Korea Capital Market Institute

In response to economic downturn following the global financial crisis, governments are implementing large scale expansionary fiscal policy. Since the fiscal expansion is not sufficiently supported by tax revenue, governments are issuing more bonds, and the public sector debt of major industrialized countries has increased significantly since the crisis. A rapid increase in government debt could dampen fiscal sustainability and raise market interest rates, which could act to slow the economic recovery. Korea has low public debt to GDP ratio compared to other major advanced countries and has thus gained a good reputation for fiscal soundness. However, the current debt ratio is neither a guarantee nor conclusive evidence of Korea`s sound fiscal condition. Judgement on whether a certain country has an appropriate level of public debt depends not only on the relative size of the public debt, but also on other factors such as the growth rate of public debt and the country`s economic environment. Estimating a public sector optimal debt ratio is important because it can be used as a benchmark to maintain a desirable level of debt. A simple comparison of debt ratios between different countries could be misleading since they have different policies and economic backgrounds. With that perspective, this paper estimates the optimal public debt ratio of OECD member countries using an economic growth model. Empirical results show that the optimal public debt ratio corresponding to the maximum GDP growth rate is 56.2% for OECD advanced countries. The estimated optimal debt ratio for a pool of small open economies including Korea is 35.2%, which is 21 percentage points lower than that of OECD advanced countries. According to the results, the public debt ratio should remain low for small open economies, such as Korea, which depends heavily on trade and are vulnerable to external shocks. The results also suggests that public debt should be held around the optimal level to maximize and sustain economic growth.