Economic freedom, institutional quality, and cross-country differences in income and growth.

• Author: Gwartney, James D.

In the past few decades, the issues in the literature on economic growth have broadened from the development of general theories of growth, largely based on Solow (1956), toward an examination of why there are differences in growth rates across countries, and why some countries continue to grow while others stagnate at low levels of income. This study takes an institutional approach and uses a recently developed measure of institutional quality, the Economic Freedom of the World (EFW) index (Gwartney and Lawson 2003) to examine the issue of cross-country differences in income levels and growth rates. The emphasis on the importance of institutions to economic prosperity goes back at least to Adam Smith (1776), and has been found in the more recent work of Olson (1982), Scully (1988), North (1990), Barro (1996), Barro and Sala-i-Martin (1995), Landes (1998), Hall and Jones (1999), and Acemoglu, Johnson, and Robinson (2001). Despite this interest in institutions, much work on economic growth treats institutions peripherally if at all.

One challenge to the institutional approach is to find a way to quantify the quality of institutions. The EFW index used here is a measure of institutional quality and, to the extent that higher EFW ratings lead to more rapid growth and higher income levels, it provides insight into the characteristics of an environment conducive to prosperity. The results show that better institutions lead to higher income, and that institutional improvements result in higher rates of economic growth.

Three Explanations of Cross-Country Differences in Economic Performance

Over the past decade, the economics literature has offered three different types of explanations for the differences in income levels and growth rates across countries. The most well-established explanation in the literature takes a production function approach based on the work of Solow (1956). The second approach explains differences in income and growth across countries as a function of institutions, and is represented by the work of North (1990) and Landes (1998). A third type of explanation, promoted by Sachs (2003), points to the effects of geography and location as determinants of growth and income.

The production function approach views output (Q) as a function of capital (K) and labor (L), such that Q = f(K,L). Within this framework, output is increased by increasing the amount of inputs (K and L), and by technological improvements that alter the production function so that more output can be produced with the same amount of inputs. This approach focuses on increasing human and physical capital, and on technological progress through, for example, research and development. This explanation suggests that higher growth rates can be generated by increasing inputs into the production function, and by discovering ways to employ those inputs more productively.

The institutional approach to growth is based on the idea that both the availability and productivity of resources will be influenced by the institutional and policy environment. While there is some debate about the exact characteristics of the institutions that are most appropriate for economic growth and prosperity, there is considerable agreement that secure property rights are crucial, and that the impediments to exchange must be minimal. Institutions and policies are reflective of government actions. To promote economic growth, governments must not only follow actions that are supportive of secure property rights and freedom of exchange, they must "also make a convincing and credible commitment that the policies will be maintained in the future. Public policy must be designed to implement what Mancur Olson (2000) has referred to as "market-augmenting government." (1)

A third approach to identifying factors that lead to prosperity looks at geographical factors. During the last several years, Jeffrey Sachs has promoted the idea that geography and location are major determinants of cross-country differences in income levels and growth. Sachs has stressed the importance of three major geographic-locational factors: a tropical climate, access to an ocean port, and distance of country from the world's major trading centers (Rotterdam, New York, and Tokyo). According to this view, a tropical climate inhibits economic growth because of the increased threat posed by diseases such as malaria, and because of the negative impact of a hot and humid climate on the energy level and productivity of labor. The lack of access to an ocean port will mean higher transactions costs and less trade with a sizable portion of the world's population. A distant location from the major markets of the world will also retard trade. In turn, less trade will reduce the gains from division of labor, specialization, and economies of scale. Furthermore, each of these geographic-locational factors will reduce the attractiveness of a country as a base for production, and thereby retard its ability to attract investment.

These three alternative theories of cross-country differences in income levels and growth are not necessarily inconsistent with each other, and may even be mutually reinforcing. For example, if the institutional and geographic-locational factors influence capital formation and the productivity of capital and other inputs, this has implications for the production function approach to growth. However, the policy implications of the three models have substantial differences. The production function approach naturally focuses on policies that will increase the quantity and improve the productivity of capital and labor. The institutional approach focuses on economic, legal, and political institutions, reasoning that if appropriate institutions are in place, the market system provides an incentive for market participants to invest in human and physical capital, and to improve their methods of production through innovation. The geographic-locational approach suggests that greater attention should be paid to the control of tropical diseases and an analysis of how technology can be applied to affect the productivity of resources in tropical regions.

Measurement of Cross-Country Differences in Institutional Quality

Institutional quality will be measured using the Economic Freedom of the World index published in Gwartney and Lawson (2003). (2) The EFW index has been used in a number of previous studies, and a review of both the index and other studies in which it has been used is found in Berggren (2003). The EFW index measures institutional quality in five major areas: (1) size of government, (2) legal structure and security of property rights, (3) access to sound money, (4) exchange with foreigners, and (5) regulation of capital, labor, and business. The index provides current ratings for 123 countries, but data are available for only about 100 countries continuously (at five-year intervals) throughout 1980-2000. These countries make up the data set for the empirical analysis that follows.

The EFW index reflects the key elements of the new institutional economics. For many years, Douglass C. North (1990), Friedrich Hayek (1945, 1960), Peter Bauer (1957, 1972), Hernando de Soto (1989), Gerald Scully (1988, 1992), and Scully and Slottje 1991) have stressed the importance of institutions and related policy variables. Following this same path, the new growth theory argues that sound institutions and policies are the keys to economic progress (e.g., see Torstensson 1994; Knack and Keefer 1995; Barro 1995, 1996; Olson 2000; Knack 2003; and Azfar and Cadwell 2003). The EFW index is also closely related to what Hall and Jones (1999) call "social infrastructure." Using the language of Hall and Jones, a quality infrastructure is present when the institutions and government policies of a country encourage productive behavior (e.g., accumulation of skills or the development of new goods and production techniques) and discourage predatory activities (e.g., rent seeking, corruption, and theft.)

The EFW measure is available for a large number of countries over a lengthy period of time. This is a major advantage because it allows the study of how changes in institutional quality affect economic growth. (3) While there are advantages to using proxies for institutional quality, such as is done by Hall and Jones (1999) and Acemoglu, Johnson, and Robinson (2001), that approach precludes looking at the effect of decade-by-decade changes in institutional quality. In contrast, the approach employed here makes it possible to investigate directly the impact of changes in institutional quality on economic performance.

Measurement of Geographic and Locational Factors

Jeffery Sachs has popularized the view that a country's level of economic activity will be adversely affected by a tropical climate and a location that is distant from the world's major market centers while access to an ocean coastline will exert a favorable impact. We measure these factors in the same manner as Sachs and his fellow researchers. The proportion of a country's geographic area located in a tropical region (Tropics) will be used to measure the tropical location variable. (4) The distance from core markets (Air Distance) variable is the minimum air distance (in kilometers) of a country from any one of the world's major trading centers (Rotterdam, New York, or Tokyo). Finally, the coastal variable is a percentage of a country's population living within 100 kilometers of an ocean coastline. (5)

Measurement of Physical and Human Capital

The data for physical capital per worker (Kpw) and human capital per worker (Hpw) are from Baier, Dwyer, and Tamura (2003). The physical capital stock was derived from annual investment data in the usual manner. A 7 percent depreciation rate was used to convert the annual investment data into capital stock estimates. The human capital estimates reflect cross-country differences in both years of schooling...