Regulation and Government Debt

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.