Financial development, fiscal capacity, and public expenditure in East Africa: A panel ARDL approach

Abstract

Despite the recognized importance of financial development in shaping public sector outcomes, the mechanisms through which financial sector development influences public expenditure via fiscal capacity remain underexplored in East Africa . This study addresses this gap by examining how financial development affects public expenditure decisions through fiscal capacity in seven East African countries including, Burundi, Ethiopia, Kenya, Rwanda, Sudan, Tanzania, and Uganda, over the period 1990–2023. The study employs dynamic heterogeneous panel estimators, including Mean Group (MG), Pooled Mean Group (PMG), Dynamic Fixed Effects (DFE), Augmented Mean Group (AMG), and Common Correlated Effects Mean Group (CCE-MG), to account for cross-sectional dependence, unobserved heterogeneity, and distinct short-run and long-run adjustment dynamics. The results reveal a strong long-run relationship between financial development, fiscal capacity, and public expenditure. Specifically, financial development, enhanced government revenue, and improved governance significantly increase fiscal capacity, whereas debt service obligations reduce it. In turn, fiscal capacity and financial development expand public expenditure, while inflation and population growth constrain spending. Short-run results show asymmetric adjustments, reflecting temporary responses to macroeconomic shocks. These findings emphasize the importance of financial deepening, revenue diversification, and anti-corruption reforms for strengthening fiscal capacity and optimizing public expenditure. This study provides novel evidence on the role of fiscal capacity in linking financial development and public expenditure, using long-term dynamic heterogeneous panel methods that account for cross-country institutional differences.