Financial Sector Development, Fiscal Capacity, and Social Welfare in East Africa: A Principal Component Analysis Approach

This study investigates the interconnected roles of financial sector development and fiscal capacity in shaping social welfare outcomes in East Africa. Using panel data from 1990 to 2023 for seven countries: Burundi, Ethiopia, Kenya, Rwanda, Sudan, Tanzania, and Uganda, the research constructs a Composite Welfare Index (CWI) through Principal Component Analysis (PCA). This index integrates key social, economic, political, and environmental indicators to provide a multidimensional measure of welfare. Descriptive analysis reveals persistent disparities in welfare performance, with Kenya consistently leading the region and Sudan ranking lowest. Empirical results from a dynamic heterogeneous panel model indicate that robust financial sector development and strong fiscal capacity significantly enhance social welfare. These effects operate primarily through improved government ability to mobilize resources, deliver essential services, and implement inclusive policies. The findings underscore the critical role of financial and fiscal institutions in promoting equitable and sustainable welfare outcomes. Based on the study's findings, it is recommended that East African countries strengthen financial infrastructure to broaden access to financial services, thereby supporting the delivery of essential social services. Enhancing fiscal capacity through efficient revenue mobilization and improved tax administration is crucial for sustainable public financing. Moreover, governments should strategically allocate public resources to key sectors such as healthcare, education, and infrastructure to optimize welfare outcomes.