Government debt, European Institutions and fiscal rules: a synthetic control approach

International Tax and Public Finance https://doi.org/10.1007/s10797-023-09791-z Government debt, European Institutions and fiscal rules: a synthetic control approach Robert Kraemer1 · Jonne Lehtimäki2 Accepted: 14 June 2023 © The Author(s) 2023 Abstract Public debt and its development are key questions of public sector economics and fiscal policy. This paper uses the Synthetic Control Method to study how different large-scale steps of European integration and the establishment of the EU fiscal framework have affected government debt in EU Member States. The results point to a notable debt-restricting effect of EU membership and the introduction of the Stability and Growth Pact for a large majority of the studied country groupings as well as for individual countries. Outside of a few individual countries, the actual government debt levels are substantially lower than in the synthetic alternatives. Keywords European union · Stability and growth pact · European fiscal framework · Fiscal rules · Government debt · International fiscal issues JEL Classification E62 · H6 · H63 · H87 1 Introduction Public debt and its development are key questions of public sector economics and fiscal policy. Traditionally studies have shown (for example, Reinhart & Rogoff, 2010; Panizza & Presbitero, 2014 as well as others) that a high amount of public debt will slow down economic growth once the debt-to-GDP ratio exceeds certain thresholds. On the other hand, Blanchard (2019) has suggested that, at least in a low interest rate environment, government debt can be expanded far more than was previously envisaged without stifling growth. Others, however, argue that governments The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Stability Mechanism (ESM). * Jonne Lehtimäki 1 European Stability Mechanism, Luxembourg, Luxembourg 2 University of Turku, Turku, Finland 13 Vol.:(0123456789) R. Kraemer, J. Lehtimäki should not interpret negative interest-growth (r-g) environments as free lunches, given that a growing probability of a tail event could have major impacts on the safe rates and associated bond issuance (e.g. Lian et al., 2020; Rogoff, 2020), or on the negative effects of debt in a more general sense such as Boskin (2020), who states that in the long run, large debt ratios can lead to substantially higher taxes, lower future net incomes and intergenerational inequity. The formation of government debt is a complicated process and it is challenging to differentiate between the effects of different large-scale reforms, other factors such as policy choices or technical aspects like stock-flow adjustments. This paper approaches the question by using the novel econometric approach of the Synthetic Control Method (SCM), originally presented by Abadie and Gardeazabal (2003), which can be used to study the effects of large-scale reforms by simulating counterfactuals using control samples where similar reforms were not introduced (or vice versa). The aim of the paper is to study how different large-scale steps of European integration and the EU fiscal framework have affected public debt in EU Member States. A greater understanding in this regard would enable policymakers to design future policies to be more efficient in reaching their goals regarding levels of public debt. It should be noted that this paper concentrates on the level and dynamics of government debt. It takes no stance on, for example, the potential long-term growth effects from a short-term increase in government debt if invested in a growth-enhancing manner. To the best of the authors’ knowledge, this is the first attempt at explicitly analysing the impact of different EU-level fiscal rules to all EU countries using the methodological innovation of the SCM. In the previous literature, the most closely related studies are Koehler and König (2015), which studies the effect of the Stability and Growth Pact (SGP) on the euro area (EA) aggregate government debt and Strong (2023), which studies how fiscal rules have affected government debt in CFA zone countries. Beyond them applications of the SCM to questions of fiscal issues are somewhat rare with (Pfeil & Feld, 2016; Roesel, 2017) being the most notable exceptions, although they study smaller-scale fiscal rules. The remainder of the paper is organised as follows: Sect. 2 summaries some of the literature and background on government debt and European institutions, Sect. 3 describes the SCM and the data used in the study, Sect. 4 presents the results of the empirical study, and Sect. 5 studies the robustness of the results. Section 6 concludes. 2 Government Debt and European Institutions During the last 50 years, the role of the public sector and the conduct of fiscal policy have adjusted to better match the environment of a global economy. Advanced countries around the world have chosen to implement fiscal rules to control the dynamics of several public sector aspects such as government debt, budget balance, and public expenditure. In fact, Yared (2019) suggests that setting fiscal rules is one of the most promising policy choices to subdue the growth of government debt. The number of 13 Government debt, European Institutions and fiscal rules:… countries which are applying some form of fiscal rules has risen rapidly in the past 30 years (Halac & Yared, 2018, 2019). Due to the increasing use of fiscal rules, an expanding amount of literature discusses different aspects such as their design, implementation, numerical compliance and effects. Reuter (2015, 2019) notes that fiscal rules have a benchmarking effect for policy makers as well as the public and they drive fiscal policy towards numerical targets or limits, even in times of non-compliance. Reuter et al. (2022) further elaborate on this aspect, noting that actual compliance with numerical fiscal rules does not play a systematic role and the effects can be observed even if the rules are not complied with. Reuter (2015) also identifies determinants of compliance with various types of national numerical fiscal rules, finding significantly higher compliance with rules constraining stock (rather than flow) variables, rules set out in coalitional agreements, as well as rules covering larger parts of general government finances. Another paper by Doray-Demers and Foucault (2017) notes that fiscal stress prevents fiscal reforms in the short term, and leads to stronger fiscal rules in the long term. The paper also suggests that countries facing financial difficulties after the sovereign debt crisis were coerced into adopting more stringent fiscal rules in order to obtain financial support. Badinger and Reuter (2017) identify significant effects of fiscal rules on the budget balance, government bond spreads as well as the volatility of output. In the European context, the introduction of fiscal rules coincides with the advancement of European integration, which began (...truncated)