Essays on fiscal policy and debt sustainability

The first chapter develops an endogenous growth model with public debt and publicly financed infrastructure and human capital accumulation. The government sets the primary surplus as a positive function of the debt-GDP ratio to ensure intertemporal solvency. Conditions for the existence of a unique equilibrium and saddle-path stability are discussed: in a simplified version of the model these are ensured by a strong enough reaction to a debt increase. Dynamics associated with debt-reducing policies and budget-neutral fiscal reforms in a calibrated economy are described through numerical simulations. Tax-based fiscal consolidations turn out growth-enhancing in the long run, while spending cuts improve welfare. In general, a trade-off emerges between short and long-run growth, but it is weaker when consolidation is implemented by reducing the debt-GDP target. Reallocating funds from education to infrastructure and increasing the government size may also boost economic growth, but only the former policy change is also welfare improving. The second chapter studies the growth and welfare effects of alternative fiscal policy reforms in a model calibrated to describe an over-indebted advanced economy. When a debt feedback rule is used, fiscal consolidations can stimulate long-run growth, and, if based on spending cuts, even improve welfare. Indeed, as the debt stock declines, tax cuts and increases in public spending follow, thus encouraging the agent to spend more time on work and education. On the one side, this restricts the effectiveness of debt-reducing policies, on the other it boosts growth and improves the welfare results. Shifting the tax burden from labor to capital or consumption also has positive effects on long-run growth, but increasing the capital tax rate should be avoided if the government is concerned about containing the debt-GDP ratio or if the goal of the policy-maker is to improve welfare. What constitutes ample fiscal space or a “safe level of debt” to conduct countercyclical policy while ensuring debt sustainability? The last chapter addresses the question by exploring the relationship between debt dynamics, and the probabilistic distribution of the primary balance and the effective interest rate. Using this approach, we find that two-thirds of Low-Income Developing Countries (LIDCs) presently have fiscal policy space to address adverse shocks, subject to the availability of domestic and external financing. Countries with strong institutional capacity tend to have more fiscal space: seventy-five percent of countries with high and medium institutional capacity maintain debt levels below both their “debt sustainability ceiling” and their “safe debt” level estimated in this paper. Countries with weak institutional capacity, mostly countries in conflict and fragile states, tend to lack fiscal space.