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The new member states (NMS) of the European Union must comply with the Stability and Growth Pact (SGP) and the investment goals implied by the Lisbon Agenda. However, the SGP rules may result in underinvestment or distortions in the allocation of public expenditure. This paper provides new evidence on the effects of debt sustainability and the SGP fiscal constraints on government expenditure on fixed capital, education and health in OECD countries by estimating government expenditure reaction functions to public debt and cyclical conditions. We find that, at high levels of debt, government capital expenditure and education expenditure are significantly reduced as the debt ratio increases in all OECD countries independently of EMU (or EU) membership. By contrast, neither capital expenditure nor education expenditure is affected by the debt ratio in low-debt countries. These findings are robust to the inclusion of the government deficit in the estimated reaction functions. Hence, it appears that EU countries have been constrained in their investment decisions more by the need to ensure debt sustainability than by the rules of the SGP. In low-debt NMS countries, public investment even increases with the debt ratio, a finding that is reassuring for their growth prospects. However, a less optimistic picture emerges when we focus on expenditures on public health and education, as it appears that NMS governments cut such expenditures - even at low levels of debt - as the deficit increases. Problems in controlling total expenditure together with the preventive arm of the SGP may have penalised investment in human capital in the NMS while leaving fixed capital investment unaffected.

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