Abstract
<title>Abstract</title> <p>This paper empirically studies the role of financial development in the fiscal response function by distinguishing between high and low financial development regimes based on a data-driven selection mechanism for European Union members from 2000 to 2019. Applying the panel smooth transition regression to separate two regimes based on the status of financial development we find that the stance of financial development matters for the fiscal policy design. The response effectively differs for low financial development regime situations compared to high financial development regimes, both regarding debt sustainability and output stabilization. While in the low regime, debt tends to be sustainable and the business cycleper forms pro-cyclically, in high regimes, the picture changes to a more mixed behavior, including debtnon-sustainability and counter-cyclical output. Particularly, once controlled for international trade andinstitutional influence, the situation in the second regime changed to unsustainable debt behavior. In addition,improvements in financial market efficiency strengthen debt sustainability, whereas deeper financial markets weaken it, while greater financial institution depth promotes more sustainable fiscal behavior. Our results indicate that the financial system affects fiscal policy behavior, and too much financial development can lead to unsustainable debt behavior. JEL Classification: E44, E62, H63</p>