Empirical study on the determinants of fiscal vulnerability: evidence for the European Union

The aim of this paper is to study the factors that drive fiscal vulnerability in the European Union countries. For this purpose, we employ a logit model with random effects for a balanced panel comprising of 20 countries and on annual data extracted for 2000-2012. We use as a dependent a dummy variable which takes value of 1 if fiscal policy is assessed as being vulnerable, and 0, otherwise. As explanatories, we use two distinct categories which capture the intrinsic and the exogenous sources of fiscal vulnerability. The results show that higher overall taxation and non-distortionary taxes decrease the likelihood of fiscal policy to be vulnerable, whilst the size of total and of productive government expenditures contribute to an increase in the fiscal vulnerability. Tight fiscal policy has an important contribution to decrease in the fiscal vulnerability. The responsiveness of fiscal policy through discretionary actions also is more likely to reduce fiscal vulnerability than through the automatic response of stabilizers. Improved economic conditions mitigate the risk of one country to become more fiscal vulnerable, whilst large financial sector increase the probability. Tighter control of corruption will lead to a decrease in fiscal vulnerability, while stronger rule of law contributes to growth in fiscal vulnerability.