Political incentives often push leaders toward policies that prioritise short-term gains over long-term benefits. This column argues that the decision to raise public debt plays a key role in shaping political incentives around implementing reforms. Beneficial reforms are more likely if sufficient debt can be raised and if enough of the future gains are of private good nature. Furthermore, soft debt limits are preferable over hard limits for efficient reform provision. Empirical evidence on debt capacity, public investment, and transfers from OECD countries is consistent with the theoretical predictions.
Policymakers face a difficult balancing act. On the one hand, there is a clear need to invest in the green transition and reform economies to address long-term challenges like climate change. However, political incentives often push leaders toward policies that prioritise short-term gains over reforms that may incur near-term costs but yield long-term benefits. This raises an important question: How can we reconcile these competing goals to ensure efficient, forward-looking reforms are implemented through the political process?
Since reforms require balancing current costs against future benefits, a key factor is using public debt to distribute costs over time without limiting future room for growth-enhancing reforms. Global debt levels have risen to cope with recent crises, especially in Europe. With high debt, lagging innovation (Fuest et al. 2024), and severe investment needs, Europe faces tensions between reform costs, debt risks, and long-term gains. These dynamics have shaped debates on European fiscal rules (Bénassy-Quéré 2022, Friis et al. 2022, Darvas and Wolff 2022).
A theory of debt and reforms
In a recent paper, we make progress on this question and show that the decision to raise public debt plays a key role in shaping the political incentives around implementing reforms (Boyer et al. 2024). Specifically, we prove that beneficial reforms are more likely to be implemented if sufficient debt can be raised. This is the case if enough of the future gains from a reform are of a private good nature, translating into an overall increase in the future endowment. With public debt, these future resources can be transferred to the present to offset short-term reform costs. Our analysis demonstrates that prudent use of debt can help align political motivations with economically efficient policies that have long-term benefits.
Our approach builds on the framework that emphasises the role of targeted spending to specific voter subsets, i.e. pork-barrel politics, in electoral competition (Lizzeri 1999). Thus, the decision to pursue long-term reforms hinges on the ability to target resources. Our analysis identifies two key determinants of reform implementation: (i) whether the reform generates private goods that allow redistribution or public goods with non-rival, non-excludable benefits, and (ii) the interaction between debt limits and reform incentives. These results provide a new perspective on the trade-off between pork-barrel spending that does not increase aggregate welfare and efficient policies like investing in reforms. If reforms accrue future benefits across electoral cycles, allowing sufficient debt-financed targeted spending may be necessary to incentivise reform investment. Moreover, the higher the public good share of benefits, the more debt-enabled targeted spending is needed.
Public debt facilitates reform implementation by enabling politicians to smooth costs over time. Without debt, politicians can only target current-period resources. This disadvantages reformers who lose part of their targeting capacity by incurring reform costs now. In contrast, with debt, future resources can be used for targeting now, which aids reformers whose advantage lies in the future benefits. Our results show that enabling reformers to compensate for lost current targeting capacity via debt-financed spending is key for implementing reforms through the political process. Specifically, we find that (i) hard and soft debt limits both reduce reform incentives, but (ii) soft limits are preferable to hard limits regarding efficient reform provision.
Empirical regularities: Public investment, debt, targeted transfers
To investigate stylised facts related to our theory, we perform a descriptive analysis of debt, public investment, and targeted transfer trends for OECD countries from 1995-2019. Our theory predicts that for countries with moderate-to-high debt capacity, public investment and targeted transfers are predicted to decline as debt levels rise. This is consistent with our empirical observation in Figure 1 that lower levels of ‘debt capacity’ – measured as the distance between the level of debt in the previous period and the mean level of debt over the whole period – are associated with below-average levels of public investment and targeted spending.
Figure 1 Relationship between debt and reforms
Notes: Figure 1 shows the relationship between the de-meaned levels of (lagged) government debt and two expenditure indicators under consideration – pblic investment as a percentage of GDP (left) and spending on housing and community amenities as a percentage of GDP (right) – across unbalanced panels of OECD countries from 1995 to 2019. The blue line shows a linear fit.
We also investigate the relationship between the type of debt limit and reform implementation. Our theory predicts ‘harder’ types of debt limits decrease the chances of a reform being implemented. Supporting this, our analysis of euro area versus non-euro area OECD countries suggests the tighter debt constraints for euro area members may restrict their reform implementation ability relative to countries with more flexible debt policies. Euro area countries face a 60% limit on domestic debt-to-GDP levels, originally introduced by the Maastricht Treaty in the 1990s and later enshrined by the Stability and Growth Pact. In Figure 2, we examine this supranational debt constraint for euro area members and find a negative relationship between debt capacity and public investment and targeted transfers. Compared to non-euro area states in our sample, euro area countries exhibit lower levels of these policy variables as debt capacity decreases.
Figure 2 Relationship between debt and reforms: Euro area and non-euro area
Notes: Figure 2 shows the relationship between the de-meaned levels of (lagged) government debt and the two expenditure indicators under consideration – public investment as a percentage of GDP (top row) and spending on housing and community amenities as a percentage of GDP (bottom row) – across unbalanced panels of euro area (left column) and non-euro area (right column) OECD countries from 1995 to 2019. The blue line shows a linear fit.
These results provide a cautionary note for the empirical literature analysing reform success factors without considering debt and targeted transfers. While we do not claim identification of causal effects in our analysis, the observed relationships between debt capacity, public investment, and transfers suggest debt plays an enabling role in the political economy of reforms. Abstracting from debt may overlook a key mechanism influencing reform outcomes. The alignment between our model and the descriptive trends points to fruitful avenues for future research on the precise role of debt in incentivising or impeding efficiency-enhancing reforms through the political process.
Perspectives: Getting the right political incentives to raise debt
The combination of tight public budgets and immense financing needs will apply unprecedented pressure on public finances. Creating the right political incentives to pursue long-term investments and reforms is a necessity. This analysis shows that sufficient debt allowance is needed to enable efficiency-enhancing policies. Binding constraints on debt issuance may impede welfare-improving reforms, while judicious debt can align political motivations with growth-enhancing policies. As policymakers navigate competing economic and political objectives, it is important to understand these dynamics.
Source : VOXeu
