Big Government, High Debt, and Fiscal Adjustment in Small States

IMF Working Papers, February 1, 2008

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Using a new fiscal dataset for small states, the paper analyzes the link between country size, government size, debt, and economic performance.
On average small states have larger governments and higher public debt.
Small states with smaller governments and lower public debt tend to:
- grow faster, and
- be less vulnerable.
Large fiscal adjustments, primarily through expenditure restraint, can underpin growth, although sometimes other elements can also impact.
Better governance is associated with lower debt; therefore, fiscal adjustment should be supported by governance improvements.

The paper identifies intrinsic factors that explain why governments are bigger in small states.
It highlights that expenditure restraint is the primary channel through which large fiscal adjustments have supported growth in some cases.
Governance quality interacts with debt outcomes, implying institutional reforms are complementary to fiscal consolidation.

Prioritize expenditure restraint as the main instrument for large fiscal adjustments to underpin growth.
Combine fiscal adjustment with governance improvements to achieve lower public debt and more sustainable outcomes.
Recognize country-size–specific factors when designing fiscal policy for small states.