Ekonomický časopis, 70, 2022, č. 9 – 10, s.

723 – 742 723

The Effect of Public Debt on Income Inequality

in Advanced Economies:
Does Institutional Quality Matter?1

NGUYEN VAN BON*

Abstract

Global income inequality becomes one of the severe problems in most econo-
mies, while government spending financed by public debt can be a good instru-
ment of fiscal policy to reduce this inequality in society. Does institutional quality
affect the public debt – income inequality relationship in advanced economies?
For the answer, the paper employs the system-GMM and PMG estimator to
examine the effects of public debt, institutional quality, and their interaction on
income inequality for a group of 30 advanced economies from 2002 through
2020. The paper finds some exciting results. Public debt and institutional quality
narrow income inequality, but their interaction term widens. Furthermore, eco-
nomic growth and unemployment increase income inequality, while education
decreases it. The findings suggest some necessary policy implications to narrow
income inequality through public debt and institutional quality.

Keywords: institutional quality, public debt, income inequality, advanced economies

JEL Classification: D31, E24, H63
DOI: https://doi.org/10.31577/ekoncas.2022.09-10.03

Introduction

Global income inequality in society is one of the severe challenges in most

economies under increasing globalization because it may lead to social instabil-
ity. Decreasing the income gap across countries becomes one of the eight MDGs
(Millennium Development Goals) by the United Nations. Governments in advanc-
ed economies have several appropriate resources to achieve it. Public spending

* NGUYEN VAN BON, University of Finance Marketing (UFM), Faculty of Finance –

Banking, No. 778 Nguyen Kiem St., Phu Nhuan District, Ho Chi Minh City, Vietnam; e-mail:
nv.bon@ufm.edu.vn
1
The research work is supported by University of Finance – Marketing (UFM).
724

keeps a crucial role in the fiscal policy of governments. Compared with tax reve-
nue, government spending is an active instrument of governments in running
the economy and overcoming economic cyclicality. Governments actively spend
more for a recession economy with high unemployment (an expansionary fiscal
policy with increased government spending). However, they will spend less for
a hot economy with high inflation (a contractionary fiscal policy with decreased
government spending). In particular, governments can spend more to help low-
income individuals access healthcare and education through social transfers to
reduce the income difference between high-income individuals and low-income
individuals, narrowing income inequality in society. However, rising public
spending financed by borrowing leads to high public debt. Economic history
shows that public debt crises often lead to economic crises: the European debt
crisis in the second half of 2009 with high public debt in Portugal, Greece, Italy,
Ireland, and Spain, the financial crisis in East Asia officially in 1997 with the
collapse of the Thai baht, the Latin American debt crisis of the 1980s. These
economies often have to enforce austerity policies and lose economic sovereignty
to receive rescue packages from the IMF or World Bank. Their citizens face an
unstable economy with more unemployment. Therefore, governments should
control public debt with strict fiscal discipline to avoid a public debt crisis in the
future. Despite its significant role in reducing inequality in society, the effect of
government debt on wealth and income inequality remains a controversial topic.
Since the birth of the GINI index in 1912, several related studies have tested the
impact of public/government debt on inequality. However, no studies investigate
the contribution of institutional quality to the public debt – income inequality
relationship in advanced economies. Therefore, this paper will do it to contribute
to the literature.
Global income inequality is one of the severe problems, while increasing
public debt can lead to a debt crisis and social instability. In particular, institu-
tional quality can significantly contribute to the public debt – income inequality
relationship in advanced economies. Given these facts, the paper employs the
system-GMM and PMG estimator to investigate the impacts of public debt, insti-
tutional quality, and their interaction on income inequality for a balanced panel
dataset of 30 advanced economies during the period 2002 – 2020.
The paper shows the structure as follows. The introduction presents the intro-
duction, while Section 1 gives an overview of global public debt as well as global
income inequality. The theoretical framework and literature review in Section 2
focus on the impact of government debt on inequality, and Section 3 notes the
methodology and research data. Meanwhile, Section 4 reports the results and dis-
cussion, and the last section provides a conclusion and some policy implications.
 725

1. Overviews of the Global Public Debt and Global Income Inequality

in Advanced Economies

1.1. Global Public Debt In Advanced Economies

Regarding the global public debt situation, International Monetary Fund

(2021a) reports that in 2020, global public debt amounted to 88 trillion USD,
which rose sharply because of the crisis. China and advanced economies cap-
tured more than 90 percent of the accumulation of worldwide debt. In 2021,
public debt accounts for 97.8% of the world’s GDP. Although it is 0.8% lower
than one year ago, it still stands at record-high levels due to a massive fiscal
response from governments to deal with the waves of the coronavirus pandemic.
The statistical data from IMF note public debt in the coming years is still persis-
tently higher than the levels projected before the coronavirus pandemic. It is
expected to be near 20% higher in advanced economies through 2026. Public
debt in the United States will decline by 0.6% to 133.3% in 2021 and stand
at 133.5% in 2026. Japan’s public debt will come to 256.9% of GDP this year,
up 2.8% from one year ago, before decreasing to 251.9% in 2026. Likewise,
International Monetary Fund (2021b) notes that the coronavirus pandemic has
put a severe challenge to public finances. During the global financial crisis, the
contraction in output and government revenues leads to public deficits and debts
beyond levels. Notably, global public debt is forecast to increase further from
98% of GDP in 2020 to nearly 100% of GDP in 2021 driven by advanced and
emerging economies.

1.2. Global Income Inequality in Advanced Economies

DESA (2020) says that many economies that experience high-income gaps
have enjoyed a decrease in income inequality. Several economies and regions
with low levels of income inequality in 1990 have seen increases in the income
gap. Germany, many Eastern European economies, and Nordic economies have
suffered rises in income inequality. Furthermore, some large middle-income
economies have enjoyed rises in income inequality since 1990. Notably, China’s
income inequality increased in both urban and rural areas.
Notably, the income share by the top 1% increased in 59 out of 100 econo-
mies. In 2015, the richest 1% earned more than 20% of all income in 18 econo-
mies, including the United States, the United Arab Emirates, Turkey, Thailand,
the Russian Federation, India, Chile, and Brazil. Although income inequality in
Brazil has decreased, the income share of the top 1% before transfers and taxes
increased to 28.3% in 2015 from 26.2% in 2001. In particular, the incomes of
726

the bottom 40% increased faster than average in France but slower than average
in the United States, meaning that France moved towards decreasing income
inequality while the United States did not.
Since the 2008 financial and economic crisis, the incomes of the top 10%
and the top 1% have fallen in most high-income economies. In the meantime,
the incomes of the bottom 10% have suffered a sustained decrease in around
one-third of advanced economies. Among them are economies (Spain, Ireland,
and Greece) that experienced the greatest income losses through the crisis.

2. Theoretical Framework and Literature Review

2.1. Theoretical Framework

Given the relevance, Chatzouz (2014) and Borissov and Kalk (2020) suggest
theoretical frameworks to note the impact of public debt on income inequality.
Chatzouz (2014) offers a simple analytical model to show how government debt
affects wealth inequality with the presence of altruism. Meanwhile, Borissov and
Kalk (2020) develop an economic growth model with government borrowing
financed by income taxes and the presence of positional concerns. The analysis
shows that policies focusing on narrowing initial inequality by government debt
can widen wealth inequality in the long run. Notably, this paper discovers that
institutional quality has a significant contribution to the public debt – income
inequality relationship in advanced economies. According to Li and Filer (2007),
advanced economies are those with rule-based governance (good institutional
quality). These economies have enough appropriate resources to handle the in-
come gap in society. They design, formulate and enforce regulations and policies
(institutional quality) to narrow income inequality between the rich and the poor.
They have higher levels of social spending and spend more on social protection
(Ortiz-Ospina and Roser, 2016). They use public spending financed by debt to
support the poor and low-income individuals through social transfers throughout
economic development, reducing the income difference between low-income
and high-income individuals. As a result, public debt and institutional quality
decrease income inequality.
However, because high public debt can cause a public debt crisis and social
instability, some regulations and policies (institutional quality) in these econo-
mies focus on controlling and managing strictly public debt. It leads to a decline
in public debt. Therefore, the interaction between public debt and institutional
quality can increase income inequality.
 727

2.2. Literature Review

Most investigations on the income inequality and public debt relationship

have been recently carried out. Notably, the number of studies on the impact of
government debt on income inequality is not much.
Regarding the effect of income inequality on public debt, some studies (Ara-
watari and Ono, 2017; Röhrs and Winter, 2017; March and von Weizsäcker,
2020; Maebayashi and Konishi, 2021) develop theoretical models while others
(Lee, 2005; Aksman, 2017; Luo, 2020; Carrera and de la Vega, 2021; Obiero
and Topuz, 2021) carry out the empirical investigation. Arawatari and Ono (2017)
develop a theoretical model to show the conflicts over fiscal policy across and
within generations in which public debt and income inequality vary. The analy-
sis notes that low-inequality economies implement contractionary fiscal policies
with low government debt. However, high-inequality economies realize expan-
sionary fiscal policies with high government debt. Similarly, Röhrs and Winter
(2017) suggest a theoretical model indicating the effect of public debt reduction
on wealth and income inequality. It shows that a decline in public debt leads to
a good distribution of wealth and income. Recently, March and von Weizsäcker
(2020) determine a theoretical model to highlight the mediating role of coordi-
nation in the effect of wealth inequality on government debt. More recently,
Maebayashi and Konishi (2021) report an endogenous growth model focusing on
the relationship between government debt sustainability and income inequality.
The analytic results indicate that government debt sustainability affects both in-
come inequality and the relative size of public debt. Meanwhile, Aksman (2017)
does not find the impact of inequality on public debt using the bias-corrected
LSDV estimator for all European Union countries from 1995 to 2015. Recently,
Luo (2020) employs the fixed effects model for a sample of OECD members
between 1970 and 2010. He finds that capital income inequality decreases public
debt, but labor income inequality increases. Lately, Carrera and de la Vega (2021)
apply the system-GMM (SGMM) estimator and the D-LSDVC estimator for
a panel dataset of 158 countries from 2000 to 2019. They report a positive effect
of inequality on government debt.
Regarding the effect of public debt on income inequality, Lee (2005) uses the
fixed effects and random effects models for a group of 64 advanced and develop-
ing economies between 1970 and 1994. He notes public debt increases income
and wealth inequality in limited democracies or nondemocracies but decreases
it in fully institutionalized democracies. Similarly, Tung (2020) finds public debt
narrows income inequality using the fixed-effects and random-effects models
for 17 emerging and developing economies in the Asia and Pacific from 1980
to 2018. More recently, Biglaiser and McGauvran (2021) use the fixed effects
728

model for a group of 71 developing countries between 1986 and 2016. They find
that debt restructurings widen income inequality. In the same vein, Obiero and
Topuz (2021) employ the ARDL model for the data of time series in Kenya from
1970 through 2018. They note that both public and internal debt increase income
inequality in the long term.
In short, the literature review shows: (i) no studies examine the contribution of
institutional quality to the public debt – income inequality relationship in advanced
economies, (ii) no studies employ the PMG estimator and the system-GMM
estimator that can deal with serial autocorrelation and endogenous phenomena
in the empirical models. Governance/institutional quality can significantly affect
public debt. Tarek and Ahmed (2017) find that the three poor governance indica-
tors lead to high public debt in the MENA countries. Plus, Asamoah (2021) dis-
covers that institutional quality can narrow income inequality in developed and
developing countries. Institutional improvement can change public debt, which
can reduce/increase income inequality. Therefore, studying the impact of public
debt on income inequality without the role of institutional quality can be a short-
coming. This paper focuses on these issues as a new contribution to the literature.

3. Methodology and Research Data

3.1. Methodology

Following the literature review, the paper uses the empirical equation as follows:
GIN it = γ 0 + γ 1GIN it −1 + γ 2 DEBit + γ 3GOit + γ 2 ( DEB × GO )it + X it γ ′ + σ i + τ it (1)

where t and i are the time and country index. GINit is the Gini index, a proxy for
income inequality. Its value ranges from 0 to 100 where 0 notes complete equa-
lity (everyone has the same income) and 100 reports the highest level of income
inequality; GINit-1 is the lagged dependent variable; DEBit is public debt (% GDP);
GOit is one of the six governance indicator (control of corruption, political stability,
government effectiveness, rule of law, regulatory quality, voice and accountabil-
ity), a proxy for institutional quality; ( DEB × GO )it is the interaction between
public debt and institutional quality. Xit contains some control variables as eco-
nomic growth, education, and unemployment; σi is a country-specific, time-
invariant, unobserved effect and τit is an observed error term; γ0, γ1, γ2, and γ’ are
estimated parameters. Following Lee (2005) and Biglaiser and McGauvran
(2021), the paper uses education and economic growth as control variables. Fur-
thermore, it also uses unemployment in the empirical equations as unemploy-
ment can significantly contribute to income inequality.
 729

The study applies Equation (1) to test the impacts of government debt, insti-
tutional quality, and their interaction on income inequality for a group of 30
advanced economies. It employs six governance indicators by the World Bank
(with values ranging from –2.5 to 2.5) to proxy for institutional quality. Daniel
et al. (2018) confirm that an “institutional void” can arise and impede policy
efforts to decrease economic inequality through the operations of efficient mar-
kets. From the views of individuals and firms, the following six governance
indicators have been suggested by World Bank (2021) to facilitate economic
activities, improve welfare, and reduce poverty and economic inequality:
• Control of corruption: Corruption has adverse impacts on the economy. It is
a constraint facing firms in developing economies (World Bank, 2021). Gupta
et al. (2002) indicate that corruption leads a high-income inequality and poverty in
several developing economies. Notably, higher corruption negatively affects efforts
in income distribution conducted by governments (Gyimah-Brempong, 2002).
• Government Effectiveness: This indicator supports the government to design,
issue, and enforce sound policies in which citizens are centric (Duho, 2020). Some
poor institutional factors, i. e. government ineffectiveness, can lead to a deteriora-
tion in the income distributions of developing economies (Acemoglu et al., 2001).
• Political Stability: Political instability leads to uncertainty in the economy
and impedes efforts in income distribution by governments. By contrast, political
stability enhances welfare by improving income distribution and removing ine-
quality from the economy (Shafique et al., 2006).
• Regulatory Quality: This indicator shows the government’s capability to de-
sign, issue, and enforce sound regulations and policies that promote efficient
economic activities (World Bank, 2021). Governments may achieve targets by
increasing spending on regulatory measures like equitable income distribution
(Shafique et al., 2006).
• Rule of Law: This indicator captures the independence and functioning of
the judiciary, including contract enforcement quality, property rights protection, the
police, and the likelihood of violence and crime (World Bank, 2021). Acemoglu
et al., (2001) argue that the absence of the rule of law can the income distribution
efforts in developing economies. By contrast, government effectiveness is neces-
sary to eradicate poverty and narrow income inequality (Kraay and Dollar, 2003).
• Voice and Accountability: This indicator is the guarantee of stability and
transparency of regulations and policies built by governments. It makes policyma-
kers responsible for failures in implementing regulations and policies. Accounta-
bility in public officials contributes to efficient resource allocations (Farrington,
2009). Perera and Lee (2013) indicate democratic accountability reduces the
income gap in some Asian countries.
730

Some severe problems in econometrics arise from estimating Equation (1).

Firstly, public debt, economic growth, and unemployment can be endogenous.
They may correlate with σi, which results in the endogenous phenomenon. Second-
ly, some unobserved effects such as culture, geography, customs, and anthropology
(fixed effects) can correlate with the independent variables. These fixed effects
exist in σi. Thirdly, a high autocorrelation comes from the presence of GINit-1.
Finally, panel data contain a large unit of economies (M = 30) and a short length
of observation (L = 19). These problems can make the OLS regression biased.
The random-effects model (REM) and the fixed-effects model (FEM) could not
handle serial autocorrelation as well as endogenous phenomena. The IV-2SLS
estimator needs some suitable instruments out of independent variables in the
empirical model. Following Judson and Owen (1999), we apply the system-GMM
estimator and the PMG estimator for estimation and robustness check.
Holtz-Eakin et al. (1988) are the first to propose the general method of mo-
ments (GMM) Arellano and Bond (1991). Two kinds of GMM estimators are
developed: the difference and the system. The past values of persistent regressors
in the empirical models do not provide information for their changes, making
their lags become weak instrumental variables in the difference GMM estimator.
Therefore, the S-GMM (system-GMM estimator) is better than the D-GMM
(difference-GMM estimator) (Arellano and Bover, 1995).
For estimation, the two-step S-GMM can be more efficient than the one-step
S-GMM. However, employing the two-step S-GMM in small research samples
like our sample has a problem (Roodman, 2009). It is the instrumental variable
proliferation that quadratically rises as the dimension of time increases, which
causes the number of instruments to be larger than the number of panel units.
The solution is to employ the thumb rule to keep the number of panel units more
than or equal to the number of instruments (Roodman, 2009). The study uses
Arellano-Bond, Sargan, and Hansen statistics to test the instruments’ validity in
the S-GMM. The Arellano-Bond test AR(2) searches the serial autocorrelation of
errors in the first difference while the Sargan and Hansen tests detect endoge-
nous phenomena.
The study applies the PMG estimator by Pesaran et al. (1999) to check the
robustness of the two-step S-GMM estimates. The PMG-based Error Correction
Model is shown as follows:
p
∆Yit = ψ X it −1 + π ij ∆Z it − j + σ it + τ it where X it −1 = Yit −1 − λ Z it −1 (2)
j =1

where Y is the Gini index, a proxy for income inequality; Xit-1 is the deviation from
long-run equilibrium for group i at any period t, and ψ is the error-correction
 731

coefficient. The vector captures the long-run coefficients. They express the
long-run elasticity of inequality corresponding with every variable in Zit-1. Mean-
while, the vector π captures the short-run responses of the Z variables. σi is
a fixed effect and τit is an error term. The study uses the value and significance
level of the speed of adjustment ψ (negative, smaller than 1) to examine the
validity of the PMG estimates.

3.2. Research Data

Data consist of the GINI index, public debt, governance indicators, real per
capita GDP, primary school enrollment, and unemployment. The study extracts
them from World Bank and International Monetary Fund databases. The sample
contains 30 advanced economies2 between 2002 and 2020.
The study presents the descriptive statistics in Table 1 and definition of the
dataset and the matrix of correlation coefficients among variables in the Appendix
(Table A, Table B, and Table C).

Table 1
Descriptive Statistics
Variable Obs. Mean Std. Dev. Min Max
Income inequality (GIN) 570 31.612 4.252 23.6 42.5
(Slovenia, 2020) (Israel, 2010)
Public debt (DEB) 3.765 211.2
570 63.456 35.240
(Estonia, 2007) (Greece, 2020)
Economic growth (GDP) 8008.4 111968.4
570 40492.5 21573.0
(Lithuania, 2002) (Luxembourg, 2007)
Education (EDU) 95.648 126.575
570 102.189 4.177
(Latvia, 2006) (Latvia, 2017)
Unemployment (UNE) 2.01 27.466
570 7.648 4.134
(Czech, 2019) (Ireland, 2013)
Regulatory Quality (IN1) -0.189 2.469
570 1.304 0.711
(Greece, 2006) (Denmark, 2012)
Rule of Law (IN2) 0.197 2.353
570 1.374 0.474
(Italy, 2007) (Denmark, 2007)
Voice and Accountability -1.626 1.755
570 .774 0.545
(IN3) (Israel, 2009) (Finland, 2002)
Control of Corruption 0.148 2.047
570 1.333 0.363
(IN4) (Greece, 2016) (Netherlands, 2017)
Government Effectiveness 0.083 2.100
570 1.360 0.489
(IN5) (Greece, 2017) (Finland, 2014)
Political Stability (IN6) 0.570 1.800
570 1.224 0.286
(Israel, 2009) (Denmark, 2004)
Source: Stata software’s processing.

2
Austria, Belgium, Canada, Cyprus, Czech Republic, Denmark, Estonia, Finland, France,
Germany, Greece, Iceland, Italy, Israel, Ireland, South Korea, Luxembourg, Lithuania, Latvia,
Malta, Norway, Netherlands, Portugal, Switzerland, Slovak Republic, Spain, Slovenia, Sweden,
United Kingdom, United States.
732

The results in Table B show that public debt, education, and unemployment
are positively connected with income inequality, but economic growth is nega-
tively associated with it. The value of correlation coefficients among control
variables is low (lower than 0.8), so the study uses all in the empirical models.
However, the value of all correlation coefficients among governance indicators
in Table C is high (higher than 0.8), so the study uses them separately in the
empirical equations.

4. Estimated Results and Discussion

4.1. Estimated Results

Table 2 and Table 3 show the two-step and one-step S-GMM estimates across
all empirical models for the group of 30 advanced economies. Each column is
the model corresponding with each governance indicator. The paper detects that
public debt is endogenous in estimation procedures, thus it uses public debt as an
instrumented variable in GMM style and income inequality, institutional quality,
economic growth, education, and unemployment as instrumental variables in IV
style.
The results in Table 2 and Table 3 indicate that public debt and institutional
quality reduce income inequality, but their interaction increases it. The main
result is that public debt narrows income inequality, and this negative effect is
hindered by institutional quality. Notably, although governance indicators (con-
trol of corruption, political stability, government effectiveness, rule of law, regu-
latory quality, and voice and accountability) are separately applied in the empiri-
cal equations, the results note that the sign and significance level of their and
interaction terms’ estimated coefficients are completely consistent. Furthermore,
economic growth and unemployment increase income inequality, but education
decreases.
Advanced economies are those with good institutional quality that have
enough appropriate resources to deal with the income gap in society. With rich
resources and high levels of development, governments in these economies for-
mulate and enforce policies and regulations (institutional quality) to reduce the
income difference between high-income and low-income individuals. Concern-
ing taxation, regulations and policies in these economies (which can be shown in
terms of regulatory quality and government effectiveness) focus on taxing high-
income people, not low-income people, and collect the tax revenue partly to
support low-income people. Regarding the control and collection of taxes, regu-
lations and policies (which can be expressed in terms of corruption control and
 733

the rule of law) strictly control the income of the rich to eliminate the possibility
of tax evasion, thereby ensuring fairness for tax payment between the rich and
the poor. In particular, policies and regulations issued by the government are
always publicly and transparently monitored (voice and accountability), thus
ensuring a more equitable allocation of national resources in society, thus reduc-
ing the income gap between the rich and the poor, thus narrowing income ine-
quality. The paper finds it in Richmond and Triplett (2018), Matallah (2019),
and Law et al. (2020). Furthermore, they use high levels of public spending on
social protection (Ortiz-Ospina and Roser, 2016). They use spending financed by
public debt to support the poor and low-income individuals through social trans-
fers throughout economic development. In addition to social transfer, public
expenditures on health and education are allocated to help people improve their
skills and knowledge so that they can find appropriate jobs with high incomes. In
particular, these expenditures in developed countries are fairly distributed and
mostly spent for low-income and jobless people (the poor), so narrowing the
income difference between high-income and low-income individuals. The paper
finds the same result in Tung (2020).
However, high government debt can cause a debt crisis and social instability.
For example, the European debt crisis in the second half of 2009 with high pub-
lic debt in Portugal, Greece, Italy, Ireland, and Spain (developed economies) led
to economic and political instability in these economies. The number of poor and
homeless in these economies increased rapidly during this crisis period, especially
since the majority of the severely affected people were poor and low-skilled. To
quickly get out of this crisis, these economies must accept the austerity solutions
proposed by the IMF to receive bailouts. Accordingly, regulations and policies
(institutional quality) must be changed and adjusted to cut government expendi-
ture for retirees and jobless people, thereby focusing on reducing budget deficits
and controlling and managing government debt. In particular, all these regula-
tions and policies must reach a consensus among political parties (political sta-
bility), representing people's voices. In short, regulations and policies (institu-
tional quality) that are issued and implemented to control public debt may reduce
public debt. However, it leads to a decrease in public expenditures for the poor
and low-income people, while the rich are almost unaffected by these regulations
and policies, narrowing the income gap between the rich and the poor. As a re-
sult, the interaction between public debt and institutional quality widens income
inequality.
This finding recommends that governments in advanced economies can use
public debt to narrow income inequality in society. They should spend more on
education and health to support the poor to improve their skills and knowledge,
734

decreasing the income difference between high-income and low-income indivi-

duals. Income inequality is one of the inherent social natures in human develop-
ment, meaning that we can not eliminate income inequality but can reduce it.
In particular, equality and efficiency are two opposite sides of the same coin,
so when acting on one side, it affects the other side and vice versa. Governments
should recognize it as the tradeoff between efficiency and equality throughout
economic development. Increasing equality (or decreasing inequality) leads to
decreasing efficiency and vice versa. It is important to have consensus among
parties (representing people’s voice) in determining and choosing a relative bal-
ance point between efficiency and equity to ensure social stability during eco-
nomic development. Notably, they should control and manage public debt be-
cause rising public debt can lead to a public debt crisis and social instability.
Governments in developed economies should note that policies and regulations
(institutional quality) must be carefully considered in terms of their effectiveness
in enforcement. Institutional quality includes political stability (consensus among
political parties representing the people’s voice), control of corruption, rule of
law, government effectiveness (control of appropriate government revenues and
spending), the rule of law, regulatory quality, voice and accountability (social
equity with priority given to the poor and low-income people, regulations and
policies are publicly and transparently implemented). In particular, when the
economic crisis occurs, the majority of the poor and low-income people are the
first and most severely affected, and its most obvious consequence is an increase
in the income gap between the rich and the poor, widening income inequality.
In economic development, the outcomes may mainly benefit the rich while
the poor do receive not much. The Kuznets (1955) curve argues that industrializ-
ing economies experience an increase and subsequent decrease in wealth and
income inequality. Apergis (2021), Demir et al. (2020), Richmond and Triplett
(2018), and Lee (2005) support this result. This finding indicates a challenge for
governments in the appropriate allocation of the outcomes in economic devel-
opment. Similarly, the high rate of unemployment often falls on the poor who
lack the necessary knowledge and skills to get a high-income job, boosting the
income gap in society. This finding implies that governments in advanced eco-
nomies should pay more attention to the poor and support them to access educa-
tion and healthcare to get high-income jobs. By contrast, education is a public
good that governments supply for free, and students do not pay the money to
attend public schools. Students from low-income families can improve their
knowledge and skills from education to find a high-income job, which decreases
the income gap between high-income and low-income individuals. This finding
can be found in Lee (2005) and Obiero and Topuz (2021).
 735

Table 2
Institutional Quality, Public Debt and Income Inquality: Two-step S-GMM
Estimates Dependent Variable: GINI Index (income inequality)
Variables IN1 IN2 IN3 IN4 IN5 IN6
*** *** *** *** ***
Gini index (–1) 0.930 0.923 0.908 0.937 0.922 0.919***
(0.023) (0.025) (0.021) (0.019) (0.025) (0.027)
Public debt –0.020*** –0.039*** –0.016*** –0.041*** –0.028** –0.088***
(0.007) (0.015) (0.005) (0.015) (0.013) (0.034)
Institutional quality –1.177*** –2.615*** –1.642*** –2.659*** –2.138*** –5.403**
(0.353) (0.911) (0.367) (0.909) (0.739) (2.190)
Public debt*Ins. quality 0.013*** 0.029*** 0.016*** 0.032*** 0.020** 0.073***
(0.004) (0.011) (0.004) (0.010) (0.009) (0.028)
Economic growth 0.006*** 0.007*** 0.005*** 0.005*** 0.007*** 0.010***
(0.001) (0.002) (0.001) (0.001) (0.002) (0.003)
Education –0.027** –0.026* –0.020* –0.004 –0.027** –0.028*
(0.013) (0.014) (0.010) (0.012) (0.013) (0.015)
Unemployment 0.055** 0.061** 0.064*** 0.070** 0.053* 0.104**
(0.025) (0.030) (0.016) (0.028) (0.027) (0.041)
Instrument 11 13 13 12 12 11
Country/Observation 30/510 30/510 30/510 30/510 30/510 30/510
AR(2) test 0.216 0.233 0.279 0.114 0.186 0.269
Sargan test 0.578 0.564 0.266 0.741 0.452 0.720
Hansen test 0.647 0.805 0.660 0.838 0.689 0.867
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Stata software’s processing.

Table 3
Institutional Quality, Public Debt and Income Inquality: One-step S-GMM
Estimates Dependent Variable: GINI Index (income inequality)
Variables IN1 IN2 IN3 IN4 IN5 IN6
Gini index (–1) 0.925*** 0.917*** 0.905*** 0.928*** 0.919*** 0.910***
(0.011) (0.011) (0.013) (0.010) (0.011) (0.012)
Public debt –0.021*** –0.038*** –0.010** –0.044*** –0.040*** –0.097***
(0.005) (0.010) (0.005) (0.010) (0.008) (0.024)
Institutional quality –1.240*** –2.610*** –1.003** –2.996*** –2.729*** –6.129***
(0.287) (0.686) (0.448) (0.717) (0.556) (1.493)
Public debt*Ins. quality 0.013*** 0.028*** 0.008 0.033*** 0.028*** 0.080***
(0.003) (0.007) (0.005) (0.007) (0.006) (0.020)
Economic growth 0.006*** 0.008*** 0.003*** 0.006*** 0.008*** 0.012***
(0.001) (0.001) (0.001) (0.001) (0.001) (0.002)
Education –0.027*** –0.025** –0.001 –0.009 –0.032*** –0.030***
(0.011) (0.012) (0.008) (0.008) (0.011) (0.011)
Unemployment 0.057*** 0.056*** 0.047*** 0.074*** 0.060*** 0.121***
(0.020) (0.021) (0.017) (0.019) (0.020) (0.028)
Instrument 12 13 17 12 12 11
Country/Observation 30/510 30/510 30/510 30/510 30/510 30/510
AR(2) test 0.255 0.248 0.291 0.107 0.216 0.299
Sargan test 0.374 0.564 0.178 0.741 0.307 0.253
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Stata software’s processing.
736

4.2. Robustness Check

The paper employs the PMG estimator for Equation (2) to test the robustness
of S-GMM estimates. It uses only economic growth as a control variable. The
PMG estimator requires the co-integration between regressors and the dependent
variable. So, the paper examines the stationary of all variables in the empirical
model to ensure that they all have the same order of co-integration. Then, it per-
forms the panel co-integration tests by Westerlund (2007).
The stationary tests in Table D (Appendix) report income inequality, public
debt, institutional quality, and economic growth are stationary at a significance
level of less than 10%, meaning that they have a co-integration of zero-order
I(0). The Westerlund tests in Table 4 note that three of four tests deny the null
hypothesis of no co-integration, suggesting that income inequality co-integrates
with public debt, six governance indicators, and economic growth.

Table 4
Westerlund Panel Co-integration Tests Normalized Variable: GINI Index
(Income inequality)
Covariates Gt Gα Pt Pα
Public debt –2.523** –7.992 –12.728*** –7.318***
Institutional quality 1 –2.080** –7.928 –11.238*** –7.526***
Institutional quality 2 –2.315*** –9.377*** –12.332*** –9.584***
Institutional quality 3 –2.371*** –9.326*** –13.408*** –8.422***
Institutional quality 4 –2.069** –7.988 –10.887*** –7.243***
Institutional quality 5 –2.418*** –8.498* –11.852*** –7.952***
Institutional quality 6 –4.342*** –8.914** –10.725*** –5.622*
Economic growth –2.624*** –8.234 –12.766*** –7.907***
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Stata software’s processing.

Table 5
Institutional Quality, Public Debt and Income Inequality: PMG Estimates Long
Run Co-integrating Vectors Dependent Variable: GINI Index (income inequality)
Variables IN1 IN2 IN3 IN4 IN5 IN6
*** ** *** ***
Public debt –0.041 –0.045 –0.008 –0.047 –0.271 –0.027
(0.016) (0.020) (0.007) (0.010) (0.050) (0.020)
Institutional quality –1.301* –3.239*** –1.447** –2.892*** –13.38*** –1.327
(0.774) (1.075) (0.687) (0.663) (2.151) (1.262)
Public debt*Ins. quality 0.029* 0.032*** 0.016** 0.024*** 0.002 0.010
(0.016) (0.012) (0.007) (0.007) (0.033) (0.015)
Economic growth 0.042*** 0.020** 0.024** 0.006 0.007 0.043***
(0.011) (0.010) (0.010) (0.007) (0.004) (0.011)
Error correction –0.522*** –0.542*** –0.557*** –0.552*** –0.339*** –0.523***
Observation 540 540 540 540 540 540
Log likelihood –373.453 –375.424 –377.215 –367.568 –416.977 –373.162
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Stata software’s processing.
 737

The paper shows the results in Table 5. In line with the S-GMM estimates,
public debt and institutional quality narrow income inequality, but their interac-
tion term widens. Furthermore, economic growth enhances income inequality.
The significance level and value of the speed of adjustment at the bottom of
Table 5 report that PMG estimates are highly reliable.

Conclusion and Policy Implications

Public spending financed by debt keeps a crucial role in running the economy,
while income inequality is one of the severe problems. Governments in these
economies can use public debt to deal with the income gap in society. In particu-
lar, institutional quality can significantly contribute to the public debt – income
inequality relationship. Given these facts, the paper investigates the impacts of
public debt, institutional quality, and their interaction on income inequality for
a group of 30 advanced economies from 2002 through 2020. It employs the
S-GMM and PMG estimator for estimation and robustness check. The results
show that public debt and institutional quality decrease income inequality, but
their interaction increases it. The main result shows that public debt narrows
income inequality in developed economies and this negative effect is impeded by
institutional quality. Furthermore, economic growth and unemployment widen
income inequality, but education narrows it.
The findings in the paper imply that governments in advanced economies can
use public debt to deal with income inequality in society between the rich and
the poor. They can design, formulate, and implement policies and regulations
(institutional quality) to increase public spending financed by debt to support the
poor and low-income individuals through social transfers. More importantly,
they should spend more on health and education to improve the poor’s skills and
knowledge, which enhances the poor’s income and reduces the income gap in
society. However, they should be prudent in controlling and managing public
debt to avoid a public debt crisis and social instability. Future research should
focus on the contribution of institutional quality to the external/domestic public
debt – income inequality relationship.

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 741

Appendix

Table A
Data Description
Variable Definition Type Source
Income inequality (GIN) Gini index measures the extent to which value World Bank
the distribution of income (or, in some cases,
consumption expenditure) among individuals
or households within an economy deviates
from a perfectly equal distribution.
Public debt (DEB) Gross debt consists of all liabilities that % IMF
require payment or payments of interest and/or
principal by the debtor to the creditor at a date
or dates in the future (% GDP)
Economic growth (GDP) GDP per capita is gross domestic product ln World Bank
divided by midyear population.
Education (EDU) Gross primary school enrollment ratio is the % World Bank
ratio of total enrollment, regardless of age, to
the population of the age group that officially
corresponds to the level of education shown.
Unemployment (UNE) Unemployment refers to the share of the labor % World Bank
force that is without work but available for and
seeking employment.
Regulatory Quality (IN1) “Regulatory Quality captures perceptions of
the ability of the government to formulate and
implement sound policies and regulations that
permit and promote private sector development.”
Rule of Law (IN2) “Rule of Law captures perceptions of the
extent to which agents have confidence in and
abide by the rules of society, and in particular
the quality of contract enforcement, property
rights, the police, and the courts, as well as the
likelihood of crime and violence.”
Voice and Accountability (IN3) “Voice and Accountability captures
perceptions of the extent to which a country’s
citizens are able to participate in selecting
their government, as well as freedom of
expression, freedom of association, and a free
media.”
Control of Corruption (IN4) “Control of Corruption captures perceptions of level World Bank
the extent to which public power is exercised
for private gain, including both petty and
grand forms of corruption, as well as “capture”
of the state by elites and private interests.”
Government Effectiveness (IN5) “Government Effectiveness captures
perceptions of the quality of public services,
the quality of the civil service and the degree
of its independence from political pressures,
the quality of policy formulation and
implementation, and the credibility of the
government's commitment to such policies.”
Political Stability (IN6) “Political Stability and Absence of
Violence/Terrorism measures perceptions
of the likelihood of political instability and/or
politically-motivated violence, including
terrorism.”
Source: Author.
742

Table B
The Matrix of Correlation Coefficients between Variables
GIN DEB GDP EDU UNE
GIN 1
DEB 0.242*** 1
GDP –0.134*** 0.053 1
EDU 0.173*** –0.011 –0.001 1
UNE 0.270*** 0.407*** –0.418*** 0.024 1
*** ** *
Note: , , note significance level at 1%, 5%, 10% respectively.
Source: Author.

Table C
The Matrix of Correlation Coefficients between Six Dimensions of Governance
IN1 IN2 IN3 IN4 IN5 IN6
IN1 1
IN2 0.929*** 1
IN3 0.448*** 0.414*** 1
IN4 0.847*** 0.827*** 0.409*** 1
IN5 0.944*** 0.923*** 0.496*** 0.858*** 1
IN6 0.883*** 0.807*** 0.651*** 0.777*** 0.856*** 1
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Author.

Table D
Fisher Type Unit Root Tests
Augmented Dickey-Fuller test Phillips-Perron test
Variables Prob > chi2 Prob > chi2
Without trend With trend Without trend With trend
Income inequality 52.894 42.426 69.221 104.949***
Public debt 59.773 80.610** 26.197 24.853
Institutional quality 1 73.156 56.127 224.666*** 157.362***
Institutional quality 2 96.673*** 65.915 120.871*** 105.612***
Institutional quality 3 95.006*** 66.252 224.916*** 157.084***
Institutional quality 4 61.690 67.764 77.742* 77.599*
Institutional quality 5 57.655 57.367 87.633*** 83.252**
Institutional quality 6 121.610*** 85.124** 114.410*** 103.406***
Economic growth 83.006** 46.863 62.778 27.851
Note: ***, **,* note significance level at 1%, 5%, 10% respectively.
Source: Author.