Government debt is large in most developed countries, and while budget deficits may reflect short-term attempts to kick-start the economy in times of crisis by means of fiscal stimulus, the longer-term consequences may be detrimental to investment and growth. Those negative consequences make it important to identify factors that are associated with public debt. While previous studies have related government debt to economic and political variables, they have not incorporated the degree to which the economy is regulated. Using a measure of regulatory freedom (absence of detailed regulation of labor, business and credit) from the Economic Freedom of the World index, we conduct an empirical analysis covering up to 67 countries during the period 1975–2010. The main finding is that regulatory freedom, especially with respect to credit availability, reduces debt accumulation. The effect is more pronounced when the political system is fractionalized and characterized by strong veto players, indicating policy stability and credibility, and when governments have right-wing ideologies.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Price excludes VAT (USA)
Tax calculation will be finalised during checkout.
Debt is also relevant when considering other long-term goals, e.g., inflation, employment, intergenerational equity and fiscal sustainability (Auerbach 2008).
Indeed, Reinhardt and Rogoff (2010) find that the debt–growth relationship is quite weak at “normal” debt ratios, but that very high debt ratios (above 90% of GDP) tend to reduce growth sharply, from 3% to 1.7% over the two-century period they study, but even more, from 3 to − 0.1% in the post-war sample. The estimates were criticized by Herndon et al. (2014), who find smaller negative effects of high debt and no particular threshold at 90%, but Reinhart et al. (2012) provide some further support for the previous findings. See also Eberhardt and Presbitero (2015) for further evidence of a negative relationship, but with no common threshold across countries; cf. Égert (2015).
High debt levels also make it more difficult for stimulus to be effective: see Nickel and Tudyka (2014).
Political business cycles could provide a further explanatory mechanism for debt accumulation, if voters reward expansionary fiscal policy and punish more restrictive policy. However, Alesina and Passalacqua (2015, p. 18) write that such cycles “cannot be the main explanation for large and long-lasting accumulation of public debt”.
In Sect. 4.4, we provide an explorative empirical analysis to see whether some of these four possibilities can be shown to function as actual channels between regulation and debt.
This exposition concerns democracies. For non-democratic settings, voters and the legislature are not relevant as such—authoritarian regimes often have legislatures that have only nominal power, and if there are voters, they do not de facto have alternatives to vote for.
We here follow the general approach of Peltzman (1976). However, the public choice literature has documented a number of mechanisms by which politicians’ stated ideological preferences could be either distorted or reversed entirely: Hillman (2009) and Holcombe (2016) provide compendia of such mechanisms.
The Initiative on Global Markets (IGM) Economic Experts Panel leaned towards the Keynesian position in 2014 (IGM 2014). When asked whether the benefits of US stimulus efforts would end up exceeding their costs, 20% strongly agreed, 36% agreed, 23% were uncertain and 5% disagreed. Even stronger agreement with Keynesian ideas was found in a large survey of economists some decades earlier (Frey et al. 1984).
A number of studies link stricter regulation to less adaptability and dynamism. For example, Alesina et al. (2005) show that regulatory reform of product markets in OECD countries is associated with an increase in investment. Djankov et al. (2006), Jalilian et al. (2007) and Justesen (2008) find that countries with fewer regulatory restrictions grow more rapidly. Haltiwanger et al. (2014) find strong and robust evidence that stringent hiring and firing regulations tend to reduce the pace of job reallocation. Bjørnskov (2016) shows that countries with more-regulated markets tend to experience substantially longer and deeper economic crises.
Including a lagged dependent variable is equivalent to estimating changes in debt levels during five-year periods. Empirically, using the change as either a left-hand side variable or the level is the same as long as both specifications include a lagged dependent variable. The only real difference is the estimated coefficient on the lagged dependent variable.
The results that follow are robust to applying either a standard random-effects estimator or adding country fixed effects. We do both, but prefer an OLS estimator with panel-corrected standard errors, as the use of fixed effects more clearly identifies short- to medium-term relations. We note that our choice in the present context produces the most conservative estimates.
Estimating the association between our control variables and regulation, and using the latter as the dependent variable, illustrates the potential problems. Regulation is strongly associated with both veto player strength, proportional voting, presidential democracy and government ideology. Not including those characteristics in the specification must give rise to omitted-variable bias in our main estimate.
Inspired by Gørgens et al. (2005), we have also tried nonlinear modeling, but it did not produce evidence of curvilinear effects. Including a squared regulation term yields a worse fit and no statistical significance. Furthermore, categorizing the regulatory freedom variable in four equal categories suggests that the effects are approximately linear.
We also tried including four additional indicators of economic freedom, indicators that together with regulatory freedom constitute the Economic Freedom of the World index (Gwartney et al. 2016). As can be seen in Table A3 in the Appendix, the four are not related to the debt ratio in a statistically significant way.
We also tested whether an ideological change in government within each 5-year period is related to debt. We find that a dummy variable indicating such change is statistically nonsignificant and that its inclusion does not affect any of our main findings.
The standard solution is an instrumental variables (IV) approach, but the most obvious candidates as identified in previous studies—ideological differences and legal origins—are also candidates for direct influences. We have been unable to find any other theoretically valid variables that solve the identification problem, and therefore cannot undertake any IV estimates.
However, the interaction with ideology loses significance in the fixed-effect estimates.
This is a way of recognizing that the regulatory environment is a complex one, and that any aggregation is bound to hide a great deal of heterogeneity, e.g., in terms of what the effects on some outcome variable may be. The point estimates we produce are to be seen as “net effects” of all the components of a particular index, where both sizes and signs can vary between those variables.
Afonso, A., Gomes, P., & Rother, P. (2011). Short- and long-run determinants of sovereign debt credit ratings. International Journal of Finance and Economics, 16(1), 1–15.
Aghion, P., Algan, Y., Cahuc, P., & Shleifer, A. (2010). Regulations and distrust. Quarterly Journal of Economics, 125(3), 1015–1049.
Alchian, A. A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58(3), 211–221.
Alesina, A., Ardagna, S., Nicoletti, G., & Schiantarelli, F. (2005). Regulation and investment. Journal of the European Economic Association, 3(4), 791–825.
Alesina, A., & Passalacqua, A. (2015). The political economy of government debt. NBER working paper 21821, Cambridge, MA.
Auerbach, A. J. (2008). Long-term objectives for government debt. Report 2008/1, Swedish Fiscal Policy Council, Stockholm.
Beck, T., Clarke, G., Groff, A., Keefer, P., & Walsh, P. (2001). New tools and new tests in comparative political economy: The database of political institutions. World Bank Economic Review, 15(1), 165–176.
Beck, N., & Katz, J. N. (1995). Nuisance versus substance: Specifying and estimating time-series cross section models. Political Analysis, 6(1), 1–36.
Biglaiser, G., & Staats, J. L. (2012). Finding the “democratic advantage” in sovereign bond ratings: The importance of strong courts, property rights protection and the rule of law. International Organization, 66(3), 515–535.
Bjørnskov, C. (2015). Institutional shocks and economic crises. Paper presented at the annual meetings of the Southern Economic Association, New Orleans, November 20–23, 2015.
Bjørnskov, C. (2016). Economic freedom and economic crises. European Journal of Political Economy, 45, S11–S23.
Bjørnskov, C., & Potrafke, N. (2012). Political ideology and economic freedom across Canadian provinces. Eastern Economic Journal, 38(2), 143–166.
Bjørnskov, C., & Potrafke, N. (2013). The size and scope of government in the US states: Does party ideology matter? International Tax and Public Finance, 20(4), 687–714.
Bjørnskov, C., & Rode, M. (2018). Regime types and regime change: A new dataset. Working paper, Aarhus University. Data available at http://www.christianbjoernskov.com/bjoernskovrodedata/ (accessed May 11, 2018).
Brambor, T., Roberts Clark, W., & Golder, M. (2006). Understanding interaction models: Improving empirical analysis. Political Analysis, 14(1), 63–82.
Buchanan, J. M., & Wagner, R. E. (1977). Democracy in deficit: The political legacy of Lord Keynes. New York: Academic Press Inc.
Cheibub, J. A. (2006). Presidentialism, electoral identifiability and budget balances in democratic systems. American Political Science Review, 100(3), 353–368.
Cochrane, J. H. (2014). Challenges for cost-benefit analysis of financial regulation. Journal of Legal Studies, 43(S2), S63–S105.
Cukierman, A., & Tommasi, M. (1998). When does it take a Nixon to go to China? American Economic Review, 88(1), 180–197.
Djankov, S., McLiesh, C., & Ramalho, R. M. (2006). Regulation and growth. Economics Letters, 92(3), 395–401.
Eberhardt, M., & Presbitero, A. F. (2015). Public debt and growth: Heterogeneity and non-linearity. Journal of International Economics, 97(1), 45–58.
Égert, B. (2015). Public debt, economic growth and nonlinear effects: Myth or reality? Journal of Macroeconomics, 43(March), 226–238.
Elgie, R., & McMenamin, I. (2008). Political fragmentation, fiscal deficits and political institutionalisation. Public Choice, 136(3–4), 255–267.
Elmendorf, D. W., & Mankiw, N. G. (1999). Government debt. In J. B. Taylor & M. Woodford (Eds.), Handbook of macroeconomics (Vol. 1C, pp. 1615–1669). Amsterdam: Elsevier.
Feldmann, H. (2009). The unemployment effects of labor regulation around the world. Journal of Comparative Economics, 37(1), 76–90.
Frey, B. S., Pommerehne, W. W., Schneider, F., & Gilbert, G. (1984). Consensus and dissension among economists: An empirical inquiry. American Economic Review, 74(5), 986–994.
Fuchs, A., & Gehring, K. (2017). The home bias in sovereign ratings. Journal of the European Economic Association, 15(6), 1386–1423.
Gørgens, T., Paldam M., & Würtz, A. (2005). Growth, income and regulation: A non-linear approach. Working paper 2015-12, Centre for Applied Microeconometrics, Department of Economics, University of Copenhagen.
Grilli, V., Masciandaro, D., Tabellini, G., Malinvaud, E., & Pagano, M. (1991). Political and monetary institutions and public financial policies in the industrial countries. Economic Policy, 6(13), 342–392.
Gunzinger, F., & Sturm, J.-E. (2016). It’s politics, stupid! Political constraints determined governments’ reactions to the great recession. Kyklos, 69(4), 584–603.
Gwartney, J. D., Lawson, R. A., & Hall, J. C. (2016). Economic freedom of the world: 2016 annual report. Vancouver, BC: The Fraser Institute.
Hall, P. A. (Ed.). (1989). The political power of economic ideas: Keynesianism across nations. Princeton: Princeton University Press.
Haltiwanger, J., Scarpetta, S., & Schweiger, H. (2014). Cross country differences in job reallocation: The role of industry, firm size and regulations. Labour Economics, 26(January), 11–25.
Henisz, W. (2002). The institutional environment for infrastructure investment. Industrial and Corporate Change, 11(2), 355–389.
Herndon, T., Ash, M., & Pollin, R. (2014). Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff. Cambridge Journal of Economics, 38(2), 257–279.
Heston, A., Summers, R., & Aten, B. (2012). Penn world table version 7.1, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania.
Hillman, A. L. (2009). Public finance and public policy. Cambridge: Cambridge University Press.
Holcombe, R. G. (2016). Advanced introduction to public choice. London: Edward Elgar.
IGM (2014). Economic stimulus (revisited). http://www.igmchicago.org/igm-economic-experts-panel/poll-results?SurveyID=SV_5bfARfqluG9VYrP (accessed October 11, 2016).
Jalilian, H., Kirkpatrick, C., & Parker, D. (2007). The impact of regulation on economic growth in developing countries: A cross-country analysis. World Development, 35(1), 87–103.
Justesen, M. K. (2008). The effect of economic freedom on growth revisited: New evidence on causality from a panel of countries 1970–1999. European Journal of Political Economy, 24(3), 642–660.
Justesen, M. K. (2014). Better safe than sorry: How property rights and veto players jointly affect economic growth. Comparative Politics, 46(2), 147–167.
Keynes, J. M. (1936). The general theory of employment, interest and money. London: Palgrave Macmillan.
Koehler, S., & König, T. (2015). Fiscal governance in the Eurozone: How effectively does the Stability and Growth Pact limit governmental debt in the Euro countries? Political Science Research and Methods, 3(2), 329–351.
Leachman, L. L., Rosas, G., Lange, P., & Bester, A. (2007). The political economy of budget deficits. Economics and Politics, 19(3), 369–420.
Mulligan, C. (2008). Professor Krugman is right: “Now is not the time to worry about the deficit”. Blog post, http://caseymulligan.blogspot.se/2008/10/professor-krugman-is-right-now-is-not.html (accessed November 10, 2016).
Nickel, C., & Tudyka, A. (2014). Fiscal stimulus in times of high debt: Reconsidering multipliers and twin deficits. Journal of Money, Credit and Banking, 46(7), 1313–1344.
Nizalova, O. Y., & Murtazashvili, I. (2016). Exogenous treatment and endogenous factors: Vanishing of omitted variable bias on the interaction term. Journal of Econometric Methods, 5(1), 71–77.
Peltzman, S. (1976). Toward a more general theory of regulation. Journal of Law and Economics, 19(2), 211–240.
Pennington, M. (2011). Robust political economy: Classical liberalism and the future of public policy. Cheltenham: Edward Elgar.
Persson, T., & Tabellini, G. (2003). The economic effects of constitutions. Cambridge, MA: The MIT Press.
Pitlik, H., & Kouba, L. (2015). Does social distrust always lead to a stronger support for government intervention? Public Choice, 163(3), 355–377.
Potrafke, N. (2010). Does government ideology influence deregulation of product markets? Empirical evidence from OECD countries. Public Choice, 143(1–2), 135–155.
Reinhart, C. M., Reinhart, V. R., & Rogoff, K. S. (2012). Public debt overhangs: Advanced-economy episodes since 1800. Journal of Economic Perspectives, 26(3), 69–86.
Reinhart, C. M., & Rogoff, K. S. (2010). Growth in a time of debt. American Economic Review, 100(2), 573–578.
Romer, C. D., & Romer, D. H. (2009). Do tax cuts starve the beast? The effect of tax changes on government spending. Brookings Papers on Economic Activity, 40(1), 139–214.
Roubini, N., & Sachs, J. (1989). Political and economic determinants of budget deficits in the industrial economies. European Economic Review, 33(5), 903–938.
Skedinger, P. (2011). Consequences of employment protection legislation. Nordic Economic Policy Review, 2(1), 45–83.
Thornton, Grant. (2018). Grant Thornton global dynamism index. Chicago: Grant Thornton.
Tullock, G. (1981). Why so much stability? Public Choice, 37(2), 189–204.
Volkerink, B., & de Haan, J. (2001). Fragmented government effects on fiscal policy: New evidence. Public Choice, 109(3–4), 221–242.
Zingales, L. (2015). Does finance benefit society?. Journal of Finance, 70(4), 1327–1363.
The authors wish to thank Niklas Potrafke and participants at the 2016 Conference of the Italian Society of Law and Economics in Torino, especially Enrico Colombatto, the 2017 Research Workshop of the Institute for Research in Economic and Fiscal Issues (IREF) in Manchester, the 2017 Conference of the European Association of Law and Economics in London and the 2018 conference “The Importance of Janos Kornai’s Research for Understanding the Changing Role of the State in the Economy” at Corvinus University in Budapest for valuable comments and suggestions. Olga Pugatšova provided excellent research assistance. Financial support from the Swedish Research Council (Grant 2103-734, Berggren), Torsten Söderberg Foundation (Grant E1-14, Berggren), the Czech Science Foundation (GA ČR) (Grant 16-19934S, Berggren) and the Institute for Research in Economic and Fiscal Issues (IREF) is gratefully acknowledged.
Electronic supplementary material
Below is the link to the electronic supplementary material.
Rights and permissions
About this article
Cite this article
Berggren, N., Bjørnskov, C. Regulation and government debt. Public Choice 178, 153–178 (2019). https://doi.org/10.1007/s11127-018-0621-6
- Economic freedom