Fiscal Rules, Green Investment, and Debt Sustainabilty: A Conditional Analysis for European Countries

This paper examines the relationship between fiscal rules, green public investment, and public debt sustainability in European countries over the period from 2000 to 2023, using a dynamic panel framework estimated with System GMM. The analysis introduces an interaction term between fiscal rules and green investment to assess whether institutional quality conditions the fiscal impact of climate-related spending. The results reveal strong persistence in public debt dynamics, with a coefficient on lagged debt of approximately 0.85, indicating that past debt levels are a key determinant of current fiscal outcomes. Green public investment is found to have a positive and statistically significant effect on public debt in the short run, with a coefficient of 0.60–0.75, implying that a one percentage point increase in green investment raises public debt by up to 0.75 percentage points. This finding provides support for the short-run hypothesis that climate-related investment increases borrowing needs. However, the interaction between fiscal rules and green investment is negative and statistically significant, with an estimated coefficient of -0.28. This indicates that stronger fiscal frameworks reduce the debt impact of green investment. The marginal effects analysis reveals a clear threshold- when the fiscal rules index is low (FR = 1), the effect of green investment on debt is strongly positive (+0.47), while at higher levels of fiscal rule strength (FR = 5), the effect becomes negative (-0.65). This implies a total shift of approximately 1.12 percentage points in the marginal effect across institutional regimes. These results suggest that the fiscal impact of green investment is conditional on institutional quality. While climate-related spending increases debt in countries with weak fiscal frameworks, it becomes neutral or even debt-reducing in countries with strong and credible fiscal rules. The findings therefore provide strong support for the hypothesis that well-designed fiscal frameworks can reconcile fiscal discipline with green investment. Overall, the paper contributes to the literature by integrating climate-related fiscal policy into standard models of debt sustainability and by demonstrating the critical role of fiscal institutions in shaping the effectiveness of green investment. The results have important policy implications, highlighting the need for fiscal rule reforms that combine credibility with flexibility to support the green transition without compromising fiscal stability.