Structural Breaks and Fiscal Deficit Sustainability in EAC Countries: Empirical Evidence

Abstract

The study examines fiscal sustainability of the East African Community (EAC) Countries by testing for cointegration between government spending and revenue. The study tests for breaks in the long-run relationship between spending and revenue using Bai and Perron’s (2003) method. The presence of regime shifts is then accounted for when testing for cointegration by using testing procedures suggested by Gregory & Hansen (1996) and Hatemi-J (2008) to respectively account for one and two endogenous breaks. The findings show that the presence of regime shifts in the relationship between government spending and government revenue could not be rejected for all the EAC countries. Moreover, both cointegration tests used accounting for regime shifts suggest that government spending and revenue are cointegrated for all the EAC countries thus indicating that fiscal deficits in the EAC countries are sustainable. However, the cointegrating coefficient shows that budget deficits are only weakly sustainable in the long-run for Burundi, Kenya, Tanzania and Uganda and strongly sustainable for Rwanda. The finding implies that for Burundi, Kenya, Tanzania and Uganda, fiscal sustainability needs to be reinforced otherwise the countries are at high risk of default since they spend more than they earn.