotes higher crowding-in effects

of fiscal policy In addition, this paper finds interesting evidences that the external debt has linear effects on economic growth, whereas the heterogeneous effects of fiscal policy on economic growth as positive effects in low indebted level and negative effect in high indebted level may explain the mechanism of this non-linear relationship The results have significant contributions to the literature and useful implications for authorizers in promoting sustainability

non-of the economy The authorizers are strongly recommended to focus on improving the institutional quality that not only boosts the effectiveness of fiscal policy in general, but also solves the dilemma of high indebted countries when the fiscal policy loses the effectiveness

1.2 Motivations

Fiscal policy is conducted by government through taxation and public spending with the aims

at sustainable development for the economy So, fiscal policy and its impacts on the economic growth tend to be at the center of macroeconomic and political debates The field of the effectiveness of fiscal policy has re-highlighted in light of the 2008 global financial crisis with the new contemporary drivers such as external debt (Ruščáková & Semančíková, 2016) Since the complexity of the process by which fiscal policy is conducted is not fully captured, that why different theories provide different answers regarding macroeconomic effects of fiscal policy and arguments about the suitability and real effects of government expenditures on economic growth are still interesting field of study (Bouakez, Chihi, & Normandin, 2014) Whereas, the main question in the literature of the fiscal policy’s effectiveness is that whether fiscal policy presents crowding-out and/or crowding-in effects in a country and what its drivers In fact, many

researchers try to find evidences with the parallel existence of both and mixed conclusions (see Ahmed and Miller (2000), Heutel (2014), Şen and Kaya (2014))

The studies of the effectiveness of fiscal policy have developed and conducted in long history through many economic growth models Many studies use versions of the Solow (1956) model

to study the dynamic effects of taxation on economic growth, while other studies use classical growth model (Easterly & Rebelo, 1993) In this regard, researchers argue that the effects of government expenditures on economic growth follow two different regimes including crowding-out effects and crowding-in effects The neo-classical theory states that government expenditure crowds out private investment then has negative impacts on economic growth While, Keynesian view, in contrast, states that government expenditure stimulates private investment in the case of un-fully employment, which then has positive impacts on economic growth, especially in developing countries (Ahmed & Miller, 2000)

neo-Moreover, the effects of fiscal policy on economic growth is driven by many factors such as the employment in the economy, the transparency of government, the composition of government expenditures, or even the government size (see Akanbi (2013), Arestis (2011), Kasselaki and Tagkalakis (2016), Hemming, Kell, and Mahfouz (2002)) In empirical literature about the determinants of fiscal policy’s effectiveness, there are, in fact, some studies that consider the role of institutional framework such as corruption situation, economic freedom, democracy (see Baldacci, Hillman, and Kojo (2004), Martinez-Vazquez, Boex, and Arze del Granado (2007), Nelson and Singh (1998))

Meanwhile, the burdens of external debt on the sustainability of fiscal policy are also concerned For instance, Amato and Tronzano (2000) document that a restrictive fiscal stance, a lengthening of average debt maturity and an increase in the share of foreign-denominated debt are crucial to stabilize the exchange rate in Italia Bal and Rath (2014) find that central government debt, total factor productivity (TFP) growth, and debt-services are affecting the economic growth of India in the short-run and they recommend that Indian government should follow the objective of inter-generational equity in fiscal management over the long term in order

to stabilize debt-GDP ratio Which means that the external debt may influence the effectiveness

of fiscal policy Recent study, Doğan and Bilgili (2014) examine the relationship between external indebtedness and growth variables in Turkey They find that external borrowing has negative impact on growth both in regime at zero and regime at one, but the public debt has

higher negative effects on economic growth and development Precisely, they conclude that that the economic development and borrowing variables do not follow a linear path

1.3 Research questions

In fact, there are very early studies about the effects fiscal policy such as Smith (1937), Bailey (1971), Buiter (1977), and Arestis (1979), and many recent studies try to investigate the impacts of both government expenditures on private investment and especially economic growth However, the debate with regard to the effectiveness of fiscal policy is still ongoing (Bouakez et al., 2014; Heutel, 2014; Kameda, 2014a; Şen & Kaya, 2014) Precisely, the literature of fiscal policy is lacking of the studies about the effectiveness of fiscal policy under the contributions from the institutions and external debts in a comprehensive work Therefore, this study is conducted under the motivations from the study of Doğan and Bilgili (2014) by investigating the effectiveness of fiscal policy on economic growth under the relationships with the changes in the institutions and the burdens of external debt in the context of 20 emerging markets including Argentina, Bangladesh, Brazil, Bulgaria, China, Colombia, Egypt, India, Indonesia, Malaysia, Mexico, Pakistan, Peru, Philippines, Romania, Russia, South Africa, Thailand, Turkey, and Vietnam

In which, this study goes to answer two main questions:

Question 1: do the institutions enhance the effectiveness of fiscal policy in emerging market

respectively, to test the impacts of institutions on economic growth Next, we use the interaction terms between government expenditure and institutions to examine the effectiveness of fiscal policy under the associations of institutional framework We then estimate the growth model with the explanatory variables including both external debt level to GNI and its square to examine the non-linear relationship between external debt and economic growth After that, we divide our data into two sub-samples (the low indebted countries and high indebted countries) to investigate the effectiveness of fiscal policy under two regimes At last, we use GDP per capita growth rate in replacing GDP growth rate to check robustness of results

By doing this strategy, we believe that this study has significant contributions to both theory and practice Firstly, this study has contribution to the literature of fiscal policy effectiveness and fiscal indebtedness by adding the effects of government expenditures under the external debt level and the associations with institutional quality The results find significant evidences that the institutions enhance the effectiveness of fiscal policy Notable, the external debt level presents the non-linear relationship with economic growth through the mechanism that the fiscal policy has the heterogeneous effects on economic growth: the crowding-in effect in low indebted level and crowding-out effects in high indebted one Secondly, this study has significant implications for the authorizers in implementing the long-term sustainable fiscal policy in line with borrowing policy and the solutions for the high indebted countries that face to the dilemma of ineffective fiscal policy

This study is structured as following Chapter 1 focuses on our motivations of this study Chapter 2 presents literature reviews and then our arguments on the effectiveness of fiscal policy under the contributions from institutions and external debt Methodology and data are provided

in Chapter 3 Chapter 4 presents the results and our discussions The concluding remarks are discussed in Chapter 5

CHAPTER 2: LITERATURE REVIEWS 2.1 The effectiveness of fiscal policy

2.1.1 The theoretical framework of fiscal policy’s effectiveness

In the literature of fiscal policy effectiveness, it is natural place to start with the Keynesian theory In Keynesian model, the sticky price and excess capacity are assumed that contraries to the classical economics, so that aggregate demand determines output and government expenditures have a multiplier effect on aggregate demand and output (Coddington, 1976) Therefore, Keynesian economics call for the government intervention and incorporate government expenditure into the aggregate demand function The Keynesian views argue that there is very rare case for an fully employed economy, thus the sensitivity of investment to interest rates would be low and then an increase in interest rates due to expansionary fiscal policy would be minimal, the government expenditure, in turn, has positive impacts on economic growth (O’Hara, 2011; Şen & Kaya, 2014) This view is also called as the crowding-in effects of fiscal policy, where the government should undertake the expenditure in the recession time to cover the lack of private consumption and investment (Jahan, Mahmud, & Papageorgiou, 2014) However, some of extensions in the line of Keynesian model allow for crowding-out effects

of fiscal policy, which means the expansion of government expenditure crowds out the private demand and then influences negatively on output, through the changes in interest rates and exchange rate in the case of open economy With the assumption that the private investment is negative impacted by the increase in interest rate, the expansionary fiscal policy that backed by borrowing leads to the lower private investment due to higher interest rates Moreover, the higher interest rates due to the expansionary fiscal policy attract capital flows in the case of open economy that appreciate exchange rate and then results the deterioration in current account (see Mundell (1963), Fleming (1962))

The neo-classical economics address the shortcomings of Keynesian economics on its lack of microeconomic foundations The neo-classical views focus on the determination of goods, outputs, and income distributions in markets through both supply and demand sides by adding the assumption of utility maximization of income-constrained individuals and firms under the boundary of factors in production and available information (see Gaffney (1994), Goodland and Ledec (1987), Davis (2006)) In which, the neo-classical economics raise the rational

expectations in comparing to the adaptive expectations in Keynesian economics This brings forward adjustments in economic factors that occur more progressively so that fiscal policy matters in not only long-term but also short-term period And the permanent fiscal changes can lead to the crowding-out effects since private sectors expect the persistent changes in interest rates and exchange rates in this case (see Buiter (1977), Arestis (1979), Mundell (1963), Fleming (1962))

In addition to neo-classical economics, the Ricardian view that is based on Ricardian equivalence theorem assumes that the individuals are forward-looking in the current activities, which is also in contrasting with the Keynesian economics view as individuals rely on current income (see Barro (1988), McCallum (1984)) In Ricardian view, individuals anticipate a present tax cut as higher government borrowing that turns into the higher taxes in the future so that there

is no change in permanent income This condition in along with the assumptions of no liquidity constraints and perfect financial markets lead to no change in private consumption in general (Barro, 1974) Thus, Ricardian view suggests neither crowding-in nor crowding-out effects of fiscal policy (Arestis, 2011; Şen & Kaya, 2014) However, if governments change lump-sum taxes for the fiscal policy, the features of progressive taxes will have impacts on permanent income and then the aggregate demand and output As a result, the effectiveness of fiscal policy most likely depends on how it is paid in the future and the productivity of government expenditures (Hemming et al., 2002)

As a brief summary, the government expenditure, as according to the Keynesian views, is needed to cover the lack of consumption in private sectors, which means the fiscal policy presents a positive effect on economic growth However, the Keynesian view is lacked of considering other factors such as institutional environment or debt burden on the effectiveness of fiscal policy The neo-classical economics views further explains the effectiveness of fiscal policy in the some manner relationship with the public debt In neo-classical views, today’s individuals think that the existing budget deficits due to the expansionary fiscal policy to increase the consumption level have to pay back through taxes for future generations While, government expenditure is less productive than private investment thus the increased output as a result of the debt financed government expenditure does not fully offset the negative effect due

to the crowding-out to private investment on output Therefore, the fiscal policy presents crowding-out effects at the end Meanwhile, the Ricardian view suggests that fiscal policy

presents neither crowding-in nor crowding-out effects since private investment and government spending are considered to behave independently from each other Where, the increase in government spending is anticipated to be accompanied by a rise in taxes in the future, thus government expenditure financed by debts is expected to be repaid by revenue generated through taxes levied in the future As the result, interest rates and private investment remain unchanged All above economic views require assumptions to be presence such as no liquidity constraints, perfect financial markets in Ricardian equivalence However, these assumption are usually un-existed thus the significance of theories is questioned in both theory and practice (Haque & Montiel, 1989) Furthermore, there are some cases that the effectiveness of fiscal policy is explained by all of these views For instance, if government is restricted by the fiscal rules to balance the fiscal budget in the long run, thus individuals may partial adjust their behaviors if they have short-term horizon which presents the presence of both Ricardian and neo-classical views In the same idea, if the current path of government debt is not sustainable and future tax increases will be required to lower the debt, the Ricardian view may be presence in expansionary fiscal policy seemingly with the Keynesian view which depends on the level of public debt (Sutherland, 1997) Or, if the government expenditure is in line of an upward-trending stochastic process that individuals believe a sharply fall when it approaches a specific

“target point”, there will be a non-linear relationship between private consumption and government expenditure (Bertola & Drazen, 1991) Therefore, the argument of a non-linear relationship between fiscal policy and economic growth makes sense in literature However, the literature needs the explanations for the mechanism and empirical evidences

2.1.2 The empirical works

In fact, many previous studies have investigated the effects of fiscal policy in many countries, especially in advanced countries such as US, Japan, European area1 In which, empirical works usually focus on the relationships between fiscal policy, interest rates, private investment, exchange rates, and the existence of Ricardian equivalence with three main streams including the estimation of fiscal multiplier from macroeconomic model simulations, the lesson studies of fiscal policy, and the determinants of fiscal multipliers (Hemming et al., 2002) Hemming et al (2002) summary that the fiscal policy presents mostly with positive multipliers,

it means that government expenditure has positive impacts on economic growth in the short run

1 See Hemming et al (2002) for the more detail summary

In addition, they find few evidences of negative short-term multipliers They also document that the spending changes have higher fiscal multipliers than the tax changes However, the long-term fiscal multipliers, in contrasting to the short-term, are generally smaller and reflect the crowding-out effects of government expenditures

Recently, Afonso and Strauch (2007) find that the European fiscal policy in 2002 makes market swap spreads response in mostly around five basis points or less Similarly, the study of Kameda (2014a) finds that a percentage point increase in both the projected/current deficit-to-GDP ratio and projected/current primary-deficit-to-GDP ratios raises real 10-year interest rates

by 26–34 basis points that implies a crowding out effect of Japanese fiscal policy Kameda (2014b) also studies the determinants of the effectiveness of fiscal policy and documents that the diffusion index of the attitudes of financial institutions have a definite impact on fiscal expansion effects In particular, the demand-enhancing effects of government expenditure should be non-Keynesian effects if the existence of liquidity-constrained households when banks’ attitude toward lending is tight and the financial condition of the government is bad Bhattarai and Trzeciakiewicz (2017) use a DSGE analysis to examine the fiscal policy in UK They note the highest GDP multipliers for government consumption and investment in the short-run, whereas capital income tax and public investment have long-run crowding-out effect on GDP Moreover, they emphasize that the effectiveness of fiscal policy decreases in a small open-economy scenario

Table 1 Some additional evidences of fiscal policy’s effectiveness

Nguyen and Turnovsky (1983) Australia,

UK, US

Crowding-out effects

D Cohen and Clark (1985) US Crowding-out and crowding-in effects

Kormendi and Meguire (1985) 47

countries

No relationship between government spending and economic growth

Engen and Skinner (1992) 107

countries

Crowding-out effects in the balanced –budget increase the government expenditure

Easterly and Rebelo (1993) 100

countries

Public investment in transport and communication is consistently correlated with growth

van de Klundert (1993) Europe,

US

Crowding-out effects on exports

Devarajan, Swaroop, and Zou

(1996)

43 developing countries

Crowding-in effects of public current expenditures

Kneller, Bleaney, and Gemmell

(1999)

22 OECD countries

Crowding-in effects for productive expenditures, crowding-out effects for distortionary taxations

Ahmed and Miller (2000) 39

countries

Public investment in transport has crowding-in effects, tax-financed expenditure has crowding-out effects

Leleux and Surlemont (2003) 15

European countries

Public investment crowding-ins the private venture-capital

activities

government grants crowd in private donations

Şen and Kaya (2014) Turkey Government current transfer spending,

government current spending, and government interest spending crowdout private investment, whereas government capital spending crowds-in private investment

Kasselaki and Tagkalakis

(2016)

Greece A government spending-based fiscal

consolidation improves financial markets and boosts economic sentiment

da Silva and Vieira (2017) 113

countries

Fiscal policy behaves in a procyclical way only

in the pre-crisis period and there is no significant relationship between output gap and government spending for the post-crisis period

Besides the presence of plentiful empirical literature in the effectiveness of fiscal policy, this field of study is got much less evidence on the short-term effects in developing countries due to data deficiencies, the structural/institutional factors in the last century (see Hemming et al (2002)) For instance, Haque and Montiel (1989) find that the Ricardian equivalence is not supported in the developing countries due to liquidity constraints Montiel and Haque (1991) go further by using the Mundell-Fleming model with rational expectations and full employment for

31 developing countries and conclude that the increasing of government expenditures have contractionary short-term and medium-term effects Previous, M S Khan and Knight (1981) find positive nominal income elasticities of government expenditures and taxes and they are close to unity in 29 developing countries Then, other empirical studies such as Agenor and Montiel (1996), Easterly, Rodriguez, and Schmidt-Hebbel (1994), Rama (1993) document evidences that fiscal policy has crowding-out effects on private investment through the impacts

on interest rates in developing countries Meanwhile, empirical studies also provide evidences supporting for partial or/and fully existences of the Ricardian equivalence in developing countries such as Agenor and Montiel (1996), Corbo and Schmidt-Hebbel (1991), Masson, Bayoumi, and Samiei (1995), Giavazzi, Jappelli, and Pagano (2000)

However, the economic development in emerging market economies, which is a new definition of the development level of economies and nearly relating to the developing countries definition, boosts their roles in the world economy In addition, the better fulfill of data have re-highlighted the interesting in investigating the effectiveness of fiscal policy by adding more methods and conditions into model for this group For example, Cuadra, Sanchez, and Sapriza (2010) note that emerging market economies typically exhibit a pro-cyclical fiscal policy, where governments increase (decrease) expenditures in economic expansions (recessions) and rise (reduce) tax rates in bad (good) times This situation is in line with the characteristic of counter-cyclical default risk in their business cycle They also document the importance of incomplete markets and sovereign default risk premium in explaining the pro-cyclicality of public expenditures and tax rates in these economies Therefore, the assumptions of Ricardian view are not existed that propose for the Keynesian or neo-classical views of fiscal policy

For instance, Papageorgiou (2012) emphasizes that government should decrease the tax rate

on labour income and increase the consumption tax rate to stimulate the economy and increase

welfare, while higher public investment spending is good for the economy In the same direction

of study in Greece, Kasselaki and Tagkalakis (2016) find that the tax based fiscal consolidation has more pronounced and more protracted negative effects on output, while the government spending-based fiscal consolidation improves financial markets and boosts economic sentiment While, Akanbi (2013) tests the effectiveness of fiscal policy with existing structural supply constraints versus demand-side constraints in South Africa for the period 1970 – 2011 The results suggest that fiscal policy is more effective in conditions of limited or no supply constraints In addition, expansionary or consolidating fiscal policies through government spending changes will be more effective in condition of no structural supply constraints, while tax changes will be more effective in contrasting cases Jha, Mallick, Park, and Quising (2014)

go further to examine fiscal policies in 10 emerging Asian countries and find that tax cuts have a greater countercyclical impact on output than government spending

No surprising that the debate on the role and the effectiveness of fiscal policy are continuous argued broadly in both literature and practice Recently, Arestis (2011) notices that the “New Consensus in Macroeconomics”, recent developments in macroeconomics and macroeconomic policy, downgrades the role of fiscal policy in contrasting with monetary policy due to its ineffective Through a careful literature review and discussion at recent developments on the fiscal policy front, he then concludes that fiscal policy does still have a significant role to play as

an instrument of economic policy through its impact on allocation, distribution and stabilization However, researchers and authorizers have to careful consider the assumption in economic theories of fiscal policy’s effectiveness as the existence of Ricardian and non-Ricardian economic agents, liquidity-constrained households, and the endogenization of labour supply and capital accumulation Whereas, other features of the economy should be considered in study the effectiveness of fiscal policy such as the institutional framework and the debt burden

2.2 The institutions and the effectiveness of fiscal policy

In fact, the dependence of fiscal policy’s effectiveness on institutional aspects is discussed under the literature with two main strands including the inside and outside lags of effects and the

political economy considerations (Hemming et al., 2002) First, the fiscal policy has inside and

outside lags, where the inside lags present the needed time to see that fiscal policy should changes, the outside lags are the function of the political process and the effectiveness of fiscal

management that is the time for fiscal measures take effects on aggregate demand (Blinder & Solow, 1974) Due to the long time to design, approval, and implementation, the inside lag may

be longer, while the outside lag is more variable depending on the institutional environment

Second, the fiscal policy is impacted by the political considerations such as the fiscal illusion of

public and policy-makers, the favor of transferring current fiscal burden to future generations, the limitation of government due to the debt accumulation, the delay of fiscal consolidations due

to the political conflicts, and the function of current budget institutions that leads to high spending

The institution is defined as the social rules of the game (Douglass C North, 1990), which includes “humanly devised”, “the rules of the game” to set “constraints” on human behavior, and the economic incentives (see Douglass Cecil North (1981), Acemoglu and Robinson (2008)) The better institutions reduce asymmetric information problem, transaction cost, and risk, while they improve the market efficiency, especially efficiency of asset allocation (K J Cohen, Hawawini, Maier, Schwartz, & Whitcomb, 1983; T S Ho & Michaely, 1988; M Khan, 2007; Williamson, 1981) Therefore, the better institutions should have positive associations with the effectiveness of fiscal policy since the lower asymmetric information problem, transaction cost, and higher market efficiency reduce both the inside and outside lags that then increase the efficiency of fiscal policy, especially the short-term effects Moreover, the problems of inside and outside lags are more important in emerging market economies, thus the improvement in institutional framework is expected with higher enhancing impacts on the effectiveness of fiscal policy In addition, the better institutions also reduce the fiscal illusions, the political conflicts, while it pushes more responsibility of governments in building and implementing fiscal policy, the fiscal policy, in turn, should be more effective

Table 2.Studies relating to the institutions and its impacts to fiscal activities

Kaufmann, Kraay,

and Zoido-Lobatón

(1999)

150 countries

a strong causal relationship from better governance to better development outcomes

Kaufmann and 175 The improvement in public governance shapes public

Kraay (2002) countries policy

Neumayer (2002b) 136

developing countries

Governments are accountable, respect democratic rights

as well as refrain from imposing burdens on business have a statistically significant influence on country’s debt forgiveness

Baldacci et al

(2004)

39 income countries

low-Factor productivity is some four times more effective than investment as a channel for increasing growth through fiscal policy in low-income countries High-deficit low-income countries can nonetheless benefit by reducing unsustainable fiscal deficits because of governance-related factor productivity responses that increase growth

Cubbin and Stern

(2004)

28 developing countries

A regulatory law and higher quality governance is positively and significantly associated with higher per capita generation capacity levels and higher generation capacity utilisation rates, and this positive regulatory impact appears to increase with experience at least for three years or more

Azmat and Coghill

(2005)

Bangladesh the need for integrated governance linking government,

business and civil society as paramount for promoting good governance for the success and sustainability of the reforms

Capuno (2005) Philippines The uneven quality of local governance thus may have

contributed to imbalanced regional growth in the fiscal decentralization process

The rule of law; control of corruption; regulatory quality; government effectiveness and political stability are positively correlated with FDI

Rajkumar and

Swaroop (2008)

91 countries

Public spending on primary education becomes more effective in countries with good governance

of corruption is not usually an economic objective for the development, but the frustration with the lack of effectiveness of traditional economic theories and the recognition of the important roles of institutions and good governance practices have led the more attention to the corruption Precisely, Dimakou (2015) finds that corruption constrains the fiscal capacity to tax and increases the reliance on inflation

However, no comprehensive study has considered the fiscal policy’s effectiveness under the institutional framework More interesting, it lacks of empirical study in emerging market economies, which have more space in improving institutional quality and the economic growth For example, the study of Aidt, Dutta, and Sena (2008) document that corruption has a substantial negative impact on economic growth in high institutional quality economies, otherwise it has no impact on economic growth in low quality one P.-H Ho, Lin, and Tsai (2016) find that the improvement in country governance just enhances the effectiveness of banks and then promote the economic growth in developing countries, while it reduces these effects in

developed countries due to smaller spaces for improvement In addition, Wang, Cheng, Wang, and Li (2014) argue that the improvements in institutional quality just have strong effects on promoting economic development only when institutional quality is within a certain range Therefore, we can argued that the improvement in institutions has strong impacts on the effectiveness of fiscal policy in emerging market economies

2.3.The external debt and the effectiveness of fiscal policy

The debt burdens, on the other hand, are also concerned in the literature of fiscal policy effectiveness

Table 3 Studies relating to the external debts and fiscal policy

Sutherland

(1997)

Theoretical arguments

At moderate levels of debt fiscal policy has the traditional Keynesian effects

Amato and

Tronzano (2000)

Italia All fiscal and debt management indicators display

significant effects on exchange rate’s devaluation expectations

Alt and Lassen

(2006)

OECD countries

A higher degree of fiscal transparency is associated with lower public debt and deficits

Ardagna, Caselli,

and Lane (2007)

16 OECD countries

The effect of debt on interest rates is non-linear: only for countries with above-average levels of debt does an increase in debt affect the interest rate

Lima,

Gaglianone, and

Sampaio (2008)

Brazil The fiscal austerity led to very low rates of growth for the

Brazilian economy, with negative impact on employment

Jayaraman and

Lau (2009)

6 major Pacific island countries

External borrowing contributes to growth in PICs in the short run, growth enhances the image of a PIC as an efficient user of borrowed funds, enabling it to borrow from abroad on better terms; consequently, higher growth

results in further rise in external debt level

Drine and Nabi

(2010)

27 developing countries

An increase of the public external debt share increases the production efficiency through a positive externality effect However, it generates an opposite effect via the reduction

of the formal sector’s size in favour of a less efficient informal sector The resultant effect becomes negative beyond an optimal level

Claeys, Moreno,

and Suriñach

(2012)

OECD countries

The crowding out effect of public debt on domestic long term interest rates is small Emerging markets are not as well integrated into international capital markets, causing a stronger crowding out effect

Bal and Rath

(2014)

India Central government debt, total factor productivity (TFP)

growth, and debt-services are affecting the economic growth in the short-run

Ramzan and

Ahmad (2014)

Pakistan External debt has a negative impact on growth, but this

adverse effect can be reduced or even reversed in the presence of sound macroeconomic policy

debt as a share of GDP has a negative influence in the short-run as well as in the long-run growth

Galstyan and

Velic (2017)

10 emerging market

economies

The nominal exchange rate and inflation differentials are more important determinants in states of high debt than in states of low debt

According to the review of Hemming et al (2002), the debt accumulation may be used as a strategic instrument to limit the fiscal room for the maneuver of future government, while the availability and cost of domestic and external financing is often a major constraint on fiscal policy in developing countries Thus, an emerging market economy with highly level of debts will determine the size of fiscal deficit in facing with more difficulties in assessing to international capital market (inaccessible or accessible with unfavorable terms), which then leads

to the stronger crowding-out effects Meanwhile, the low indebted countries have higher fiscal room for future government in implementing fiscal policy, which may undertake with the favorable terms of debt-financing, and that in turn promotes the crowding-in effects

Moreover, the individuals in high indebted countries are more sensitive to the government expenditures in following the framework of neo-classical views The public may expect that the increasing of government expenditures in this case be in along with the less favorable terms of government’s borrowings and less efficiency of spending, which then stimulate individuals to cut back their current consumption more and more As a result, this proposes higher crowding-out effects of fiscal policy In contrast, the individuals in low indebted countries may less sensitive to the government expenditures, especially through the debt-financing spending, since the interest rates are less responsive and they are easier to access the financial markets, thus the fiscal policy

is argued with the existence of crowding-in effects

According to Kirchner and Wijnbergen (2016), the effectiveness of fiscal stimuli is impaired when banks are substantially invested in sovereign debt since deficit-financed fiscal expansions reduce private access to credit in this case Therefore, we use the total external debt, which includes public debt and private debt in this study to examine the impacts of debt on effectiveness of fiscal policy This helps us consider the constraints of external debt of ability of private sector in accessing international financial markets We argue that the expansionary fiscal policy in the highly indebted countries not only creates the crowding-out effects for the private sectors through the impacts on interest rates and exchange rates, but also crowds out the availability of private sectors in accessing into the international financial markets that creates more constraints for private sectors to implement economic activities In contrast, these effects may not exist or less significance in the case of low indebted countries As a summary, our hypothesis is argued that the relationship between fiscal policy with the economic growth is non-linear one as the positive effect in the low indebted level and the negative effect in the high indebted level

In fact, the non-linear relationships between fiscal policy and economic factors are examined under some manners Adam and Bevan (2005) investigate the relationship between fiscal deficits and growth for a panel of 45 developing countries and find evidence of a threshold effect at a level of the deficit around 1.5% of GDP They also find evidence of interaction effects between deficits and debt stocks with high debt stocks exacerbating the adverse consequences of high

deficits While, Catão and Terrones (2005) examine inflation as non-linearly related to fiscal deficits through the sample of 107 countries over 1960–2001 period They find a strong positive association between deficits and inflation among high-inflation and developing country groups, but not among low-inflation advanced economies

This fact suggests that we should consider the non-linear relationship between fiscal policy and eonomic growth in the emerging market economies Emerging market economies are an emerging group of countries with interesting economic features in developing countries While, the expected future revenue plays an important role in explaining the low fiscal limits of developing countries relating to developed countries (Bi, Shen, & Yang, 2016) Therefore, the study of the relationships between institutions, external debts and the effectiveness of fiscal policy is more significant for both literature and practice Next section presents the methodology and data

CHAPTER 3: METHODOLOGY AND DATA 3.1 Methodology

It is easy to begin with the production function of an economy in the methodology to examine the determinants of economic growth following the founding study of Cobb and Douglas (1928) as:

𝑌 = 𝐴𝐾𝛼𝐿𝛽 (1)

in which: Y is the total output; K is the capital input; L is the labor input; A is the total factor

productivity; α and β are the output elasticities of capital and labor, respectively Then, taking

logarithm both sides of eq.1, we have:

𝐿𝑜𝑔(𝑌) = 𝐿𝑜𝑔(𝐴) + 𝛼𝐿𝑜𝑔(𝐾) + 𝛽𝐿𝑜𝑔(𝐿) (2) According to eq.2, the changes in capital input, labor input and total factor productivity determine the output growth as the simplest function of economic growth Thus, economic growth can be presented as the function:

f(g) = f(T, K, L, e) (3)

in which: g is the proxy of economic growth, T is the technology, K and L are same as previous,

and e the random shocks in output

In fact, technological factor in economic growth is anything that is new in product or production method, or raw material, or business area, or financial method, or organization scheme (Schumpeter, 1934) This then is deeply studied in many previous works including the pioneer works as Solow (1956), Arrow (1962), Lucas (1988), Paul M Romer (1986), Paul Michael Romer (1991) And, recent studies such as Shahiduzzaman and Alam (2014), Luo, Olechowski, and Magee (2014), Pradhan, Arvin, and Norman (2015), Maswana (2015), Salahuddin and Alam (2016), Bhattacharya, Rafiq, and Bhattacharya (2015), and Kurt and Kurt (2015) In addition to technology, the capital formation is other important determinant of economic growth especially in low developed economies (Ghosal & Nair-Reichert, 2009; Kapelko, Oude Lansink, & Stefanou, 2015; Malaga-Toboła, Tabor, & Kocira, 2015) From the Harrod–Domar growth model in 1940s through Harrod (1939) and Domar (1946), economic growth can explained in terms of the saving level and capital productivity, thus the increasing of capital investment is a stimulating factor for economic growth (Sato, 1964; Solow, 1988)

Due to the lack of concerns about the productivity in Harrod-Domar model, the exogenous growth model (or Solow model) was developed by Solow (1956) and Swan (1956) that had included the term of productivity growth to explain long-run economic growth through capital accumulation, labor or population growth, and increases in productivity or technological progress Then, Paul M Romer (1986), Lucas (1988), and Rebelo (1990) propose the endogenous growth theory in the mid-1980s from the basic studies of Arrow (1962), Uzawa (1965), and Sidrauski (1967) Endogenous growth theory suggests that besides other main drivers of economic growth the endogenous factors of economic growth are investment in human capital, innovation, and knowledge This theory also focuses on positive externalities and spillover effects of a knowledge-based economy such as the contributions from the capital flows and trade openness In fact, many empirical studies recently have applied the endogenous growth theory in examining the determinants of economic growth (see Lee (2005), Bronzini and Piselli (2009), Arvanitis and Loukis (2009), Teixeira and Fortuna (2010), Banerjee and Roy (2014), van Lottum and van Zanden (2014), Chowdhury, Schulz, Milner, and Van De Voort (2014), Scherngell, Borowiecki, and Hu (2014), Breton (2015), Zlate and Enache (2015))

Beside the common elements of economic growth as stated, there is an extensive literature has focused on the impacts of financial development on economic growth (Levine, 2005) Schumpeter (1912) is seen as the first economist who addressed the relation between financial development and economic growth He argued that a well-functioning financial system should promote economic growth through the selection of the productive investments which are the most likely to be successful and the efficient allocation of resources (via bank credits) to these innovative technologies Financial markets overcome transaction costs and informational asymmetries to reduce liquidity constraints and improve the allocation of capital, it increase the physical capital accumulation and productivity growth to affect to economic growth (Rioja & Valev, 2009) In which, stock markets and banking sector both enhance economic growth (Beck

& Levine, 2001, 2004; Rousseau & Wachtel, 2002), but banking sector is more important in developing countries

Therefore, we recruit the common determinants of economic growth including capital, technology, labor, technology, capital flows, trade openness, and add the credit element for the basic model of economic growth in this study With this beginning of basic model, we incorporate government expenditure to examine the impacts of fiscal policy on economic growth

for 20 emerging market economies in the period 2002-2014, and follows the empirical model in Miller and Russek (1997):

𝑔𝑖,𝑡 = 𝜕1𝑔𝑖,𝑡−1+ 𝜕2𝑔𝑑𝑝𝑝𝑐𝑖,𝑡−1+ 𝛼𝑋𝑡+ 𝛽1𝐺𝑜𝑣𝑒𝑥𝑔𝑖,𝑡+ 𝜀𝑡,𝑠 with i i d N (0,δs t2,) (4)

in which: i and t is country i at time t g is GDP growth rate (gdpg) that proxies for the economic growth The lag of g is put into the model to control for the dynamic of economic growth model, while the gdppc is logarithm of GDP per capita that presents for the starting economic development level X is vector of control variables including: the capital investment factor that presented by the gross capital formation growth rate (capg); the labor factor that presented by the population growth rate (popg); the credit factor that presented by the logarithm of domestic credit to private sector by banks (credit); the technology factor that presented by the logarithm of total patent applications by both residents and non-residents (patent); the trade openness that presented by the logarithm of total trade to GDP (trade); and the capital flow that presented by the net inflows of foreign direct investment to GDP (fdi) govexg is the proxy for fiscal policy

that presented by the general government final consumption expenditure growth rate All the

definitions and sources of variables are presented detail in Table 1

Table 4 Variables, definitions and sources

Dependent

variables

Gdppcg GDP per capita growth rate (% annual) WDI

Capg Gross capital formation growth rate (% annual) WDI Popg Population growth rate (% annual) WDI Credit

Logarithm of domestic credit to private sector by banks

Calculation from WDI

Patent

Logarithm of total patent applications by both residents and non-residents

Calculation from WDI

Trade Logarithm of trade ratio to GDP

Calculation from WDI

Fdi

Net inflows of foreign direct investment to GDP (%)

WDI Debt Ratio of External debt stock to GNI (%) WDI

s

ε

Concor Control of corruption indicator WGI

In next step, we also incorporate institutional factors into the model to investigate the effects

of institutional quality on economic growth following the empirical model suggesting in Lee and Hong (2012) In this step, we collect three dimensions of institutions from World Governance

Indicators (Worldbank) including the government effectiveness (Goveff), regulatory quality (Regu), and control of corruption (Concor) to proxy for the institutional framework, respectively

Despite of critics about bias or lack of comparability and the utility of institutional quality in World Governance Indicators (Thomas, 2010), there are many previous studies that use these indicators as the best proxies for institutional quality (see Kaufmann and Kraay (2002), Neumayer (2002a), Neumayer (2003), Dollar and Kraay (2003), Naudé (2004), Lash (2004), Llamazares (2005), Neumayer (2005), Andrés (2006), SCHUDEL and Schudel (2008), Clist (2011), Park (2012), In’airat (2014), Herrera-Echeverri, Haar, and Estévez-Bretón (2014), Nordveit (2014), Barry and Tacneng (2014), Zhang (2016))

As explained in World governance indicators, government effectiveness “reflects perceptions

of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies” Regulatory quality “reflects perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development” And control of corruption

“reflects perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as "capture" of the state by elites and private interests” We believe that these aspects of institution have the highest significance for the effectiveness of fiscal policy as discussed in literature review As one of the most important aim

of this study, we use the interaction terms between fiscal policy with each indicator of institutions to examine the effectiveness of fiscal policy under the associations with institutional framework

Next, we estimate the growth model with the explanatory variables including both external debt to GNI and its square to examine the non-linear relationship between external debt and economic growth Basing on the results of these estimations, we then divide sample into two sub-samples First sub-sample includes 8 low indebted economies that have the average external