Debt Reduction, Fiscal Adjustment, and Growth in Credit-Constrained Economies
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

This paper assesses the effects of fiscal consolidations associated with public debt reduction on medium-term output growth during periods of private debt deleveraging. The analysis covers 107 countries and 79 episodes of public debt reduction driven by discretionary fiscal adjustments during 1980–2012. It shows that expenditure-based, front-loaded fiscal adjustments can dampen growth when there are credit supply restrictions. Instead, fiscal adjustments that are gradual and rely on a mix of revenue and expenditure measures can support output expansion, while reducing public debt. In this context, protecting public investment is critical for medium-term growth, as is the implementation of supply-side, productivity-enhancing reforms.

Abstract

This paper assesses the effects of fiscal consolidations associated with public debt reduction on medium-term output growth during periods of private debt deleveraging. The analysis covers 107 countries and 79 episodes of public debt reduction driven by discretionary fiscal adjustments during 1980–2012. It shows that expenditure-based, front-loaded fiscal adjustments can dampen growth when there are credit supply restrictions. Instead, fiscal adjustments that are gradual and rely on a mix of revenue and expenditure measures can support output expansion, while reducing public debt. In this context, protecting public investment is critical for medium-term growth, as is the implementation of supply-side, productivity-enhancing reforms.

Introduction

The recent increase in the ratio of public debt to GDP in advanced economies has been accompanied by the assumption of banking sector liabilities by the public sector following the inception of the global crisis in 2007.2 The average contribution of financial-sector support to gross public debt has been over 10 percent of GDP.3 This has worsened public debt dynamics in some countries, raised market pressure on credit risk spreads, and undermined output recovery. In addition, access to credit by the private sector has been hampered by the deterioration in balance sheets of the banking sector, owing to the accumulation of non-performing assets, funding pressures from credit markets, and poor quality of collateral. As a result, output has been shrinking or growing modestly in advanced economies, while fiscal and financial sector weaknesses remain to be addressed (IMF, 2012a).

Under these conditions, fiscal consolidations have not succeeded in lowering public debt in relation to GDP (IMF, 2012b). Fiscal deficit-reducing measures in the presence of credit restrictions have worsened budget positions without being compensated by a substantial increase in private sector’s activity. As a result, domestic demand, economic activity, and government revenues have declined. The beneficial effect of fiscal adjustment on interest rates (and thus private credit growth) has been limited because of the perceived link between sovereign and financial sector credit risks. Furthermore, monetary policy effectiveness has been limited by impaired financial sector transmission channels.

This paper studies the effects of fiscal adjustment on output growth by focusing on credit conditions that typically follow financial crises. The center of analysis is episodes of public debt reduction arising from discretionary fiscal adjustment. In doing so, the paper departs from the existing literature on the nexus between fiscal adjustment and growth, which typically side-steps the question of whether public debt was ultimately reduced in the process. By focusing on the medium term, the paper complements recent studies on short-term fiscal multipliers (Guajardo, Leigh, and Pescatori, 2011; Corsetti, Meier, and Muller, 2012).

The rest of the paper is organized as follows: Section II covers the literature review, Section III introduces a stylized framework to guide the empirical investigation, and Section IV presents the data and methodology used in the econometric analysis. Results from the empirical analysis are presented in Section V, including some robustness tests, and the final section discusses their key policy implications.

I. What Explains the Link Between Fiscal Adjustment and Growth?

There is little consensus in the literature on the short-term output effects of deficit reduction. This has recently been attributed to the way in which discretionary fiscal policy is measured (Guajardo, Leigh, and Pescatori, 2011). It has been argued that the “traditional” method 4—which identifies discretionary adjustments on the basis of changes in the cyclically-adjusted primary balance (CAPB)—could be biased in favor of supporting expansionary fiscal contractions. Changes in cyclically-adjusted fiscal variables are often influenced by developments that cannot be attributed to changes in economic policy (such as a boom in the stock market that improves tax revenues or other developments that raise private consumption and investment).5 An alternative is to identify episodes of fiscal adjustment on the basis of budget plans and government press releases to highlight true discretionary budget changes.6 Empirical findings tend to differ, depending on the method used to identify consolidation episodes: while some authors (Alesina and Perotti, 1996; Perotti, 1999; Alesina and Ardagna, 2010) find evidence of output growth three years after the end of a deficit-consolidation episode under the “traditional” approach, supporters of the “narrative” approach find that a 1 percent reduction in the fiscal deficit dampens output by 0.75 percent in the next two years (Devries and others, 2011; Guajardo, Leigh, and Pescatori, 2011). In empirical papers with large sample of countries, where budget plans are not easily available, the “traditional” approach based on changes in the CAPB is still the most commonly used.

There is greater consensus in the literature on the medium-term effects of fiscal adjustment on output growth. If deficit cuts succeed in lowering public debt, they reduce uncertainty about debt sustainability and expected tax pressures, thus stimulating private investment and consumption via lower interest rates and higher labor force participation (IMF, 2012a). However, the relationship between public debt and growth is complex: in empirical studies countries with higher levels of public debt tend to experience more subdued growth (Reinhart, Kenneth, and Rogoff, 2010); but low economic growth can increase public debt ratios even when fiscal adjustment is in place (Herndon, Ash, and Pollin, 2013).

The link between fiscal policy and medium-term output growth becomes even more complex when credit market conditions are taken into account. A shortage of credit and impaired financial channels can damage growth, while spillovers of risks from the financial sector to sovereign debt markets can affect debt sustainability. However, studies that deal with the interaction between fiscal policy, financial markets, and output growth are limited. The existing literature can be classified into three groups:

  • Studies that focus on the reaction of financial markets to fiscal policy—most papers show that financial markets value fiscal discipline (Ardagna, 2004; Alesina and Ardagna, 2010; and Cottarelli and Jaramillo, 2012). Interest rates, particularly those on long-term government bonds, fall when fiscal conditions improve and rise in periods of budget deterioration. Stock market prices surge around times of substantial fiscal tightening and plunge in periods of loose fiscal policy.

  • Studies that focus on the effect of financial crises on fiscal conditions—recent empirical analyses have shown that financial crises significantly worsen countries’ fiscal position, both in terms of budget balances and public debt (Reinhart and Rogoff, 2009; Laeven and Valencia, 2008; 2012). In fact, the repair of the banking sector is found to be a precondition for fiscal consolidation to succeed (Barrios and others, 2010).

  • Studies that focus on the interaction between financial crises, fiscal multipliers, and economic growth—Baldacci, Gupta, and Mulas-Granados (2009) show that expansionary fiscal policies are helpful in reducing recessions’ length after a financial crisis, while expenditure-based, fiscal consolidations are more likely to be successful in lowering public debt to sustainable levels. However, this is only partially valid in a post-financial crisis environment (Baldacci, Gupta, and Mulas-Granados, 2010, 2012; IMF, 2012b). Output and consumption multipliers are unusually high during episodes of financial distress (Afonso, Grüner, and Kolerus, 2010; Corsetti, Meier, and Mueller, 2012). The expansionary effects of expenditure-based deficit reductions start to dissipate when large public debt has been accumulated due to financial crises and there is a need for new revenue sources. Expansionary austerity is also more difficult when interest rates are close to the zero-bound and/or when countries cannot devaluate (Cottarelli and Jaramillo, 2012; Baum and others, 2012; Guajardo and others, 2012; IMF, 2012b; Blanchard and Leigh, 2013; IMF, 2013).

In parallel to this literature, the financial crisis and the subsequent accumulation of public debt in advanced economies have motivated research on the factors that help shorten successful public debt reduction episodes (Baldacci, Gupta, and Mulas-Granados, 2010; 2012; Eyraud and Weber, 2013), and on the relative contribution of growth and fiscal policy to reducing debt-to-GDP ratios (Escolano, 2010; Abbas and others, 2013).

The present article builds on these studies and assesses the contribution of fiscal policy to medium-term economic growth in the context of private debt deleveraging and credit constraints, which typically arise after financial crises. The analysis focuses in particular on the fiscal mix that is more likely to lead to better output performance while reducing fiscal imbalances, a key challenge now facing policymakers in many countries.

II. A Stylized Framework of Fiscal Policy and Growth During Financial Crises

This section develops a simple framework to help underpin the econometric model tested in the paper. The framework describes an economy where the government collects taxes and engages in transfers to households who save to accumulate assets and consume out of wealth and income.

In this framework (discussed in detail in Appendix I), an increase in public debt above a risk-free threshold triggers higher interest rates via a non-zero credit risk premium (Laubach, 2009), which reduces output through both lower investment and income.

Higher public debt would also have an indirect (negative) effect on growth via tax rates, which need to rise to meet the budget constraint. In this context, fiscal consolidation can increase growth by reducing equilibrium tax rates and lowering the risk premium on interest rates. This outcome is consistent with the expansionary fiscal contraction case (Alesina and Ardagna, 2010).

If public debt reduction is achieved by increasing taxes, private consumption would fall and the capital stock would decline, reflecting lower savings owing to a fall in disposable income. This, in turn, would reduce labor income and output. When fiscal consolidation relies on the reduction in government current expenditure, output can be affected negatively via lower government consumption and transfers to households. However, when public debt falls, risk premia on interest rates could decline, boosting private investment and stimulating private sector growth.

In a standard Keynesian model, expenditure cuts may be more harmful than tax increases as the fiscal multiplier of the former is higher. In the steady state solution of the model used in this paper, this depends on the propensity to consume, the level of tax rates, and expenditure composition. For example, a reduction in public investment is more harmful to economic growth than a fall in government consumption as it decreases the stock of public capital and lowers productivity. In this Keynesian case, cuts in transfers are less damaging to growth as they impact private consumption only through the share of disposable income that is not saved.

The stylized model also shows that the impact of spending cuts is in general less harmful for economic growth when public debt is moderate and the tax rate is low. When adjustment needs are large and the equilibrium tax rate is high, the growth elasticity of expenditure cuts increases—a result consistent with the empirical findings in Baldacci, Gupta, and Mulas-Granados (2012).

When fiscal consolidation is undertaken in the context of financial sector deleveraging, spending cuts could also lower output via another channel in the model: the interaction of the fiscal adjustment mix with capital accumulation.7 This would call for a more balanced contribution of revenue increases and savings to deficit reduction, compared to the expansionary fiscal contraction approach. A balanced composition of fiscal adjustment in a context of private debt deleveraging is more likely to have a positive impact on medium-term economic growth, in the presence of credit restrictions, by limiting the negative effect of deficit reduction on total investment and capital accumulation available in the economy. The supply side impact of expenditure-based adjustments on medium term growth would be negative if private investment falls as a consequence of budget cuts thus impacting capital accumulation. This is likely to occur in the presence of credit restrictions in the financial sector.8 The next section will test these hypotheses empirically.

III. Data and Methodology

The starting sample used in this paper comprises 160 episodes of public debt reduction in 107 advanced and emerging economies during 1980–2012. The episodes are defined as at least two consecutive years of reduction in the ratio of public debt to GDP.

In principle, the reduction in the debt-to-GDP ratio could stem from a decline in CAPB, a reduction in interest rates, output growth, and other adjustments to the stock of debt (such as privatizations and exchange rate movements). In our subsample, the key factor behind the reduction in the debt ratio was the improvement in CAPB.

We excluded countries that benefitted from debt relief and selected the public debt reduction spells in which a discretionary fiscal adjustment had taken place.9 This yielded a subsample of 79 episodes of public debt reduction through fiscal adjustment, with an average duration of about 3.5 years (Table 1).

Table 1.

Descriptive Statistics

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In percent of total revenues or total expenditures excluding outliers.

The dataset used for the empirical analysis includes three groups of variables: (i) GDP growth and other macroeconomic variables from the IMF’s World Economic Outlook database; (ii) a set of indicators measuring credit restrictions faced by the private sector and bank recapitalization needs from the IMF’s International Financial Statistics;10 and (iii) data on budget composition from the IMF’s Government Finance Statistics.

The average distance of initial public debt from a reference (sustainable) target 11 was 28.6 percentage points of GDP. The average debt reduction during the episodes amounted to 30 percentage points of GDP. In 45 percent of the episodes, the debt ratio was reduced to levels below the sustainable threshold. During the debt reduction episodes, the average increase in CAPB was 3.9 percent of GDP, mostly owing to spending cuts (53 percent of deficit reduction was achieved through cuts in non-productive spending); annual real GDP growth averaged 3 percent in the five years after the end of the debt-reduction episode (Table 1).

A preliminary (bivariate) analysis of the data shows that after debt consolidation spells, economic growth was negatively correlated with the fiscal adjustment size (Figure 1), but positively associated with the adjustment length (Figure 2) and contemporaneous GDP growth (Figure 3). Post-episode economic growth is also weakly associated with the quality of the fiscal adjustment (Figure 4),12 except in the presence of credit constraints (Figure 5) and bank deleveraging (Figure 6).

Figure 1.
Figure 1.

Fiscal Adjustment Size and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.
Figure 2.
Figure 2.

Debt Consolidation Length and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.
Figure 3.
Figure 3.

Average Episode Growth and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.
Figure 4.
Figure 4.

Quality of Adjustment and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.
Figure 5.
Figure 5.

Quality of Adjustment with Credit Constraints and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.
Figure 6.
Figure 6.

Quality of Adjustment with Bank Deleveraging and Average Five-Year Post-Episode Growth

Citation: IMF Working Papers 2013, 238; 10.5089/9781475516500.001.A001

Source: Authors’ own calculations.

The relationship between budgetary composition, fiscal adjustment, and economic growth is estimated by regressing the average real GDP growth five years after the consolidation episode has ended on a set of regressors, including fiscal and financial variables. The specification is consistent with earlier studies on fiscal consolidation and growth during crises (Baldacci, Gupta and Mulas-Granados, 2012). It is also consistent with the result of the illustrative model presented in Section III. The estimation equation is specified as follows.

gi,t=α+Σl=1kβlCONilt+Σh=1qβhADJiht+Σj=1mβjFINijt+δFINitADJit+Σn=1pβnBUDint+uit(1)

where gi,t is the average growth rate of real GDP (five years after the episode of debt consolidation); CONilt is a vector of control variables (initial distance from the “sustainable” debt target;13 average annual GDP growth during the episode);14 ADJiht is a vector of variables that define the fiscal adjustment strategy (duration, size, and quality of the fiscal adjustment(s) during the episode); FINijt is a vector of financial dummy variables (domestic credit growth and bank deleveraging measured by the capital-to loans ratio); and BUDint is a vector of variables that capture the relative composition of the budget (share of direct and indirect tax revenues in total public revenues; share of expenditures on goods and services in total public spending; share of transfers in total public spending, and share of public investment in total public spending).

In order to test the interplay between credit constraints and fiscal adjustment strategies, we include a term that takes into account nonlinear effects. To do so, we focus on the fiscal consolidation mix and calculate its interaction with private sector credit and banking sector lending proclivity.15 We expect that when credit conditions are weak, reflecting a weak financial sector, fiscal adjustments based on spending cuts are less effective than deficit reductions based on a more balanced contribution of revenue measures and expenditure savings.

The budget composition is also expected to have an impact on economic growth: increases in indirect taxes are expected to reduce private consumption, potentially harming growth via lower domestic demand. Public investment is expected to have a greater positive growth impact than public spending on wages and goods and services, via increases in domestic demand and productivity.

The model specifications above are estimated in steps, from the basic model (no interaction term and no budget mix variables) to the augmented versions. Coefficients are estimated using a GLS estimator. Robust estimator results are reported in the next section along with a range of other robustness tests.

IV. Empirical Results

A. General Results

In general, the basic results confirm our expectations. Fiscal adjustments relying on focused public expenditure cuts that preserve public investment contribute positively to medium-term output growth.

During debt reduction episodes, gradually paced fiscal adjustments are positive for output expansion, but large deficit cuts have a contractionary effect. A 1 percent-of-GDP reduction in the cyclically-adjusted fiscal deficit reduces average medium-term growth by 0.27 percentage points. However, one more year in the length of the debt consolidation episode raises average economic growth by 0.22 percentage points in the subsequent five-year period. Initial public debt is not a significant impediment for future growth.16 The fiscal adjustment mix can have an impact on growth: a 1 percent increase in contribution of cuts to fiscal adjustment increases medium-term growth by 0.32 percentage points.

This relationship between the fiscal adjustment mix and growth is, however, affected by financial conditions. The results show that spending-based adjustments support output growth after the debt consolidation episode, except in cases where there is sustained bank deleveraging and tight private sector credit conditions. In both cases, the coefficients of the interacted variables turn negative and are larger than the quality-of-adjustment coefficient. As a result, the potential benefits of expenditure cuts on medium-term growth would be offset under difficult financial conditions.

The shrinkage of banks’ balance sheet in response to capitalization needs makes banks less willing to finance the private sector. In these cases, revenue-based adjustments can be more effective in stimulating growth than expenditure-based adjustments. Similar results hold when private sector credit supply is scarce.

However, adequately paced deficit reductions that help lower public debt to sustainable levels are positive for economic growth both in normal times and in periods of financial sector distress.

Table 2.

Basic Model. Dependent Variable Five-Year Output Growth

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

Goldman Sachs Index on Financial Conditions. Note that this column is not fully comparable with the other as the sample size is slightly different due to data availability.

Results for budget composition variables highlight the importance of the tax and spending mix. An increase in the share of direct taxes in total revenue affects output growth positively, while increasing the share of indirect taxes during the debt consolidation episodes is generally insignificant for output growth thereafter.

Table 3.

Augmented Model. Dependent Variable Five-Year Output Growth

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

The expenditure mix also matters for growth. Higher spending (as a share of total expenditure) on public investment and transfers spurs output growth, while increasing the weight of spending on wages and purchases of goods and services is harmful for output expansion. Protecting public investment during adjustment periods and continuing to provide funds for critical investment in infrastructure is essential for raising productivity and potential output.

B. Robustness Analysis

The results presented in the previous section are significantly different from previous studies on fiscal adjustments and growth (Alesina and Perotti, 1996; Alesina and Ardagna, 2010), mostly because we incorporate in the analysis the effect of credit restrictions on the relationship between fiscal consolidation and economic activity. These results are robust to alternative estimation methods and do not change when the baseline and augmented models are estimated with robust standard errors. Results also hold when potential outliers are dropped and robust regression used. We further estimate the model using random effects and OLS with panel-corrected standard errors and find consistent results; results are confirmed when we change the dependent variable to capture average output growth three years after the episode.17 They also hold when the variable that controls for contemporaneous GDP growth is not included in the baseline model.18

Findings are robust to the choice of alternative subsamples.19 These are built by selecting episodes that have a higher-than-average value of key variables. In general, the main results are confirmed:20

  • High unemployment (Table 4). In this subsample of countries with higher-than-average unemployment, results hold except for the duration variable. Gradual (longer) debt consolidations are less clearly associated with stronger growth performance. This suggests the presence of reform fatigue in countries where social cohesion pressure, as measured by unemployment, is high. Moreover, spending cuts are more harmful for growth in this sample compared to the baseline model, and this negative impact is also valid in the absence of credit constraints.

Table 4.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample High Initial Unemployment Episodes

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • High-tax countries (Table 5). Results are confirmed when we perform the analysis on a subsample of high-tax countries, which includes most advanced economies. Interestingly, in this subsample of countries, starting with a high level of public debt is more harmful for post-episode growth than in the baseline model.

Table 5.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample High-Tax Countries

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • Countries that did not reduce debt (Table 6). In countries that implemented a fiscal adjustment but did not manage to achieve a significant debt reduction (or even increased their debt-to-GDP ratio during the period), the negative impact of expenditure-based adjustments on growth in the presence of credit constraints is weaker than in the baseline model, but still statistically significant.

Table 6.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample Non-major Debt Reductions

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • Post-crisis episodes (Table 7). When focusing on post-crisis debt consolidation episodes, we find stronger results. The negative growth impact of spending cuts in periods of high debt deleveraging and credit crunch is higher than in the baseline model.

Table 7.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample Post-Crisis Episodes

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • High credit constraints (Table 8). Results are confirmed in the subsample of countries in which credit growth was below the sample average. They show that fiscal adjustments that rely excessively on spending cuts when credit restrictions are significant can harm growth. The coefficients of the key variables are larger in this subsample than in the baseline model.

Table 8.

Augmented Model. Dependent Variables Five-Year Output Growth. Sub-sample High Credit Constraint

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • Countries that apply structural reforms (Table 9). We used an expanded version of the index of structural reforms based on Lora (2001),21 and estimated the model for a subsample of countries that implemented structural reforms during the debt consolidation episode. Major results are confirmed. In this case, the composition of fiscal adjustment is less important for post-episode average output growth than in the baseline model, but the growth-enhancing impact of public investment increases (as a share of total spending) is reinforced.

Table 9.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample Structural Reform Episodes

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • Larger sample of debt reduction episodes (Table 10). Finally, we estimated the model using the original sample of 160 episodes of debt reduction. This included countries that received debt relief, and does not differentiate between debt reductions driven by fiscal-adjustments and those caused by other factors (e.g., exchange rate appreciation and privatization). Key results largely hold. In this case, countries with high initial debt benefit from lower growth than in the baseline. The positive contribution of spending-based adjustment is weaker.

Table 10.

Augmented Model. Dependent Variable Five-Year Output Growth. Enlarged Sample of 160 Episodes

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

  • Other specific country characteristics. We ran the model on a subsample of advanced economies, and the major difference with respect to the baseline model is that the negative effect of weak credit conditions on medium term growth is higher than before (Table 11). In addition, when we ran the model on a subsample of open economies, the importance of the quality variable and other fiscal variables is reduced, possibly reflecting the fact that medium-term growth in these economies is more dependent on external conditions and less strongly impacted by domestic fiscal policy (Table 12).

Table 11.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample of Advanced Countries

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.

Table 12.

Augmented Model. Dependent Variable Five-Year Output Growth. Sub-sample of Open Economies

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Significant at 1 percent;

significant at 5 percent;

significant at 10 percent.

In percent of total revenues or total expenditures.