Debt burdens and fiscal stimulus: does perceived government effectiveness matter?

This study investigates how government debt affects the output effect of a government spending shock, depending on perceived government effectiveness. Using heterogeneous panel data from 24 OECD economies, it shows that fiscal policy is ineffective in economies with low government effectiveness, regardless of the level of government debt. However, in economies with high government effectiveness, while fiscal policy leads to negative effects on output when government debt is high, its positive effects are more pronounced when government debt is low. It implies that low perceived government effectiveness weakens the effectiveness of fiscal policy through a lack of a government’s commitment in fiscal policy and heightened policy uncertainty. Thus, our findings suggest that, regardless of the level of government debt, a country with low perceived government effectiveness needs to restore public trust by implementing rules-based rather than discretionary fiscal policy to enhance policy effectiveness.