Institutional quality and the fiscal reaction to debt: nonlinear evidence from advanced and emerging market economies

Purpose The purpose of this study is to revisit the dynamic and nonlinear association of institutional quality with debt sustainability in a sample of 75 advanced and emerging market economies through the lens of fiscal reaction function (FRF). Design/methodology/approach In doing so, the study uses a dynamic panel threshold model and decomposes countries as 33 advanced and 42 emerging market economies over the period 2002–2020. Institutional quality is measured using a principal component analysis (PCA) based on the Worldwide Governance Indicators. Findings The results reveal substantial heterogeneity across income groups and institutional regimes. In advanced economies, although the difference in the magnitude of the response differs slightly across regimes, the primary budget balance responds positively to rising public debt across both low and high institutional quality regimes. In emerging market economies, however, a positive and significant response of the primary budget balance to rising debt is only observed at high institutional quality regimes, showing the fragile structure of debt in these countries. Research limitations/implications Overall, the findings suggest that institutional quality is associated with more stabilizing fiscal reactions to public debt, particularly in emerging market economies. They also highlight the importance of strengthening institutional capacity in countries where fiscal sustainability is more vulnerable. Originality/value This study contributes to the fiscal sustainability literature by revisiting the FRF through the role of institutional quality. Unlike most previous studies, it considers the dynamic and nonlinear relationship between institutional quality and fiscal responses to public debt across advanced and emerging market economies. By applying a dynamic panel threshold model and using a composite institutional quality index, the study provides new evidence that stronger institutions are associated with more stabilizing fiscal reactions, particularly in emerging market economies.