The Institutional and Political Determinants of Fiscal Adjustment

The author empirically assesses the effects of institutional and political factors on the need and willingness of governments to make large fiscal adjustments. In contrast to earlier studies, which consider the role of political economy determinants only during periods of fiscal consolidation, the author expands the field of analysis by examining periods when governments should be making fiscal efforts but fail to do so (or do not try), as well as periods when no adjustment is required. To analyze this greater range of fiscal situations, a multinomial logit framework is applied to a panel of 61 advanced and developing countries, generating a sample size significantly larger than previous work. A key finding is that the political economy factors favouring the maintenance of sensible fiscal policies are different from those that increase the probability of achieving an exceptional adjustment. For instance, the results for developing countries indicate that sound economic institutions help governments avoid dire fiscal situations; however, those countries that actually succeed in making lasting adjustments in the face of a serious need tend to have weak institutions. There is also some evidence that high levels of transfers and subsidies diminish the probability of successful adjustment in developing countries, and that legislative majorities improve the odds. In advanced countries, strong democratic institutions appear to increase the likelihood of avoiding situations of fiscal distress.