Economic Freedom and Debt: An Empirical Investigation on the Institutional Determinants of Public Debt

Abstract

This paper investigates the role of the institutional framework in the accumulation of central government debt. We employ the Economic Freedom Index (EFI) as a proxy for institutional framework and study the causal link between institutions that promote economic freedom and the creation of public debt. The results presented in this paper are evidence of causality between institutions and debt-to-GDP ratios. This paper suggests that institutional and structural frameworks of economies bear great importance in public debt accumulation. The countries that score better on the quality of economic institutions are more likely to accrue lower levels of public debt. In particular, a 10-point enhancement in the EFI score can lead to reductions between 1.7 and 7.3 percentage points in debt-to-GDP ratios. We also observed that scores for open markets and government size affect public debt negatively across developed as well as developing countries. Additionally, the evidence suggests that countries deemed less likely to expropriate private property exhibit higher percentage of government debt relative to GDP. We stipulate this is the result of higher perceived trustworthiness which in turn leads to an increased pool of available credit.