Threshold effects of fiscal policy on economic growth in developing countries

Abstract

We examine the relation between fiscal policy and economic growth for a panel of 40 developing countries over the period of 1990 to 2012 using eight macroeconomic variables: real GDP, budget deficit, current government spending, national saving, inflation rate, total investment, public debt, and current account balance. The study documents a double threshold effect of the fiscal balance. The first one is at a level of the deficit around 4.8% of GDP; the second one is at the fiscal surplus level of 3.2% of GDP meaning that economic growth would be negatively affected when exceeding these two different levels. The result also show that the sign of the relation between budget deficit and economic growth is conditioned by the level of total investment i.e. only for total investment higher than 23%, there exists a positive relation. However, it becomes negative, when investment falls below this threshold. IntroductionIn both theory and evidence, there are controversial thoughts and debates that focus on the impact of the fiscal deficit on economic growth. Since the nineties, this subject becomes highly debated in the literature. Barro (1990) is considered as one of the most important pioneers in the field. He suggested a simple endogenous growth model and showed that the share of government spending in GDP might have a significant effect on economic growth. Nevertheless, a few empirical and theoretical studies have taken into account the non-linearity that can prevail on the relationship between growth and budget deficit [Minea and Villieu (2005), Adam and Bevan (2005), Tanimoune, Combes and Plane (2008) and Minea and Villieu (2008)]. These authors try to identify anti-Keynesian effects, which would be related to the persistence of high fiscal contractions.Euro convergence criteria in the Maastricht Treaty (1993) outlined that the ratio of the annual general government deficit about gross domestic product (GDP) at market prices, must not exceed 3% at the end of the preceding fiscal year. Even though it is hardly justified 1 . The European debt crisis in 2010 shook the global economy when some indebted countries in Euro area, which had been maintaining high levels of debt and fiscal deficit, faced the default on payment of the public debt and its interest. Although the crisis mainly pertained to European countries, the concern of a similar public debt crisis is also shared by other countries in the world. This paper provides an empirical analysis to identify the nature of the relationship between budget deficit and 1 It has been argued by many economists that the threshold of 3% was set arbitrarily and has no basis but the circumstances as European fiscal deficits in the early 90s were less than 3%. See Buiter, Corsetti and Roubini (1993, andBuiter (2006) for more details.Threshold effects of fiscal policy… Salma, et al. JEFS (2016), 04(03), 24-37Journal of Economic and Financial Studies Page 25 economic growth for a panel of 40 developing countries using annual data over the period spanning from 1990 to 2012.This p...

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