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Interpretation and limits of sustainability tests in public finance

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Abstract:

Public debt is considered sustainable if discounted net repayments are expected to cover the initial debt issuance, i.e. if the government’s inter-temporal budget constraint is expected to hold. With risk-averse lenders and an uncertain economic environment, Bohn (1995) stresses that this constraint relies on a stochastic discount factor which depends on lenders’ preferences. To get round the difficulty related to the specification of private agents’ preferences in empirical analysis, Bohn (1998) suggests to estimate fiscal reaction functions describing how primary surplus reacts to indebtedness. After having solved the econometric issues arising when primary surplus and debt have a very different persistence (with a nonparametric approach) or are both integrated (with parametric tests), we estimate fiscal reaction functions for France and Greece. There remain important limitations and interpretation difficulties that are common to all econometric sustainability tests.

Keywords: C12; E62; F34; H60; H62; co-integration; fiscal reaction function; inter-temporal budget constraint; nonparametric tests; unit-roots

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036846.2013.861587

Affiliations: INSEE-CREST, 92240, Malakoff, France

Publication date: February 21, 2014

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