Government efficiency, institutions, and the effects of fiscal consolidation on public debt

•We study the effects of 40 fiscal consolidation programs in the OECD, 1981-2008.•We explain directly the observed change of the ratio of public debt to GDP.•Higher public sector efficiency improves consolidation policies and outcomes.•Public wage bill cuts only bring lower debt when government efficiency is low.•Parallel product market deregulation improves consolidation outcomes.

We study the evolution of the ratio of public debt to GDP during 132 fiscal episodes in 21 OECD countries in 1981-2008. Our main focus is on debt dynamics during 40 consolidation periods. To define these periods we use data on the evolution of the underlying cyclically adjusted primary balance, and as such avoid biases that may be induced by one-off budgetary measures. The paper brings new evidence on the role of public sector efficiency for the success of fiscal consolidation. First, we confirm that consolidation programs imply a stronger reduction of the public debt ratio when they rely mainly on spending cuts, except public investment. Government wage bill cuts, however, only contribute to lower public debt ratios when public sector efficiency is low. Second, we find that a given consolidation program will be more effective in bringing down debt when it is adopted by a more efficient government apparatus. Third, more efficient governments adopt consolidation programs of better composition. As to other institutions, consolidation policies are more successful when they are accompanied by product market deregulation, and when they are adopted by left-wing governments. By contrast, simultaneous labor market deregulation may be counterproductive during consolidation periods.