Impacts of Fiscal Policy on Economic Growth: Another Look from Institutional Perspective

What is the role of economic institutions in the effectiveness of fiscal policy? This paper argues that the extent to which fiscal policy affects long-term growth depends on how economically free a country enjoys. We use a sample of 72 countries over the period 1990 through 2015 to provide empirical evidence on the interrelationship between government spending, economic freedom and economic growth. The non-linear effect of fiscal policy on growth is investigated by extending the classical growth regression with an interaction term between fiscal policy and economic freedom. We also conduct a bundle of robustness checks with both cross section and panel data approach. Our study establishes that it is institutional factors that determine the effect of fiscal policy on economic growth. Public investment in infrastructure can enhance long-term growth better in countries with less degree of freedom. Meanwhile, public consumption does not benefit growth but its adverse impact is mitigated if a country is more economically free. We also find that the determining role of institutions in emerging countries is more prominent than that in advanced economies which are pretty homogenous in economic development and have already been at a high level of economic freedom.