THE FISCAL POLICY RESPONSE TO PUBLIC DEBT IN

DEVELOPING COUNTRIES

ORONDE SMALL, LEANORA BROWN and GUSTAVO CANAVIRE-BACARREZA∗

Theoretical models on fiscal sustainability hypothesize that indebted governments

can lower their current debt by generating future primary surpluses, ceteris paribus.
While both developed and developing countries struggle with the issue of debt stabiliza-
tion, the latter, in particular face heightened sensitivity from creditors, which provides
them an impetus to respond more strongly to stabilize their debt. Based on a panel of
53 developing countries, we examine the fiscal response of these countries to changes
in their debt-to-gross domestic product ratio. We find evidence of a positive relationship
between the debt and primary surplus and that countries adjust along both the revenue
and expenditure margins at roughly the same rate. (JEL E62, H50, O11)

I. INTRODUCTION strongly to stabilize debt. However, notwith-

Debt sustainability has long been a major
concern for governments in both developed and
developing countries. However, governments’
capacities to sustain their fiscal accounts differ
tremendously across the two groupings. There
is a large but still emergent literature devoted
to examining the fiscal reaction function (FRF)
for developed countries, which captures changes
in the primary balance induced by changes in
the debt-to-gross domestic product (GDP) ratio.
However, much less attention has been devoted to
this question in the context of developing coun-
tries and will therefore be the focus of this paper.
This lack of attention is somewhat surprising
given that the debt intolerance that characterizes
many developing countries, leads to a heightened
sensitivity on the part of creditors which in turn
forces these countries to respond much more
standing the impetus to react, developing coun-
tries may be more limited in the extent to which
they are able to do so. Hence, a closer enquiry
into whether fiscal policies in these countries
have been deployed responsibly is warranted.
In theory, a country can afford to incur debt
if, over time, it is able to consistently generate
higher relative growth rates in real economic
output or where it is able to consistently gener-
ate primary surpluses (as a share of GDP) that
exceed the interest rate growth rate differential.1
However, there is a limit on the extent to which
a country is able to continue to accumulate
debt before it begins to raise concerns about
the sustainability of its fiscal policy. There is
also evidence to suggest that this debt limit is
much lower in developing countries relative to
more advanced economies. Reinhart, Rogoff,

∗ We would like to thank the editor, and two anonymous 1. Bohn (1998)
referees for very helpful comments and suggestions, which
helped to improve the overall quality of the paper. We would
also like to thank Vivian Cruz Castañeda for superb research
ABBREVIATIONS
support.
Small: Director, Debt Strategy and Analysis, Economic Man- DGMM: Dynamic Difference Generalized Methods of
agement Division, Ministry of Finance and the Public Ser- Moments
vice, Kingston, Jamaica. Phone 876-932-5444, Fax 876-
FOD: Forward Orthogonal Deviations
922-7097, E-mail orondesmall@yahoo.com
Brown: Assistant Professor of Economics, Department of FRF: Fiscal Reaction Function
Finance and Economics, University of Tennessee at Chat- GDP: Gross Domestic Product
tanooga, Chattanooga, TN 37403. Phone 423-425-4154, GMM: Generalized Methods of Moments
Fax 423-425-5255, E-mail leanora-brown@utc.edu GNI: Gross National Income
Canavire-Bacarreza: Senior Economist, Inter-American HIPC: Highly Indebted Poor Countries
Development Bank, Washington, DC. Phone 240-942- IMF: International Monetary Fund
8236, Fax 202-623-3096, E-mail gcanavire@gmail.com
ODA: Official Development Assistance

155
Contemporary Economic Policy (ISSN 1465-7287)
Vol. 38, No. 1, January 2020, 155–165 doi:10.1111/coep.12432
Online Early publication April 25, 2019 © 2019 Western Economic Association International
156 CONTEMPORARY ECONOMIC POLICY
and Savastano (2003) highlight the “debt intol-
erance” that characterizes many developing
countries, which heightens sensitivity on the part
of creditors who may in turn limit access to credit
markets. In the extreme case, effective marginal
interest rates on debt can become infinite and
countries can essentially be shut out of the credit
market altogether (Flood and Marion 2006;
Ghosh et al. 2011). Access to credit markets
is therefore an important determinant of fiscal
policy in developing countries.2 This argument
is supported by Alberola and Montero (2006)
who posit that public debt sustainability accounts
for the whole procyclical fiscal policy in Latin
America. This might therefore explain similar
results for developing countries in general.
This paper seeks to estimate the FRF for a
panel of developing countries. It contributes to
the literature in a number of significant ways.
First, whereas most studies examine the response
of primary balance to changes in the debt ratio,
we extend the analysis to examine the response
of countries “fiscal effort,” defined here as total
consolidated central government tax revenues
less non-interest expenditures. Relative to the
primary balance, “fiscal effort” does not include
grants or other non-tax revenues, and arguably
captures a fiscal measure that is more closely
linked to government’s fiscal policy discretion.
Second we dichotomize the FRF into the general
revenue, tax revenue, and primary spending com-
ponents, and examine each separately. Whereas
several studies examine the FRF, very few have
examined the reaction of these separate compo-
nents and none have performed so for developing
countries. This is an important contribution
as it provides a test of how the different sides
of the budget are able to adjust in response to
changes in public debt. Moreover, the estimated
elasticities with respect to the debt-to-GDP
ratio can be used to inform appropriate fiscal
policy adjustments for the countries examined.
Third, we test for nonlinearities in the fiscal
policy response components, conditional on
the level of debt, and examine heterogeneous
responses across low/lower-middle-income and
high/upper-middle-income countries.
The results indicate a positive response
in the primary balance and “fiscal effort” to
changes in debt-to-GDP. In general, countries
2. Lukkezen and Roja-Romagosa (2012) show that
greater uncertainty in developing countries results in lower
tolerance on the part of creditors which in turn forces these
countries to respond much more strongly to stabilize debt.
in the full sample appear to adjust along both
the revenue and expenditure margins. We find
some evidence of nonlinearities in the fiscal
response—countries make larger adjustments
in the primary balance and “fiscal effort” at
relatively higher levels of debt. Interestingly,
fiscal adjustments at higher debt levels are
driven largely by increases in revenues. We
find that low/lower-middle and high/upper-
middle-income countries have been fiscally
responsible—with a generally positive FRF.
However, compared to low/lower-middle-income
countries, high/upper-middle-income countries
demonstrate a strong propensity to adjust along
both the revenue and expenditure margins.
The paper proceeds as follows. Section II
provides a discussion of the literature. A descrip-
tion of the data and our empirical strategy is
presented in Sections III and IV, respectively.
The results are discussed in Section V. Section
VI summarizes the findings and concludes with
some policy implications.
II. LITERATURE REVIEW
Much of the recent discussion in the liter-
ature on fiscal sustainability begins with Bohn
(1998) who examined the fiscal response to debt
for the United States using time series methods.
He finds that after controlling for volatility in
output and government spending (due largely to
wartime spending), the primary balance in the
United States bore a consistently positive rela-
tionship with the debt to-GDP-ratio. However,
Bohn’s work was focused on the United States
and so the question of how other governments
react to debt remained largely unexplored. Sub-
sequently, several studies have applied Bohn’s
framework to examine the FRF in other coun-
tries. Lukkezen and Roja-Romagosa (2012), for
instance, utilized a similar methodology to exam-
ine the fiscal response to debt for seven Organiza-
tion for Economic Cooperation and Development
countries. The results differ across the different
economies studied, with some showing a positive
response of the primary surplus to increases in the
lagged debt-to-GDP ratio while others struggle
to make the necessary adjustments to fiscal sol-
vency. A similar result was found by Mahmood,
Arby, and Sherazi (2014) for South Asian Asso-
ciation for Regional Cooperation countries, viz,
Pakistan, India, Sri Lanka, and Bangladesh.
Other studies approach this question using
panel data methods. Celasun, Debrun, and Ostry
(2007) examined the fiscal response for 34
 SMALL, BROWN & CANAVIRE-BACARREZA: FISCAL RESPONSE AND DEBT
emerging market economies over the period
1990–2004 using limited information maximum
likelihood and system generalized methods of
moments (GMM) models. They find a positive
relationship between primary balance and the
lagged debt-to-GDP ratio. Similar results were
also found in studies conducted by Mendoza and
Ostry (2008), Afonso and Hauptmeier (2009),
Ghosh et al. (2011), and D’Erasmo, Mendoza,
and Zhang (2015). While Krogstrup (2002)
also finds a similar result for a panel of EU
countries, this study extended the analysis fur-
ther to estimate adjustments along both the tax
and spending margins. She finds that countries
respond along both the tax and spending margins,
with slightly larger adjustments for the latter. She
also finds that debt servicing in the context of
high capital mobility does not affect countries’
response along the tax margin but that countries
respond by significantly reducing spending.
These results highlight some interesting patterns
in fiscal policy response for the EU. First, coun-
tries respond along both the tax and spending
margins and second, there is a tendency for larger
responses along the spending margin, particu-
larly when there is tax competition. Likewise,
Reicher (2013) estimates the reaction of different
categories of government spending, taxes, and
transfers to debt-to-GDP for a panel of 20 indus-
trial countries. In contrast to Krogstrup (2002),
he finds that in general, the countries studied
increase their primary balance in response to debt
and that much of this increase comes through
higher taxation with much smaller adjustments
in government spending.3
Another interesting aspect to the fiscal sustain-
ability issue is whether a threshold level of the
debt-to-GDP ratio is achieved before any adjust-
ment is made to the primary balance (including
revenue and spending margins), and if yes, what
is that threshold level? Some studies attempt to
investigate this issue and unsurprisingly find evi-
dence of a nonlinear relationship between the
primary balance and debt-to GDP ratio. Ghosh
et al. (2011) report nonlinearities in the relation-
ship between debt and the primary balance for
a panel of advanced economies. In particular,
they find that the response of the primary bal-
ance starts to decline at debt-to-GDP of about
90%–100% and turns negative as it approaches
150%. This finding is counter to Bohn (1998,
3. Estimates for individual tax measures studied (labor
tax rate, capital tax rate, and tax as a share of GDP) were all
positive but in general were imprecisely estimated.
157
2008) who found stronger responses at higher
levels of debt for the United States. Likewise,
Lukkezen and Roja-Romagosa (2012) also find
nonlinearities in the relationship between the pri-
mary balance and debt-to-GDP going in both
directions. The United Kingdom and the Nether-
lands respond more strongly—they increase their
primary balance by more at higher levels of debt.
However, Spain, Portugal, and Iceland struggle to
make the necessary adjustments, and primary bal-
ance actually declines at relatively high levels of
debt. Mendoza and Ostry (2008) also attempted
to establish a threshold effect using two coun-
try groups—Industrial Countries and Emerging
Economies. However, tests for nonlinearities did
not yield significant results for the former group
of countries, but in the latter case, there was evi-
dence of a weakened response when debt-to-GDP
exceeded 50%.4 Afonso and Hauptmeier (2009)
accounting for the effects of fiscal rules and
level of government decentralization also report
smaller response magnitudes when the debt ratio
is greater than 80% for a panel of EU countries.
This compares to the 50% threshold identified
for emerging market economies by Mendoza and
Ostry (2008). Interestingly, they also examine the
response of the primary spending component of
the primary balance and find no significant effect.
This result suggests that the EU countries studied
respond largely through the revenue margin.5
In work closely related to our paper, Mah-
davi (2014) examines the response of taxes and
spending to debt-to-GDP for a panel of American
State Governments. He finds evidence in support
of fiscal sustainability. He also finds asymmet-
ric adjustment with respect to the level of debt,
with larger revenue burden on taxpayers relative
to spending cuts. Finally, the magnitude of the
response is larger in states with a higher degree
of fiscal stringency in general and “own-revenue”
and “no-deficit carryover” provisions in particu-
lar. Again, these results highlight interesting pat-
terns in fiscal policy even for contiguous states.
In sum, the existing literature places inordi-
nate focus on examining the fiscal response
among industrial countries and countries
within the EU. Very few studies go beyond the
4. One test they did was to split the sample into high
and low debt countries and run separate regressions and
compared the estimated coefficients. They found that for
highly indebted EM countries the coefficient on the debt/GDP
was not statistically significant.
5. They find that the existence of fiscal rules and public
spending decentralization has a positive effect on the primary
balance.
158 CONTEMPORARY ECONOMIC POLICY

TABLE 1
Summary Statistics
Variables Mean SD Min Max
Primary balance 0.0295 0.0330 −0.131 0.181
Fiscal effort −0.0437 0.0602 −0.271 0.0834
Central govt. revenue 0.236 0.0798 0.0771 0.571
Central govt. tax revenue 0.163 0.0503 0.0484 0.318
Central govt. primary spending 0.207 0.0830 0.0497 0.483
Lag general govt. debt/GDP 0.498 0.298 −0.0562 2.896
Output gap −0.0027 0.0479 −0.462 0.253
Expenditure gap −0.0026 0.534 −4.838 5.840
Inflation rate 0.511 4.950 −0.0599 154.4
Openness 0.780 0.358 0.107 2.204
Agriculture share in GDP 0.141 0.103 0.0114 0.660
Income tax/total revenue 0.309 0.132 0.000 0.850
IMF or fiscal rule 0.257 0.437 0.000 1.000
Government effectiveness −0.0675 0.562 −1.293 1.388
Net ODA share in GDP 0.227 0.850 −0.0490 8.173

conventional approach and actually disaggregate
the fiscal response to better understand the
anatomy of debt consolidation within these
countries. This research attempts to fill this gap
by examining the response of the primary bal-
ance and its structural components, for a sample
of developing countries.
III. DATA
We used an unbalanced panel dataset cov-
ering 53 developing countries for the period
1990–2017 for which data were available to
examine their fiscal response to debt-to-GDP
ratio.6
The fiscal variables used in this research are
from the international monetary fund (IMF)
government finance statistics and we use data
for the consolidated central government. The use
of consolidated data reduces the likelihood of
double counting of fiscal aggregates across the
various levels of government within countries. It
also mitigates potential comparability problems
across countries with different governmental
structures. The choice of the level of govern-
mental aggregation is informed largely by data
availability. In developing countries, fiscal report-
ing at the subnational level is generally weak,
and so, much of the available data are for central
government operations. Additionally, because
major fiscal policy changes are enacted at the
central government level in most developing
6. See Table S1 in Appendix S1 for a list of the countries
used in this paper. The number of countries reduces to 44
for some regressions since all the control variables are not
available for the whole panel.
countries we feel that the choice of the level
aggregation is further justified.7 Table 1 presents
summary statistics for the variables used.
For the dependent variables, we examine five
measures of fiscal response—primary balance,
“fiscal effort,” general revenues, tax revenues,
and primary spending. Essentially this amounts
to decomposing the primary balance and “fiscal
effort” and examining the response of each com-
ponent. All outcomes examined are expressed as
a share of GDP.
The primary variable of interest is the lagged
debt-to-GDP ratio and is taken from the IMF
historical public debt database.8 Figure S1 in
Appendix S1, Supporting Information, shows
the trend in general government average debt
ratios for the countries in the full sample as well
as our subsamples—low/lower-middle-income
countries and high/upper-middle-income coun-
tries over the period. The debt-to-GDP ratio
for the full sample and the sub-groups showed
marked reductions. Figures S2–S4 in Appendix
7. Devarajan, Swaroop, and Zou (1996) examine the
effect of government spending on growth using a subset of
countries with both general and central government fiscal data
and found similar results. This suggests that the level of aggre-
gation may not significantly affect our results.
8. Data on debt-to-GDP were compiled by Abbas et al.
(2010) and measures general government debt-to-GDP. The
general government sector includes all government units and
all non-market nonprofit institutions that are controlled and
mainly financed by government units, containing central and
local governments. It does not include public corporations
or quasi-corporations. While the data series aimed to capture
general government debt, the lack of public debt data at this
level in many countries meant that central government debt
data were used in these instances. For more details, see Abbas
et al. (2010).
 SMALL, BROWN & CANAVIRE-BACARREZA: FISCAL RESPONSE AND DEBT
S1 present scatter plots of the various fiscal out-
comes against debt-to-GDP for the full sam-
ple, low/lower-middle and high/upper-middle-
income countries, respectively. The plots show
a generally positive correlation between the pri-
mary balance and fiscal effort with lagged debt-
to-GDP for all country groupings. The plots
also highlight relatively stronger responses for
general revenues and tax revenues for upper-
middle-income compared to low/lower-middle-
income countries; and low/lower-middle income
countries show a slightly negative relationship
between primary spending and debt. These rela-
tionships are subject to more formal empirical
examination below.
The controls include a measure for the output
and expenditure gaps, inflation rate, trade open-
ness, share of agriculture in GDP, share of income
tax in total tax revenue, a measure of institutional
democracy (Polity IV), and net official devel-
opment assistance (ODA) as a share of gross
national income (GNI).9 Also included is an indi-
cator variable for whether the country had a fiscal
rule and one if there was an existing IMF agree-
ment.10 A description of all the variables used
along with their sources is presented in Table S2
in Appendix S1.
IV. EMPIRICAL STRATEGY
The basic estimating equation for identifying
the impact of the lagged debt-to-GDP ratio on
several different fiscal measures can be written
as:
(1) yi,t = β0 + β1 gt + β2 et + β3 debti,t−1
+ x′it β4 + τi + εi,t
where i indexes the countries in the panel, t
the time period and τi captures the unobserved
country specific effects. The dependent variable,
yi,t captures the government’s fiscal response and
is measured along the various margins outlined
above. The independent variable of interest is the
lagged debt-to-GDP ratio(debti,t − 1 ). Following
the empirical literature et and gt are measures
of the government expenditure gap and the real
9. The net ODA captures official aid flows and do not
include for example debt forgiveness that is often extended
to highly indebted poor countries (HIPC). It therefore serves
as lower bound of development financing/budgetary support
that some countries may be able to access.
10. Following Bohn’s (1998) theoretical framework
along with more recent studies on FRF, we include measure
of the cyclical changes in output, the expenditure gap, democ-
racy to name a few.
159
output gap respectively. The other controls used
are included in xit .
We also test for possible nonlinearities in
the relationship between lagged debt-to-GDP
and each fiscal response outcome. We do this
first by fitting a quadratic specification of the
baseline model. Additionally, we consider an
alternative specification of the baseline model in
Equation (1) and estimate linear spline regres-
sions given by Equation (2). This is useful
since nonlinearity may not follow a U shape or
inverse U shape, but could instead demonstrate a
monotonic relationship.
(2)
yi,t = β0 + β1 gt + β2 et + β3 xit′
( )
+ β4 debt∗i,t−1 I debti,t−1 ≤ D
( )
+ β5 debt∗i,t−1 I debti,t−1 > D + τi + εi.,t
where D is some debt threshold and I (·) is an
indicator variable that takes the value of one if the
lagged value of the debt ratio is greater than the
chosen threshold and zero otherwise. Therefore,
Equation (2) allows for one effect for debt ratios
less than the specified threshold (D) and another
effect when debt is greater than the D.
Furthermore, the contemporaneous fiscal
response may depend on the previous year’s
fiscal balance(s) and thus implies the need for
dynamism. The incorporation of dynamism
allows Equation (2) to be rewritten as follows
and estimated using a dynamic GMM-estimator:
(3)
Δyi,t = γ1 Δyi,t−1 + γ2 Δgt + γ3 Δet
( )
+ γ4 Δx′it + γ5 Δdebt∗i,t−1 I debti,t−1 ≤ D
( )
+ γ6 Δdebt∗i,t−1 I debti,t−1 > D + Δεit .
Estimation of Equation (3) must also take into
account possible endogeneity of key independent
variables. In particular, lagged debt-to-GDP may
be correlated with in the idiosyncratic error term,
εi,t . As highlighted by Celasun, Debrun, and
Ostry (2007) a country’s debt is an accumulation
of previous deficits, if there are unobserved
factors that cause it to generate large primary
surpluses—relatively low levels of debt—this
will downward bias the estimated coefficient
on the debt ratio. A second potential source of
endogeneity comes from the persistence of pol-
icy shocks. For example, a fiscal policy shock in
the previous period that is persistent—implying
that εi,t − 1 and εi,t are serially correlated—will
160 CONTEMPORARY ECONOMIC POLICY

TABLE 2
Results of Fiscal Response to the Debt-to-GDP Ratio
Primary Fiscal Total Tax Primary
Dependent Variables Balance Effort Revenue Revenue Spending
Debt/GDP lagged 0.0421*** 0.0422*** 0.0213** 0.0119* −0.0182*
(0.0084) (0.0115) (0.0096) (0.0068) (0.0106)
Output gap 0.0788*** 0.1032*** 0.0308 0.0452*** −0.0203
(0.0256) (0.0397) (0.0216) (0.0145) (0.0253)
Expenditure gap −0.0057 −0.0132*** 0.0112*** 0.0058*** 0.0154***
(0.0042) (0.0033) (0.0035) (0.0022) (0.0029)
Inflation 0.0007*** −0.0006** 0.0001 −0.0010** −0.0002
(0.0002) (0.0002) (0.0005) (0.0004) (0.0006)
Trade openness 0.0137 0.0127 0.0175* 0.0234*** 0.0010
(0.0102) (0.0143) (0.0100) (0.0075) (0.0097)
Agriculture/GDP 0.0402 0.1177** −0.0838** −0.0182 −0.0951**
(0.0419) (0.0485) (0.0400) (0.0225) (0.0394)
Income tax/tax revenues −0.0272 0.0357 −0.0451 0.0112 −0.0185
(0.0167) (0.0255) (0.0304) (0.0160) (0.0268)
Polity −0.0010*** −0.0005 −0.0004* −0.0001 0.0002
(0.0003) (0.0004) (0.0003) (0.0003) (0.0002)
Primary balance lagged 0.6159***
(0.0740)
Fiscal effort lagged 0.6235***
(0.0908)
Total revenue lagged 0.8128***
(0.1218)
Tax revenue lagged 0.6600***
(0.1270)
Primary spending lagged 0.8284***
(0.0721)
Observations 624 624 648 647 624
No. of countries 44 44 44 44 44
AR(2) p value 0.129 0.209 0.802 0.243 0.090
Hansen J p value 0.584 0.121 0.035 0.258 0.063

Note: Dependent variables are expressed as a share of GDP. Results are for DGMM regressions using FOD (Arellano and
Bover 1995). To minimize the problem of instrument proliferation, GMM instruments are constructed using up to six lags of the
potentially endogenous variables. Arellano-Bond AR (2) diagnostic tests suggest no second order serial correlation in the errors.
Hansen J (p value) suggests that our instruments are valid. Robust standard errors in parentheses.
*p < 0.10, **p < 0.05, ***p < 0.01.

render the estimates inconsistent since we know
that debti,t − 1 is correlated with that initial shock.
To mitigate concerns regarding the possible
endogeneity of lagged debt-to-GDP and other
key covariates we adopt a dynamic difference
generalized methods of moments (DGMM)
model with forward orthogonal deviation (FOD)
(Arellano and Bover 1995).11 The DGMM
has several features that make it particularly
useful in our context. First, it works well for
panels with a short time dimension—small (T)
and a relatively large number of panel units
(N).12 Second, DGMM transforms the data by
11. FOD minimizes data loss in unbalanced panels; and
since lagged observations are not used in the transformation
they are valid instruments.
12. Celasun and Kang (2006) advance that if T is rela-
tively large (7–8) then the number of instruments generated
subtracting the average of all available future
observations from their contemporaneous val-
ues to purge the fixed effects. Relative to first
difference transformations, this approach min-
imizes data loss for unbalance panels. Third, it
uses internal instruments generated from lags of
the endogenous variables themselves.
V. RESULTS
A. Results for the Full Sample
Table 2 presents baseline results for the pri-
mary balance, fiscal effort, total revenue, tax
revenues, and primary spending. Our coefficient
will be huge if unrestricted and can weaken the Sargan and
Hansen J tests of instrument validity.
 SMALL, BROWN & CANAVIRE-BACARREZA: FISCAL RESPONSE AND DEBT
estimates suggest that a 1 percentage point
increase in lagged debt-to-GDP is associated
with an approximate 0.04 percentage point
increase in both the primary balance and fiscal
effort. In general, these results are indicative
of responsible fiscal policy for the sampled
countries. The response of the primary balance
and the fiscal effort, however, do not tell us the
margins along which fiscal policy adjustments
are made—whether countries tend to rely more
heavily on revenue increases or spending cuts,
or both. Columns 3–5 in Table 2 decompose the
fiscal response into the revenue and spending
components. Both revenue outcomes have a pos-
itive and statistically significant relationship with
lagged debt-to-GDP, though the impact on tax
revenues appears to be weak. A percentage point
increase in lagged debt-to-GDP is associated
with an increase of 0.021 percentage points in
total revenues. This compares to the results for
tax revenues, with a slightly smaller coefficient
estimate of 0.012 percentage points. Results
for primary spending indicate a negative and
statistically significant relationship in the order
of 0.018 percentage points.
These findings suggest that countries adjust
along both the revenue and expenditure margins.
Baldacci, Gupta, and Mulas-Granados (2015)
rationalize these findings, arguing that fiscal
adjustments along both tax and spending margins
when debt is high and credit constraints are about
binding can be more favorable for economic
growth post consolidation. This is plausible if
individuals have diminishing marginal utility
in net private income and public spending as
spreading the adjustments across the tax and
expenditure margin can minimize welfare loss.
For the controls, the estimated coefficient for
the output gap is positive and statistically sig-
nificant in the primary balance and fiscal effort
regressions. Additionally, it bears a positive cor-
relation with tax revenues. This provides sugges-
tive evidence of countercyclical fiscal policy in
the sampled countries, which is counter to previ-
ous literature that finds generally procyclical fis-
cal reactions in developing countries.13 Inflation
is positively correlated with the primary balance,
but negatively correlated with fiscal effort and tax
revenues. However, the point estimates are small
and suggests relatively weak economic impacts.
13. Celasun, Debrun, and Ostry (2007) point out that this
result should be interpreted with caution as it may be driven by
deteriorating fiscal outturns which are a natural consequence
of economic slowdowns and recessions.
161
Trade openness is not found to significantly
affect the primary balance, fiscal effort, or pri-
mary spending, but is positively correlated with
revenues, and particularly tax revenues. The coef-
ficient for governance takes the predicted sign.
B. Nonlinear Fiscal Reaction
We also test for potential nonlinearities in the
fiscal response and report our results in Table 3.
We do this first by fitting a quadratic regression
of the baseline model and second by estimating a
spline regression with knot at a debt-to-GDP ratio
of 90%. Results from the spline regressions high-
light nonlinearities in the fiscal response for the
countries examined.14 Overall, we find that coun-
tries respond more strongly through increases in
their primary balance, fiscal effort and revenues
and decreases in primary spending when debt-to-
GDP is above 90% compared with below 90%.
Wald tests reject the null hypothesis of equal
slopes on either side of the knot for all fiscal out-
comes except the fiscal effort.
The nonlinearities are more pronounced for
revenue outcomes, suggesting that countries tend
to delay tax increased until debt is above some
threshold. The decision to delay tax increases
until absolutely necessary might stem from the
political unpopularity of tax increases in devel-
oping countries. There are also economic effi-
ciency arguments that highlight the distortionary
impact of tax increases (Alesina and Ardanga
2010; Krogstrup 2002). Further, distributional
issues associated with tax increases in developing
countries may also influence the fiscal response
dynamics. For example, Peralta, Tavares, and
Tam (2016) suggest that increasing the value
14. For robustness, in addition to the split regression, we
perform a more restrictive threshold regression estimation
(Hansen 1999) in a smaller balanced sample. The method
requires a balanced dataset which restricts the power of the
estimates but allows identifying more than one threshold
(inflection points) for the five models. This is carried out using
a sample-splitting framework which follows an objective
strategy for identifying and testing changes in this slope. We
find that the test for a single threshold F1 is highly significant
with a bootstrap p value of 0.000 in all models, and the test
for a double threshold F2 is also slightly significant. The test
for a third threshold F3 is not statistically significant. We
conclude that there is evidence that there is a threshold in the
regression relationship and potential second threshold. The
point estimates suggest that Debt/GDP lagged is positively
related with primary balance, in the case of countries with
very low level of debt/GDP, the effect is positive but less,
and countries with higher level of Debt/GDP has the biggest
effect on primary balance. Thus, we confirm the existence of
an inflection point as presented in the split regression (see
Figures S8–S9 in Appendix S1)
 162

TABLE 3
Results for Nonlinear Fiscal Response
Primary Balance Fiscal Effort Total Revenue Tax Revenue Primary Spending
Dependent Variables Quadratic Spline 90% Quadratic Spline 90% Quadratic Spline 90% Quadratic Spline 90% Quadratic Spline 90%
Lagged dependent variable 0.6039*** 0.653*** 1.0731*** 1.141*** 0.9505*** 0.8989*** 0.6846*** 0.7301*** 0.8499*** 0.8707***
(0.1095) (0.0773) (0.3229) (0.363) (0.2146) (0.1242) (0.1502) (0.1340) (0.0834) (0.0776)
Debt/GDP lagged −0.0395 −0.1041 −0.0847 −0.0225 0.0732
(0.0475) (0.1387) (0.0841) (0.0306) (0.0642)
(Debt/GDP)2 lagged 0.0286* 0.0497 0.0406 0.0196 −0.0357
(0.0155) (0.0389) (0.0283) (0.0129) (0.0239)
Output gap 0.0788* 0.0634*** 0.0012 −0.0123 0.0098 0.0110 0.0281 0.0310*** −0.0045 −0.00385
(0.0422) (0.0218) (0.0725) (0.0902) (0.0266) (0.0230) (0.0200) (0.0117) (0.0278) (0.0234)
Expenditure gap −0.0109* −0.00692* −0.0210** −0.0199*** 0.0040 0.00820** 0.0058 0.00379 0.0194*** 0.0160***
(0.0056) (0.00375) (0.0086) (0.00713) (0.0095) (0.00351) (0.0036) (0.00251) (0.0053) (0.00248)
Inflation 0.0016 0.000897*** −0.0023 −0.00230** 0.0008 0.000414 −0.0012 −0.000627 −0.0007 −0.000356
(0.0013) (0.000227) (0.0020) (0.000894) (0.0010) (0.000615) (0.0009) (0.000484) (0.0012) (0.000627)
Trade openness 0.0268* 0.0167** 0.0103 0.0101 0.0232 0.0183* 0.0204*** 0.0254*** −0.0098 −0.00421
(0.0138) (0.00813) (0.0324) (0.0176) (0.0178) (0.0106) (0.0078) (0.00592) (0.0123) (0.00925)
Agriculture/GDP 0.1174 0.0569 0.2784 0.263*** 0.0271 −0.0210 −0.0117 0.0130 −0.1538* −0.105***
(0.0889) (0.0365) (0.1846) (0.0966) (0.1164) (0.0438) (0.0434) (0.0254) (0.0796) (0.0382)
Income tax/total revenue −0.1914 −0.0350** 0.0325 0.0545 −0.1618 −0.0560** 0.0937 −0.00151 0.0748 −0.00861
(0.1606) (0.0152) (0.3037) (0.0397) (0.2235) (0.0282) (0.0860) (0.0118) (0.1411) (0.0264)
Polity −0.0013** −0.000992*** 0.0005 0.000810 −0.0005* −0.000370** −0.0001 −0.000105 0.0004 0.000183
(0.0006) (0.000292) (0.0009) (0.000939) (0.0003) (0.000183) (0.0004) (0.000202) (0.0004) (0.000225)
Debt/GDP below 90% 0.00862 −0.0789 −0.0314** −0.0252** 0.0204
(0.0214) (0.0893) (0.0152) (0.0108) (0.0228)
Debt/GDP above 90% 0.0667*** 0.0797* 0.0615** 0.0409** −0.0480**
(0.0186) (0.0437) (0.0255) (0.0183) (0.0204)
CONTEMPORARY ECONOMIC POLICY

AR(2) p value 0.244 0.169 0.238 0.142 0.878 0.767 0.871 0.376 0.917 0.944
Hansen J p value 0.289 0.713 0.101 0.210 0.807 0.822 0.243 0.306 0.216 0.289
Wald tests p value 0.0781 0.1789 0.0026 0.0067 0.0509
Observations 624 624 624 624 648 648 647 647 624 624
No. of countries 44 44 44 44 44 44 44 44 44 44

Notes: Dependent variables are expressed as a share of GDP. Results are for DGMM regressions using FOD (Arellano and Bover 1995). To minimize the problem of instrument
proliferation, GMM instruments are constructed using up to six lags of the potentially endogenous variables. Arellano-Bond AR (2) diagnostic tests suggest no second order serial correlation
in the errors. Hansen J (p value) suggests that our instruments are valid. Robust standard errors in parentheses.
*p < 0.10, **p < 0.05, ***p < 0.01.
 SMALL, BROWN & CANAVIRE-BACARREZA: FISCAL RESPONSE AND DEBT
added tax—which is a huge revenue earner for
many developing countries—can be extremely
regressive and can lead to increases in poverty
and inequality in developing countries. To the
extent that these costs are significant, govern-
ments may choose to delay tax increases, opting
instead to cut spending.
C. Heterogeneous Effects Results
We split the sample into high/upper-middle-
income and low/lower-middle-income countries
to examine potential differences in the fiscal
reactions across country groupings.15 Previous
research (Flood and Marion 2006; Reinhart,
Rogoff, and Savastano 2003) advances that rela-
tive to industrial countries, developing countries
face less friendly credit-market access opportu-
nities that may exert significant influence on their
fiscal policy stance. For example, developing
countries may have to place much more weight
on debt stabilizing fiscal policy compared to more
advanced economies. If low-income developing
countries face less favorable credit-market access
opportunities relative to higher income develop-
ing countries, then fiscal policy in the former may
be more sensitive to debt stabilization considera-
tions. However, if there are more severe revenue
mobilization challenges and if it is more diffi-
cult to cut non-debt spending in lower-income
developing countries, then these “fiscal frictions”
might limit their ability to respond to debt.16
Our findings in Table 4 for the high/upper-
middle-income countries showed that lagged
debt-to-GDP is positively correlated with both
the primary balance (0.048) and fiscal effort
(0.039). Additionally, the results indicate that
high/upper-middle-income countries respond to
debt by making significant adjustments in both
total revenue (0.016) and tax revenue (0.012)
and primary spending (−0.025).17 Results
for low/lower-middle-income countries were
insignificant for all fiscal response variables.
15. Ghana, Ethiopia, Honduras, and Suriname are bene-
ficiaries under the HIPC initiative. If debt relief significantly
influences fiscal policy in these countries, then this could
potentially bias the results. Notably however our results are
robust to the exclusion of these countries from the sample.
16. The tax/GDP ratio for low- and lower-middle-income
countries in the sample is roughly 5 percentage points less
than middle-income countries.
17. The Hansen J p values in all the country sub-
sample regressions are inflated due to instrument prolifer-
ation. As a result, we are unable to definitively test the
validity of the instruments for the sub-sample analyses,
particularly in the regressions for low- and lower-middle
countries.
163
These results might suggest greater ability on the
part of high/upper-middle-income countries to
increases revenues and cut spending in response
to growing debt and perhaps an inability on the
part of low/lower-middle income countries to do
the same.
D. Sensitivity Analysis
We test the robustness of the baseline results
using alternative specifications of the regression
model. To do this, we simply add covariates
to the model and experiment with different
combinations of covariates to see if this would
significantly change the coefficient estimates
from the baseline results. We systematically
add the following controls: net ODA/GNI, a
dummy for whether the country had a fiscal
rule, and a dummy for whether the country
had an IMF agreement in place in regressions
for each fiscal outcome. In general, the results
presented in Tables S3–S7 of Appendix S1
suggest that the baseline estimates for our fiscal
indicators are robust to the inclusion of the
additional covariates.
VI. CONCLUSION
This paper examines the fiscal response to debt
for a panel of developing countries—a group
that had previously received scant attention in
the literature. We point out a serious omission
in the literature—by emphasizing the importance
of including countries “fiscal effort” as a key
indicator in debt sustainability analysis. Further,
we decompose key components of the primary
balance and examine the specific margins of
response for the countries in the sample.
We find that, in general, developing coun-
tries are fiscally responsible as evidenced by
the positive and significant response in the pri-
mary balance and “fiscal effort” to changes in
the lagged debt-to-GDP ratio. For the full sam-
ple, we find evidence that countries adjust along
both the revenue and expenditure margins. This
sort of measured adjustment might be indicative
of deliberate policy on the part of governments,
not to engage in asymmetric policy changes that
could impact negatively on overall economic wel-
fare. We also find evidence of nonlinearities, par-
ticularly for the fiscal components, with larger
increases in revenues when debt is relatively high.
The pattern of responses across the various mar-
gins suggests that countries delay tax or general
revenue increases until debt is relatively high.
 164

TABLE 4
Results for the Fiscal Response for Low/Lower-Middle-Income Countries and High- and Upper-Middle-Income Countries
Low/Lower-Middle-Income Countries High/Upper-Middle-Income Countries
Country Grouping: Primary Fiscal Total Tax Primary Primary Fiscal Total Tax Primary
Dependent Variables: Balance Effort Revenue Revenue Spending Balance Effort Revenue Revenue Spending
Debt/GDP lagged 0.0393 0.0096 0.0404 0.0072 −0.0287 0.0483** 0.0394*** 0.0158** 0.0121* −0.0246**
(0.0243) (0.0141) (0.0329) (0.0156) (0.0261) (0.0193) (0.0135) (0.0077) (0.0062) (0.0103)
Output gap 0.0727** 0.0607** 0.0907** 0.0753*** −0.0527 0.0809*** 0.1007* 0.0093 0.0298** −0.0415
(0.0350) (0.0301) (0.0393) (0.0245) (0.0638) (0.0287) (0.0548) (0.0239) (0.0119) (0.0297)
Expenditure gap −0.0486** −0.0524*** −0.0112 0.0040 0.0538 −0.0027 −0.0102*** 0.0111*** 0.0048** 0.0121***
(0.0190) (0.0188) (0.0343) (0.0188) (0.0367) (0.0032) (0.0022) (0.0031) (0.0019) (0.0013)
Inflation −0.0288 0.0033 −0.1070** −0.0616*** −0.0557*** 0.0008** −0.0007*** 0.0003 −0.0007* 0.0001
(0.0184) (0.0144) (0.0462) (0.0193) (0.0211) (0.0003) (0.0002) (0.0003) (0.0004) (0.0006)
Trade openness 0.0366** 0.0163 0.0597 0.0513*** 0.0427* 0.0049 0.0154 −0.0021 0.0141** −0.0103
(0.0167) (0.0185) (0.0410) (0.0129) (0.0253) (0.0190) (0.0172) (0.0094) (0.0058) (0.0124)
Agriculture/GDP 0.0027 0.0736 −0.0166 0.0395 −0.0964 0.1146 0.1552*** −0.1063** −0.0425 −0.1106**
(0.0616) (0.0804) (0.0761) (0.0405) (0.0946) (0.0711) (0.0552) (0.0502) (0.0293) (0.0494)
Income tax/tax revenue −0.0247 0.0176 −0.0021 0.0208 −0.0001 0.0024 0.0285 −0.0566 0.0016 −0.0218
(0.0284) (0.0314) (0.0866) (0.0249) (0.0240) (0.0274) (0.0344) (0.0337) (0.0187) (0.0381)
Polity −0.0010*** −0.0008 −0.0004*** −0.0000 0.0018*** −0.0010* 0.0002 −0.0004* −0.0003 −0.0003
(0.0003) (0.0006) (0.0003) (0.0002) (0.0006) (0.0006) (0.0007) (0.0005) (0.0005) (0.0003)
Primary balance lagged 0.7921*** 0.5303***
(0.0690) (0.1297)
Fiscal effort lagged 0.7318*** 0.6679***
(0.1843) (0.1252)
Total revenue lagged 0.8784 0.8718***
(0.5710) (0.0969)
Tax revenue lagged 0.6398*** 0.7640***
(0.1210) (0.1080)
CONTEMPORARY ECONOMIC POLICY

Primary spending lagged 0.3485** 0.8584***

(0.1450) (0.0635)
Observations 204 204 222 221 204 420 420 426 426 420
AR(2) p value 0.990 0.928 0.734 0.734 0.587 0.116 0.200 0.981 0.702 0.687
Hansen J p value 0.248 0.253 0.149 0.166 0.530 0.271 0.009 0.136 0.706 0.256
No. of countries 17 17 17 17 17 28 28 28 28 28

Note: Dependent variables are expressed as a share of GDP. Results are for DGMM regressions using FOD (Arellano and Bover 1995). To minimize the problem of instrument proliferation,
GMM instruments are constructed using up to six lags of the potentially endogenous variables. Arellano-Bond AR(2) diagnostic tests suggest no second order serial correlation in the errors.
Hansen J (p value) suggests that our instruments are valid. Robust standard errors in parentheses.
*p < 0.10, **p < 0.05, ***p < 0.01.
 SMALL, BROWN & CANAVIRE-BACARREZA: FISCAL RESPONSE AND DEBT
The adjustment decision might reflect developing
countries governments reluctance to raise taxes
either because of its political unpopularity or con-
cerns about the potentially distorting effects tax
increases could have on the economy.
The results for low/lower-middle-income
countries are insignificant suggesting a lack of
fiscal responsibility while high/upper-middle-
income countries have shown evidence of
fiscal responsibility. However, high/upper-
middle-income countries demonstrate a greater
propensity to adjust along the revenue and
tax revenue margins highlighting an impor-
tant difference in the fiscal reaction across the
two groups of countries. The relatively strong
response in general revenues and tax revenues
for high/upper-middle-income countries and
the lack thereof for low/lower-middle-income
countries might be indicative of systemic revenue
mobilization challenges facing the latter. One
obvious implication of this is that these coun-
tries must strengthen their revenue generating
capacity in order to better sustain their debt. This
is particularly true for countries with relatively
high levels of debt.
REFERENCES
Abbas, S. M., N. Belhocine, A. A. ElGanainy, and M. Hor-
ton. “A Historical Public Debt Database.” IMF Work-
ing Paper No. 10/245. International Monetary Fund,
Washington, DC, 2010.
Afonso, A., and S. Hauptmeier. “Fiscal Behavior in the Euro-
pean Union: Rules Fiscal Decentralization and Gov-
ernment Indebtedness.” ECB Working Paper. No 1054.
European Central Bank, 2009.
Alberola, E., and J. M. Montero. “Debt Sustainability and
Procyclical Fiscal Policies in Latin America.” Research
Paper No. WP-0611. Banco de Espana, 2006.
Alesina, A., and S. Ardanga. “Large Changes in Fiscal Pol-
icy: Taxes versus Spending.” NBER Working Paper No.
15438. National Bureau of Economic Research, Cam-
bridge, MA, 2010.
Arellano, M., and O. Bover. “Another Look at the Instrumen-
tal Variable Estimation of Error-Components Models.”
Journal of Econometrics, 68(1), 1995, 29–51.
Baldacci, E., S. Gupta, and C. Mulas-Granados. “Debt Reduc-
tion, Fiscal Adjustment and Growth in Credit Con-
strained Economies.” Journal of Applied Economics,
18(1), 2015, 71–97.
Bohn, H. “The Sustainability of Fiscal Policy in the United
States,” in Sustainability of Public Debt and Deficits,
edited by R. Neck and J. E. Sturum. Cambridge, MA:
MIT Press, 2008, 15–49.
. “The Behavior of US Public Debt and Deficits.”
Quarterly Journal of Economics, 113(3), 1998, 949–63.
165
Celasun, O., and J. S. Kang. “On the Properties of Various
Estimators for Fiscal Reaction Functions.” IMF Work-
ing Paper No. 06/182. International Monetary Fund,
Washington, DC, 2006.
Celasun, O., X. Debrun, and J. D. Ostry. “Primary Surplus
Behavior and Risks to Fiscal Sustainability in Emerging
Market Countries: A ‘Fan Chart’ Approach.” IMF Staff
Papers, 53(3), 2007, 401–25.
D’Erasmo, P., E. G. Mendoza, and J. Zhang. “What Is a
Sustainable Public Debt?” NBER Working Paper No.
21574. National Bureau of Economic Research, Cam-
bridge, MA, 2015.
Devarajan, S., V. Swaroop, and H. Zou. “The Composition of
Public Expenditure and Economic Growth.” Journal of
Monetary Economics, 37(2), 1996, 313–44.
Flood, R., and N. P. Marion. “Getting Shut Out of the
International Capital Markets: It Doesn’t Take Much.”
IMF Working Paper No. 06/144. International Monetary
Fund, Washington, DC, 2006.
Ghosh, A., J. Kim, E. Mendoza, et al. “Fiscal Fatigue,
Fiscal Space and Debt Sustainability in Advanced
Economies.” NBER Working Paper No. 16782.
National Bureau of Economic Research, Cambridge,
MA, 2011.
Hansen, B. E. “Threshold Effects in Non-Dynamic Panels:
Estimation, Testing and Inference.” Journal of Econo-
metrics, 93(2), 1999, 345–68.
Krogstrup, S. “Public Debt Asymmetries: The Effect on Taxes
and Spending in the European Union.” ECB Working
Paper No. 162. European Central Bank, 2002.
Lukkezen, J., and H. Roja-Romagosa. “When Is Debt Sus-
tainable?” CPB Discussion Paper No. 212. CPB Nether-
lands Bureau of Economic Policy Analysis, 2012.
Mahdavi, S. “Bohn’s Test of Fiscal Sustainability of the
American State Governments.” Southern Economic
Journal, 80(4), 2014, 1028–54.
Mahmood, T., M. F. Arby, and H. Sherazi. “Debt Sustain-
ability: A Comparative Analysis of SAARC Countries.”
Pakistan Economic and Social Review, 52(1), 2014,
15–34.
Mendoza, E. G., and J. D. Ostry. “International Evidence
on Fiscal Solvency: Is Fiscal Policy ‘Responsible’?”
Journal of Monetary Economics, 55(6), 2008, 1081–93.
Peralta, A., M. M. Tavares, and X. S. Tam. “The Dis-
tributional Implications of Fiscal Consolidation in
Developing Countries.” 2016. Accessed December 10,
2016. https://editorialexpress.com/cgi-bin/conference/
download.cgi?db_name=CSAE2016&paper_id=655.
Reicher, C. P. “A Set of Estimated Fiscal Rules for a Cross
Section of Countries: Stabilization and Consolidation
through Which Instruments?” Kiel Working Paper No.
1850. Kiel Institute for the World Economy, 2013.
Reinhart, C., K. Rogoff, and M. Savastano. “Debt Intol-
erance.” NBER Working Paper No. 9908. National
Bureau of Economic Research, Cambridge, MA, 2003.
SUPPORTING INFORMATION
Additional supporting information may be found online
in the Supporting Information section at the end of the article.
Appendix S1. List of Countries Used in Analysis; Data
Description and Source and Tables Containing Robustness
Results.