What the latest research says about government debt and economic growth
We are nearly seven years removed from the 2008-09 recession, and Canada’s federal government along with almost every provincial government expects to run an operating budget deficit this year. And every government will continue to dig deeper into debt, adding more dollars to the total they owe. This is troubling in light of a growing body of research that finds increasing government debt can have important, long-term negative consequences on economic growth.
This post provides a brief overview of the latest research analyzing the negative effect of government debt on economic growth, drawing on four important studies published this year in various prominent research outlets.
But first, it is important to understand that there are many ways in which government debt could adversely impact economic growth. For instance, large and growing government debt can lead to a rise in interest rates, causing capital investment to decline, which translates into weaker productivity and ultimately weaker economic growth. In addition, increased debt can hinder economic performance when governments increase taxes to pay back the debt and cover the interest payments on outstanding debt.
While each of the four studies differ in the methodology employed, period examined, and countries analyzed, all reach a similar overall conclusion: government debt can have a negative impact on long-term economic growth. All studies, however, use gross debt (before adjusting for financial assets) as a percentage of GDP as the measure of government debt.
Let’s begin with a study published in the prestigious journal Economica that examined data for 38 countries (both advanced and emerging economies) from 1970 to 2008 and found that a 10 percentage point increase in the initial level of debt as a percentage of GDP is associated with a reduction in real per capita GDP growth of around 0.2 percentage points.
Another study published in Applied Economics examined data from 20 OECD countries from 1790 to 2009. It found that when central government (i.e. federal government) debt reaches 20 per cent of the economy, a one percent increase in the debt-to-GDP ratio generally comes with a 0.04 percentage point drop in GDP growth (although the author warns that the precise threshold of 20 per cent of GDP should be interpreted cautiously).
A third study published by the International Monetary Fund (IMF) argued that the growth of government debt may have more important consequence for the economy than the level of debt. This is notable given the growth in Canadian government debt since 2007/08, particularly in Ontario where provincial net debt as a share of GDP has increased by 52.9 per cent.
While early research on the effect of government debt suggested that debt is most likely to be economically harmful after reaching a threshold of 90 per cent of GDP, more recent studies find that the actual debt threshold differs from country to country and can be much lower than 90 per cent.
For example, a study published in the Journal of International Economics that analyzed data on 187 countries from 1961 to 2012 found no evidence of a common debt threshold, though it did find evidence that government debt can negatively impact long-term economic growth. Similarly, the IMF study found that debt thresholds for advanced economies ranged from 60 per cent to 80 per cent but the threshold was much lower for developing countries (between 30 per cent and 60 per cent).
As Canadian governments continue to struggle with budget deficits and mounting government debt, it is important to recognize that there are potential long-term negative economic consequences from accumulating debt.