Based on evidence from countries in ECA over the 1992 to 2004 period and using a newly constructed fiscal data set by the World Bank, the empirical analysis in this paper explores three possible linkages between public finance policies and growth: (i) how fiscal deficits affect growth; (ii) the impact of the size of government on growth; (iii) linkages with the quality of governance. With respect to the first two components, the paper utilizes more recent data, a longer time series, and a broader, more representative sample of countries, representing an improvement over the existing literature. As for the third component, the growth-expenditure-governance nexus has not been systematically investigated in previous studies, although there is growing indirect evidence that the quality of public institutions mediate the impact of the key drivers of growth (see, for example, Burnside and Dollar 2000 and 2004).

The main results of the empirical analysis in this paper confirm that a sound fiscal position is associated with higher growth in ECA. Lower fiscal imbalances, which are associated with greater macroeconomic stability, less business uncertainty, and a stronger investment climate, are in turn, conducive to higher growth. However, the size of the public sector also affects economic growth in a nonlinear manner. At some indicative level of government expenditures in percent of GDP or higher, public spending has a measurable negative impact on economic growth, while at levels below that threshold, government size has no robust effect on growth. The quality of governance mitigates the negative impact of public sector size on growth: Public sector size impinges on growth in countries characterized by relatively weaker government effectiveness and public sector institutions, but there is no significant evidence of a negative impact when governments are relatively more effective.

The rest of the paper is organized as follows: Section 2 provides a review of literature on fiscal policy and growth. Section 3 presents the baseline model used in the analysis and its motivation. It also discusses the extensions to the baseline model. Section 4 discusses the data sources and some specification issues. Section 5 reports the main findings from the analysis and discusses their implications. Section 6 concludes.

# **2. Review of Related Literature on Fiscal Policy and Growth**

The growth literature in transition economies is still relatively in its infancy, particularly in the assessment of the links between growth and public finance, owing in large part to data constraints. In fact, it has only been about ten years since the emergence of the first empirical studies of economic growth in transition economies (e.g., Sachs 1996; de Melo et al 1996; Selowsky and Martin 1997). While the broader empirical literature on economic growth has been notoriously unwieldy—a recent metastudy identifies some 67 variables thought to be significant correlates of growth, based on existing studies (Sala-i-Martin, Doppelhofer, and Miller, 2004)—there has been, in contrast, a remarkable consensus on the determinants of economic growth in transition economies. These studies—numbering over 20 published papers as of 2002—are reviewed by Havrylyshyn (2001) and Campos and Coricell (2002). The significant 3