Public debt and the limits of fiscal policy to increase economic growth

- We examine how the public debt limits the effects of fiscal policy on growth.
- We propose a model with overlapping generations and endogenous growth.
- The effect of public expenditures on growth is limited by the debt-to-GDP ratio.
- The conclusions of the theoretical model were tested using an econometric model.

This study proposes a theoretical model of endogenous growth that demonstrates that the level of the public debt-to-gross domestic product (GDP) ratio should negatively impact the effect of fiscal policy on growth. This effect occurs because government indebtedness extracts a portion of young people's savings to pay interest on the debts. Therefore, the payment of debt interest requires an allocation exchange system across generations that is similar to a pay-as-you-go pension system, which results in changes in the savings rate of the economy. The major conclusions of the theoretical model were verified using an econometric model that provides evidence of the validity of this conclusion. Our empirical analysis controls for time-invariant, country-specific heterogeneity in growth rates. We also address endogeneity issues and allow for heterogeneity across countries in the model parameters and for cross-sectional dependence.