Background

The debt-growth relationship is interesting for many researcher and policymakers. Since we formulate empirical framework used in our study; therefore, we highlight some of the prominent contributions by the researchers. From a theoretical perspective, there is vast literature showing how economic growth gets influence by public debt. Diamond (1965) examined the influence of public debt on long-run equilibrium in growth model. The author came on conclusion that irrespective of financing external or internal debt, the taxes have the same impact on individuals. Greiner (2012) relates a higher public debt ratio with a lower long-run growth rate. However, Greiner (2013) argues that when wage rigidity is assumed, the conclusion is different. Public debt does not affect long-run economic growth or employment, but only the stability of the economy.

Public debt can affect the economic in several ways. Firstly, governments want to reduce the impact of public debt. Therefore, they issue more currency which creates inflations. Secondly, excess public debt may lead to increase the long-term sovereign yields in a nonlinear manner. High long-term return rate will crowd out private investment and reduce productive government investment due to higher capital costs. The situation will hamper the economic growth. Thirdly, public debt has a negative effect on economic growth because it crowd-out domestic investments by reducing personal incomes and raising the distortionary costs of taxation. Checherita Westphal and Rother (2012) conclude that relationship between public debt and economic growth in non-linear. They added

further that negative effect of government debt on growth stands between 70% and 80%.The authors identified several transmitting channels through which public debt affect economic growth. The channels are consisting of Total Factor Productivity (TFP), public investment, and private saving.

 

Moreover, some authors reach opposite conclusions. Puente-Ajovín and Sanso-Navarro (2015) find that when economic growth is slower, then the economic activity affects government debt through automatic stabilizers and the decrease of tax collection. Similarly, Chen (2014) argues that while debt is neutral for the US economy, the debt channels of the US economy are the stock of capital, national saving rates, and real investment. Finally, Sutherland and Hoeller (2012) highlight the transmission channels through which high levels of debt can hamper macroeconomic stability. One channel is to reduce the possibility of a government to respond efficiently to adverse shocks.

Looking at the literature on the debt-growth relationship and debt thresholds, Reinhart, & Rogoff (2010) explore the possibility of a persistent relationship between high gross central government debt levels, economic growth, and inflation. They report the existence of a weak link between low levels of debt and growth. However, when the debt ratio is over 90%, the economies' growth rates are on average, one percent lower than otherwise. Based on a panel data of advanced and developing countries over 38 years, Woo, & Kumar (2010) reach on an important conclusion: an inverse relationship between the initial level of government debt and economic growth rate.