Fiscal institutions and the development of fiscal capacity: The case of fiscal rules

The development of fiscal capacity is widely acknowledged as an important pillar for strong state-building. However, the level of fiscal capacity remains structurally low mostly in developing countries due to a number of factors, including the lack of institutions driving governments to channel public resources to public interests or the substitution of domestic resources with external financing. Fiscal rules that limit the opportunistic use of public finances and reduce governments' appetite for debt could be a valuable tool. Therefore, in this paper, we analyze the effect of fiscal rules on fiscal capacity. Two main theoretical arguments are presented to support the possible connection between fiscal rules and the development of fiscal capacity, namely the mitigation of the extraversion theory and the development of trust between citizens and governments. Based on entropy balancing and using a sample of 71 developing countries over the period 1985-2019, we show that countries that adopt fiscal rules experience an increase in their fiscal capacity. This result, which passes a series of robustness tests, reveals some heterogeneity, notably with respect to the types of fiscal rules, the effectiveness of fiscal rules, time spent under fiscal rules, and some structural factors.