Israel Affairs

ISSN: 1353-7121 (Print) 1743-9086 (Online) Journal homepage: http://www.tandfonline.com/loi/fisa20

The impact of public debt on economic growth in

the Israeli economy

Tal Shahor

To cite this article: Tal Shahor (2018) The impact of public debt on economic growth in the Israeli
economy, Israel Affairs, 24:2, 254-264, DOI: 10.1080/13537121.2018.1429547

To link to this article: https://doi.org/10.1080/13537121.2018.1429547

Published online: 06 Feb 2018.

Submit your article to this journal

Article views: 31

View related articles

View Crossmark data

Full Terms & Conditions of access and use can be found at

http://www.tandfonline.com/action/journalInformation?journalCode=fisa20
Israel Affairs, 2018
VOL. 24, NO. 2, 254–264
https://doi.org/10.1080/13537121.2018.1429547

The impact of public debt on economic growth in the

Israeli economy
Tal Shahor
Deptartment of economy and management, Max Stern Academic College of Emek Yezreel,
Emek Yezreel, Israel

ABSTRACT
This article seeks to determine the effect of the amount of public debt on the long-
run economic growth of the Israeli economy, using data from the years 1983–2013.
The accepted economic perspective is that the influence of public debt on the
economy depends on the ratio of the size of the debt to GDP. This article will also
measure the influence of the size of public debt in accordance with this ratio,
with the implication being that the larger the debt, the larger the ratio of debt
to GDP. It will indicate that the relationship between the ratio of public debt to
GDP and economic growth appears graphically as an inverted U shape. Such a
relationship implies that for relatively low levels of debt to GDP ratio there is a
positive effect on growth and only at higher levels of this ratio does the marginal
effect become negative. The article was not able to locate the exact inflection
point at which the influence becomes negative, but it can be determined that
this point lies within the range of a debt to GDP ratio of 130% and greater. These
results are contrary to other results which have shown that the negative influence
begins at a ratio of 90%.

KEYWORDS  Public debt; growth; GDP; Israel; inverted U shape

According to accepted economic theory, large amounts of public debt have a

negative effect on the economy. One of the explanations for this effect is the fact
that large amounts of public debt can cause inflation, with all of the implications
thereof. However, in recent years we are witness to many situations in which
large amounts of public debt in certain countries has not led to inflation. In
such situations there is a benefit to discovering additional ways in which large
amounts of public debt can endanger economic growth.
One possible way in which economic growth might be hindered can be
found in Panizza and Presbitero. Their explanation is based on the assumption
that government expenditures are fixed and the change in debt is caused by
changes in taxation (whereby taxes are less and therefore the debt must increase
to cover the shortfall). Another assumption is that Ricardian equivalence does

CONTACT  Tal Shahor  [email protected]

© 2018 Informa UK Limited, trading as Taylor & Francis Group
 ISRAEL AFFAIRS   255

Figure 1. The relationship between the ratio of debt to GDP and growth (estimated).

not hold true. Under these conditions, it is possible that in the short run an
increase in public debt will result in an increase in GDP (especially if produc-
tion levels are less than full capacity). However in the long run the situation is
different. The increase in private savings as a result of the fall in taxes does not
match the decrease in government savings (since consumers do not display
Ricardian equivalent behaviour). Therefore, the savings in the economy are
lower and investment is lower. A fall in investment decreases the amount of
capital, interest rates rise, and worker productivity falls (since less capital is
spread over the same number of workers). In addition, large amounts of public
debt create expectations of inflation in the short run. Already, this expectation
of inflation disrupts the economy by increasing uncertainty, which disrupts
economic activity and hampers growth. As a result, the damage to economic
growth can already occur in the short run. It is important to point out that
during an economic crisis, even if it is expected to be only a short-run phe-
nomenon, there exist long-run effects that can dampen workers’ motivation,
cause firms to fire employees, and result in damage to the ‘organisational capital’
of firms.1
Another factor whereby large amounts of public debt can hurt economic
growth stems from the potentially negative impact large amounts of public debt
can have on foreign investors. When the debt reaches a certain point, foreign
investors and lenders become wary of investing, which hurts economic growth.
However, it is not clear if this argument holds true for a developed economy,
since in a developed economy, most of the internal debt is held by citizens of
the country, and it is not clear whether the citizens are willing to transfer their
capital (whether as loans or as investments) to a foreign country. It is impor-
tant to point out that the results of many empirical studies do not support the
argument that large amounts of public debt will have a negative impact on
economic growth solely in non-developed countries; in many of these studies
256   T. SHAHOR

it was found that the negative impact of public debt on economic growth is
also characteristic of developed countries.
The relationship between the size of the public debt and economic growth
was measured in many empirical studies. In many of these studies the relation-
ship was found to be non-linear. The implication of such a relationship is that
for low levels of debt, an increase in debt actually creates growth. However, for
large levels of debt the impact at the margin becomes negative.
A central example is found in the research of Reinhart and Rogoff, who
studied the relationship between economic growth and public debt in 44 coun-
tries over a period of 200 years. For the purposes of the study, they divided
the data into four groups according to the debt to GDP ratio (whereby one
observation is the debt to GDP ratio for a given country, in a given year). The
first group includes observations for debt to GDP ratios up to 30%, in the sec-
ond group ratios of 30‒60%, in the third group ratios of 60‒90%, and in the
last group ratios above 90%. The results of the study show that there is no clear
relationship between debt level and growth up to levels of 90%. But above 90%
the results show clearly that the marginal effect of debt becomes negative. The
explanation given by the researchers is that as the debt to GDP ratio of the coun-
try reaches a certain level, lenders downgrade the country’s creditworthiness
and demand higher interest payments.2 Another study by Reinhart, Reinhart,
and Rogoff also found that debt over 90% decreases growth.3
Additionally, increased levels of debt require issuing bonds, which raises
the interest rate the government must pay, constituting a contractionary fiscal
policy. Another explanation deals with a situation where part of financing the
debt is accomplished by printing money. In such a case inflationary pressures
are created which erode the real value of the public debt relative to GDP, and
therefore the debt to GDP ratio falls. Theoretically, this inflationary pressure
could prevent, or at least lessen, the negative impact of public debt on economic
growth, but this only happens at low levels of debt. If public debt levels are too
high, the inflation created will be high, which will most likely hurt growth.
That is, even though the real value of the debt is eroded, growth is also ham-
pered. This effect requires governments to issue bonds which are indexed to the
consumer price index (CPI) so that inflation does not erode their real values.
The effect of public debt on the economic growth rate also depends on the
way in which the debt is created. If the debt is created during wartime, it is pos-
sible that in the peacetime that will follow the growth rate will be high, which
will facilitate paying back the debt. But if the debt comes about during peaceful
times then the ramifications could be damaging to the economy.
In another study, Presbitero studied the relationship between economic
growth and the level of public debt with the following additional variables
in her model: GDP in the previous period, the amount of capital investment,
amount of human capital, inflation as a measure of uncertainty, and import/
export amounts as a measure of how open an economy is to foreign markets.
 ISRAEL AFFAIRS   257

As in other studies, Presbitero found that the threshold at which the effect of
debt on growth changes is 90% of GDP, whereby debt in excess of this ratio
has a negative effect on the economy, while at lower levels of debt, growth is
supported. An interesting point that comes out of this research is that these
results and effects can only be determined for stable countries with organised
governments, and not in countries that are unstable, whose government is not
well established. A possible explanation for this result is that for unstable coun-
tries, the damage to economic growth due to inherent instability interferes with
meaningful statistical measurement of the effect of debt on growth. Presbitero
argues that the fact that she was unable to find a statistical relationship between
public debt and growth for unstable countries does not prove that such a rela-
tionship does not exist.4
Elendorf and Mankiw found that high levels of public debt negatively affected
the accumulation of capital and labour productivity. As is known, capital and
productivity influence growth, and therefore it is reasonable to conclude that
for countries with large public debt levels, growth will be lower.5
Additional studies, where it was determined that the ratio between debt and
GDP above a certain level hinders growth, offered various explanations for
why this is. Pattillo, Poirson, and Ricci claim that high levels of public debt are
caused by government investment that comes in place of private investment.
These investments are inefficient and hurt economic growth.6 Checherita and
Rother argue that a large debt to GDP ratio causes the interest rate, and there-
fore payments, to be higher (since lenders do not believe in the government’s
ability to repay high levels of debt, which results in a higher interest rate) and
therefore more money is used to pay off the debt, instead of being used for
other government functions.7
But not all studies support the claim that large levels of debt relative to GDP
hurt growth. Herndon, Ash, and Pollin reran the study done by Reinhart and
Rogoff and found some technical errors (such as mistyped data and other
similar errors). According to their revised findings, the relationship between
debt levels and growth are not uniform and vary by period and country. This
finding supports the need for additional research on the subject.8
In a study by Minea and Rarent the affect of debt on growth can be divided
into three ranges (and not two as per other studies described above). In the first
range, where the debt to GDP ratio is below 90%, an increase in the ratio has a
positive impact on growth. For ratios between 90% and 115%, an increase in the
ratio has a negative impact on growth (as was found in other studies). However
there is a third range that exists above a ratio of 115% and the trend reverses
itself, such that increasing the ratio has a positive impact on growth. This result
reveals a problem in declaring a threshold (such as 90%) exogenously, and
similarly in studies that assume that the relationship between the debt to GDP
ratio and growth must be in the graphical form of an inverted U shape.9
258   T. SHAHOR

In their study, Panizza and Presbitero pored over numerous studies which
sought to determine the impact of the ratio of public debt to GDP on growth.
They found that ‘The relationship between debt and growth is heterogeneous
across countries and time periods and that future research should focus on
these sources of heterogeneity’.10

Empirical study
The main conclusion that comes out of most of the studies mentioned above
is that the relationship between public debt and growth is non-linear, and its
shape is an inverted U. Up to a certain threshold, which most of the studies
found to be at a ratio of public debt to GDP of 90%, an increase in debt might
(if not must) increase growth. However, at a ratio above this amount any further
increase in debt has a negative effect on growth. The purpose of this research
study is to check the hypothesis that for the years 1983–2013, the relationship
between the ratio of public debt to GDP and economic growth is shaped like
an inverted U. An additional purpose is to locate the threshold at which the
relationship between the ratio of public debt to GDP and growth becomes neg-
ative, in which case growth starts to become hampered. This will be measured
by means of a quadratic regression with a dummy variable, to be presented in
the following sections.
Empirical research on this subject using a regression raises an endogenous
problem regarding the variables, such that even though we are measuring the
impact of public debt on growth, it is entirely possible that growth impacts on
the amount of public debt.11 To explain the impact of the debt on GDP we look
at two explanations. When the economy grows, tax receipts increase, which
may result in reduced debt. When there is no growth, the government may take
action that increases the debt.
One way to deal with this endogenous problem is to check how debt has
impacted growth in years past (and not in the current year). This technique
is based on the assumption that growth can impact on taxes and government
policy in the current year or in future years, but not in years past. However,
using a lag variable is not enough to solve the endogenous problem since the
decision to increase the debt could be the result of an expected reduction of
growth. Therefore, it may well be that the debt level in any given year could
be influenced by the expected growth rate for years ahead and not only by the
current year’s growth. Therefore, assessing the presence of a causal relationship
between debt and growth requires finding an instrumental variable that has a
direct effect on debt but no direct effect (or indirect effect, except for the one
that works through debt) on economic growth.
One of the accepted models used to check the relationship between the debt
to GDP ratio and growth, when the hypothesis is that the relationship is in the
shape of an inverted U, is the following:
 ISRAEL AFFAIRS   259

2
GROWTHt,t−5 = 𝛼 + 𝛽DEBTt−5 + 𝛾DEBTt−5 + 𝜆� Z (1)

As explained, the purpose of this article is to measure the effect of debt on

growth in the long run. Therefore, the dependent variable is the annual per
capita GDP growth for the last five years (from year t−5 until year t). DEBTt−5
is the debt to GDP ratio for year t‒5 (that is, five years prior to the current
year, t). Setting the regression in this fashion reduces the endogenous prob-
lem (although it does not eliminate it completely). Z is a vector of additional
variables that may affect growth. This vector includes the following variables:
inflation, the growth rate of the United States (which represents the global
business cycle), the rate of change of exports and imports of goods and services
(which represents how open the economy is to the global economy), investment
(in the previous year), and the rate of change of the population size, all for the
past five years. One more independent variable is GDP in year t‒5 (that is, five
years before the current year).
The hypothesis of this research posits that the relationship between the per
capita growth rate and the ratio of public debt to GDP is shaped like an inverted U.
In order to know the shape of the relationship it is necessary to look at the
coefficient of DEBTt−5, which is β, and the coefficient of DEBTt−52, which is γ.
If β > 0 and γ < 0, then the function will generally take the form of an inverted
U shape. If β < 0 and γ > 0 then the shape will be that of a regular U, and if both
coefficients have the same sign (both positive or negative) then the function is
monotonic (rising or falling, according to the sign).
If we find that the function takes the shape of an inverted U, that is, if it has
a maximum value, then this maximum must be checked to see if it falls within
the relevant range for the study. For example, if the value of the dependent
variable is between 10 and 100, but the function only begins to decrease when
the dependent variable reaches 200, then we can say that for the relevant range
of the study the function is increasing. In order to determine this value, we
look to the derivative of the regression function at two points. The first point
is the smallest ratio of debt to GDP, which is called DEBTt−5L. The second point
is the largest ratio of debt to GDP which is called DEBTt−5 H
. For a function that
takes the form of an inverted U shape, the lowest value of the derivative must
be positive (the function is rising) and the highest value must be negative (the
function is declining). As can be seen, the partial derivative of the regression
with respect to DEBTt−5 is

(2)
L H
𝛽 + 2𝛾DEPTt−5 > 0 > 𝛽 + 2𝛾DEPTt−5
The function takes the shape of an inverted U in the relevant range. According
to Lind and Mehlum, it is possible to check the level of significance of the result
using Sasabuchi’s measure.12
260   T. SHAHOR

Results
There are complete and uniform data for the years 1983–2013. Table 1 shows
the data for the ratio of public debt to GDP for Israel.

Table 1. Ratio of public debt to GDP for Israel.

Year Debt/GDP ratio
1983 260.5
1984 284.0
1985 199.0
1986 162.5
1987 143.2
1988 145.4
1989 147.4
1990 138.3
1991 123.7
1992 119.6
1993 118.3
1994 110.2
1995 102.2
1996 100.3
1997 99.4
1998 101.0
1999 94.9
2000 84.8
2001 89.5
2002 96.8
2003 99.4
2004 97.8
2005 93.9
2006 84.9
2007 78.5
2008 77.1
2009 79.5
2010 76.0
2011 73.9
2012 73.0
2013 72.2

Over the years there have been large changes in the debt to GDP ratio, with
a range of 72.2% to 284%, and so Israel seems a fitting country for this study.
The regression results for equation (1) appear in Table 2.

Table 2. Regression results for equation (1).

Variable Prob. Coefficient
DEBTt–5 0.00 0.00259
2
DEBTt−5 0.00 −0.0000075
Export 0.005 0.09883
Investment 0.00 0.1425
population 0.00 −1.169

Adjusted R2 0.58
 ISRAEL AFFAIRS   261

The rest of the variables were not statistically significant and therefore were
eliminated from the regression. The coefficient of DEBTt−5 is positive and the
coefficient of DEBTt−52 is negative, which means that the shape of the curve is
indeed an inverted U. Figure 1 displays graphically the relationship between
the ratio of debt to GDP and growth, as estimated and calculated according
to the equation.
2
GROWTHt,t−5 = 𝛽DEBTt−5 + 𝛾DEBTt−5 (3)

As can be seen graphically, the function is in the shape of an inverted U.

According to Sasabuchi’s measure, the condition which appears in equation (2)
exists and is significant. However, different from other studies, it is possible to
see that in the range lower than 163% the relationship between debt and growth
is positive. As is shown in Table 1, there are no data points in the range of 163%
and 200% and so it is impossible to find an exact point at which the slope of the
function changes from positive to negative. But it is clear that at very high levels
of debt to GDP, larger levels of debt hamper growth. These findings show that
when the ratio of debt to GDP is very large it impinges on growth. However,
the point at which the trend changes is not at 90%, as in other studies.
An alternative way to check the relationship between growth and debt levels
is to follow in the footsteps of Kumar and Woo. Their method makes use of a
dummy variable according to the following regression function.13

GROWTHt,t−5 = 𝛼 + 𝛽DEBTt−5 + 𝛽j DEPTt−5 Dj + 𝜆� Z (4)

The variable Dj is a dummy variable that takes the value of one for years in
which the ratio of debt to GDP is greater than J. The regression was run three
times for different values of J. The first time with J = 90% (as per the results of
previous studies), the second time with J = 130% (the value at which the curve
in Figure 1 begins to decrease), and the third time with J = 160% (the maximum
point in Figure 1). The dummy variable was significant only when J = 130%.
Table 3 shows the results for J = 130%.

Table 3. Regression results with the dummy variable for observations for which the debt
to GDP ratio was above 130%.
Variable Prob. Coefficient Coefficient
DEBTt–5 0.013 0.00078 0.00078
DEBTt–5D130 0.002 −0.00064 −0.00064
Inflation 0.015 −0.00094 −0.00094
Export 0.001 0.17922 0.17922
AR(1) 0.00 0.87586 0.87586

Adjusted R2 0.61683 0.61683

262   T. SHAHOR

The rest of the variables were not statistically significant and were subse-
quently removed from the regression. As can be seen from the data, of all the
dummy variables, only the coefficient of the variable is statistically significant,
and in this case it is negative. We can therefore conclude that the turning point
of the effect of the ratio of debt to GDP on growth is in the range above 130%.
Note that the coefficient for the variable DEBTt‒5 (0.00078) is greater than the
coefficient of the dummy variable (‒0.00064), and therefore when the debt to
GDP ratio is 130%, there is still a positive effect on growth. An interesting point
regarding this regression is that the coefficient of DEBTt−5 L
is not significant.
The implication is that when the ratio of debt to GDP is 90%, there is still no
change in the positive relationship between the ratio and growth, and this
relationship is most certainly not negative. This result is contrary to the results
of other studies which determined that above a debt to GDP ratio of 90% the
effect on growth becomes negative.

Conclusion
This article studied the effect of the ratio of public debt to GDP on the long-
run economic growth of the Israeli economy during the years 1983–2013. The
hypothesis of this study proposes that at low levels of debt to GDP, an increase
in debt can increase the long-run growth rate, but beyond a certain debt to
GDP ratio, further increases in the ratio will hurt growth. Two tools were used
to check this hypothesis. The first was a quadratic regression. In this case it was
found that the coefficient of the variable that represents the ratio of debt to GDP
was positive, and the coefficient of the square of that variable was negative.
This means that the shape of the curve of the regression is an inverted U shape
and that at low levels of debt to GDP, an increase in the debt level will increase
long-run growth, but at high levels of debt, further debt will hamper long-run
growth. The second tool added a dummy variable to the regression to capture
the years where the ratio of debt to GDP was above a certain threshold. This
regression also yielded results which show that at low levels of debt there is a
positive relationship between the debt to GDP ratio and long-run growth, and
only when the ratio reaches a level of 130% does the effect on long-run growth
begin to decline. In conclusion, these results confirm the claim that at high
levels of debt to GDP ratio long-run growth is impeded, but that the threshold
beyond which this happens is not 90%, as has been found in previous studies,
but much higher.

Notes
Panizza and Presbitero, Public Debt Economic Growth, 3–4.
1. 
2. 
Reinhart and Rogoff, “Growth in a Time of Debt,” 574–7.
3. 
Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs,” 69–70.
 ISRAEL AFFAIRS   263

4.  Presbitero, “Total Public Debt Growth,” 607–18.

5.  Elendorf and Mankiw, “Government Debt,” 1628–46.
6.  Pattillo, Poirson, and Ricci, “External Debt and Growth,” 4–5.
7.  Checherita and Rother, “Impact of High and Growing,” 22–3.
8.  Herndon, Ash, and Pollin, “Does High Public Debt.”
9.  Minea and Rarent, Is High Public Debt, 4–14.
10. Panizza and Presbitero, Public Debt and Economic Growth, 2.
11. Reinhart, Reinhart, and Rogoff, “Public Debt Overhangs,” 80.
12. Lind and Mehlum, “With or Without U.”
13. Kumar and Woo, Public Debt and Growth, 713–16.

Disclosure statement
No potential conflict of interest was reported by the author.

Notes on contributor

Tal Shahor is a lecturer at the Department of Economy and Management at the

Academic College of Emek Yezreel, Israel.

References
Bank of Israel. Series Data Base, Jerusalem, 2014. http://www.bankisrael.gov.il/series/en/
Central Bureau of Statistics. Data Bank, Jerusalem, 2014. http://www.cbs.gov.il/ts/
databank/databank_main_func_e.html
Checherita, C., and P. Rother. The Impact of High and Growing Public Debt on Economic
Rrowth: An Empirical Investigation for the Euro Area. Working Paper Series No. 1237,
European Central Bank, 2010.
Elendorf, C. S., and G. N. Mankiw. “Government Debt.” chap. 25 in vol. 1 of Handbook of
Macroeconomics, edited by J. B. Taylor and M. Woodford, 1615–1669. North Holland:
Elsevier, 1999.
Herndon, T., M. Ash, and R. Pollin. “Does High Public Debt Consistently Stifle Economic
Growth? A Critique of Reinhart and Rogoff.” Cambridge Journal of Economics 38, no.
2 (2013): 257–279. doi:10.1093/cje/bet075.
Kumar, M. S., and J. Woo. Public Debt and Growth. IMF Working Paper 10/174, 2010.
Lind, J. T., and H. Mehlum. “With or without U? The Appropriate Test for a U Shaped
Relationship.” Oxford Bulletin of Economics and Statistics 72, no. 1 (2010): 109–118.
doi:10.1111/j.1468-0084.2009.00569.x.
Minea, A., and A. Rarent. Is High Public Debt Always Harmful to Economic Growth?
Reinhart and Rogoff and Some Complex Nonlinearities. Working Papers 8, Association
Francaise de Cliometrie, 2012.
Panizza, U., and F. Presbitero. Public Debt and Economic Growth in Advanced Economies:
A Survey. Working paper 78, Money and Finance Research group (Mo.Fi.R.) - Univ.
Politecnica Marche - Dept. Economic and Social Sciences, 2013. http://docs.dises.
univpm.it/web/quaderni/pdfmofir/Mofir078.pdf
Pattillo, C., H. Poirson, and L. Ricci. “External Debt and Growth.” Review of Economics
and Institutions 2, no. 3 (2011): 1–30. Article 2. DOI: 10.55202/rei.v2i3.45.
264   T. SHAHOR

Presbitero, A. F. “Total Public Debt and Growth in Developing Countries.” European

Journal of Development Research 24 (2012): 606–626. doi:10.1057/ejdr.2011.62.
Reinhart, C. M., and V. R. Reinhart. “AND K. S. Rogoff. "Public Debt Overhangs:
Advanced-Economy Episodes since 1800.” Journal of Economic Perspectives 26, no.
3 (2012): 69–86. doi:10.1257/jep.26.3.69.
Reinhart, C. M., and K. S. Rogoff. “Growth in a Time of Debt.” American Economic
Review: Papers and Proceedings 100 (2010): 573–578. doi:10.1257/aer.100.2.573.