EUROPEAN ECONOMIC REVIEW ELSEVIER — Furopcan Feonomic Review 42.(1998) IIT 1341 ee Investment, property rights and political instability: Theory and evidence Jakob Svensson* NVL-US7, Poltey Research Department, The World Bank, [818 H Street NW, Washington, DC 20433. 084 Received 1 May 1995: accepted 1 February 1997 Abstract This paper addresses the question why investment rates differ so markedly across countries. In the paper « model is laid out explaining why governments in unstable and polarized societies may not have sufficient incentives to undertake legal reform so as to fully protect property rights, and how this may hold back private investment, The model yields testable predictions regarding the link from political instability to the quality of property rights, as well as the link from property rights to investment. These predictions hold up when confronted with cross-country data for around 100 countries. In particular, we 1 control for the quality of property rights, the different measures of political instability and polarization employed have no direct effect on private investment Thus, a possible link between political instability and investment is identified. Extensive sensitivity analyses show that the empirical results are robust to an ample of prospective statistical problems. «- 1998 Elsevier Science B.V, All rights reserved. JEL chassifweation: DIS: B62 Keywords: Political instability: Pokuization: Property rights: Lnyestment Introduct Why do investment rates. especially in the developing world. differ so mark- a common explanation for these divergences across time and edly? Is ther * Corresponding author, E-mail jsvenssomiworldbank org 01114-2921 98-$19.00 Copyright© 1998 Elsevier Science BV. All rights reserved, PH SO014-292 1197/0008 1-01318 J Svensson European Economic Review 42 (1998) 1317-4541 countries? On average, African countries have lower investment rates than countries in Latin America and in Asia. However. the striking fact is the large differences within each continent One explanation for this regularity. put forward by North (1981) and others. starts from the argument that the enforcement of property rights and contracts determines the incentive to invest in cumulative factors, Poorly enforced prop- erty rights create a wedge between the marginal product of capital and the rate of return that can be privately appropriated by investors, Thus. two countries with the same marginal product of capital will have different investment rates if the appropriable returns difler. Consequently, to explain differences in invest- ment rate and growth, one has to explain why property rights and contracts are enforced differently a Ultimately, it is the government that specifies and enforces property rights and contracts by providing an efficient legal system. The question és then: why do we observe permissive legal systems in many developing countries? And why does not a rational, forward-looking government choose to reform the legal code, of alternatively invest in legal infrastructure? In this paper I try to explain this apparent form of collective irrationality as a result of political instability and polarization. Low investment in legal infras- be the rational choice of policy makers maximizi oss countries. 1g individual welfare of their constituency, or social or ethnic group. as opposed to social tructure m: welfare. The reason for this result is twofold, First, the incumbent fully internal- izes the cost of reforming the legal system, but not the future benefits. Second poor quality of property rights leads to a reallocation of resources away from taxable activities.’ This, in turn, reduces future governments’ tax revenues, and their ability to spend. Hence, by not reforming the legal system. the current government discourages future governments from collecting taxes and spending them on goods ind services that the current government does not value. Both these effets are more pronounced in unstable and polarized countries This paper is related to various strands of research. Others have tried to provide theoretical explanations for why conflicts among interest groups may lead to capital ight and low domestic capital formation. In Tornell and Velasco (1992), low investment emerges as a response to poor protection of property rights, whereas it is uncertainty of the fiscal policies of future governments that generates capital flight and low domestic capital formation in Alesina and Tabellini (1989), Neither of the papers, however, address the question why a rational government may choose not to improve the quality of property rights. North (1981) stresses the relation between inefficient property rigbts and the revenue collecting incentives for the policy maker. According to North (1981), The elfeety of weak legal systems and excessive instance, Bates (1987) and De Soto 11989), ing are well-documented by, forJ. Stensson European Economic Review 42 (1998) 1317-1341 Be inefficient property rights exist because the cost of monitoring, metering and collecting taxes might lead to a situation in which a less efficient property rights structure yields higher tax revenues for the ruler. In this paper, I push North argument one step further by arguing that lack of political stability may adversely affect the incentives to invest in legal infrastructure. The underlying idea that the political structure influences the time path of state variables under the incumbent's control has several other applications.? In particular, the model presented here is in some respects similar to the model in Cukierman et al. (1992), However. Cukierman et al. (1992) address the question of political instability and seigniorage, and not the question of how a country's political system governs the evolution of its legal institutions. Previous empirical work has shown that there exists a negative relation between political instability and growth. However, the mechanism connecting these two variables is unclear. Alesina and Perotti (1993a) test the hypothesis that sociopolitical instability is the linkage between inequality and investment Motivated by the theory, I test the prediction that the quality of property rights is the mechanism through which political instability influences private invest- ment. In particular, once | control for institutional quality. the different measures of political instability employed have no direct effect on private investment, Thus, a possible link between political instability and investment is identified. This may be an important observation since several studies have documented the reduced-form relationship between instability and capital formation, but have not identified the quality of property rights as the linkage [see Alesina and Perotti (1993b) for a survey] This paper is organized as follows, In Section model is laid out explaining why governments in developing countries may not have sufficient incentives to undertake legal reform so as to fully protect property rights. and how this may hold back private investment. This leads to two empirical predictions which are tested in Section 3. The main results of this paper are summarized in Section 4 2. A political model of institutional reforms In this section, | will postulate a simple model which captures the general idea that institutional reforms are influenced by political considerations. The central feature of the model is a distinction between fiscal policy and legal reform. Fiscal policy is the choice of a tax rate and composition of government spending, while legal reform is a broad design of a property rights and contract structure in the economy. The important difference between the two is that a reform of the legal “The idea was originally and independently suggested by Persson and Svensson 11989) and Tabellini and Alesina (1999), See Persson and Tsbellini {1994b) for references,1320 J. Srensyon ° Ewopean Beonomie Review 42 (1998) 1317-1541 system is a process which takes time and resources, while fiscal policy can be implemented rather quickly 21. The model 241A. The private sector Consider a small open economy with a population size 1, lasting for wo periods and producing one good in the modern sector. Let the price of this good be fixed, equal to unity. The utility function for the representative agent is given by Ve Y pe [tea + Gel] w fen where U(e,) and Giz) are concave, twice continuously differentiable utility functions, f is a discount factor. ¢, is private consumption in per capita terms and z, is total public consumption, also in per capita terms. The subscript refers to time period In period I. there is no production and the agent derives her income from a given initial endowment, ¢. In period 2. the good is produced in the modern sector according to a concave technology: y= afi), where « is & measure of technology and / is domestic investment per capita. The representative agent faces the choice in period 1 to either invest in the formal sector, i, with the return r equal to the marginal product of capital. or to save in the traditional or informal sector (monmarketable production), d. with a fixed return equal to F Alternatively, d could be interpreted as savings abroad (capital flight}, with F then equal to the given world rate of interest The budget constraints for the representative agent are cpeenind 2) sth nfl Ayei + ad] Q) where 7 is a tax on second period income.’ The variable / is a rough measure of the efficiency of the legal system, broadly defined, with 2€[0, 1}, and where +. = (is the most efficient legal system. The effect of poorly enforced property "The assumption that the same tax rate applies to both # and dis made only for simplicity. All the results would continue to hold if the two tax rates differed, as long as the relative return between Hand d is independent of 2, This setup is justified by the presumption that axes in developing countries are often ofa general type affecting income irrespective of how itis generated. 1a cou with more sophisticated tax systems. eapital fight na also emerge as an insurarice against the tisk of future taxation, This effect. however, husilready been studied in the literature {see Fabellini. 1989), Therefore, Lnegleet the “laxation-elfect” in of eg Slesina and 10 focus on the novel issue of how 1 system governs the evolution of ils fegal institutions, a country’s polJ Srensson ° Ensypedtn Beanomie: Review 42 (1998) 13171351 1321 rights is modeled by assuming that a fraction. 7, of domestic investment is wasted in protection and other costs of doing business in the formal sector. 2.1.2, The gorernment The government can be of two types, A and B, The two types randomly alternate in office, where type A is in office in period 2 with probability x, and type B with probability 1 — x. The measure of instability, x, is exogenous throughout the paper.* The government raises taxes and supplies public goods. Government A’s goal is to maximize the welfare function W*, defined as WS=E) SY po lft s GMa]. (4) where E, denotes the expectation operator. Without loss of generality. | assume that there is only one good provided in period 1. whereas there are two goods supplied in the second period, Thus, 2, = g, and z, = g} + 3, where g, denotes the public good provided in period |. and g} and g3 denote the public goods ) is a concave function. whereas G'=2). following supplied in period 2. G™ Cukierman et al. (1992). is defined as Gz) = GM )) ming nel. is) al ~ where 7€(0, $], Government B's objective funetion, W®. is defined as in Eqs. (4) and (5), but with replaced with | ~ x. Hence, the wo types differ in the relative weight assigned to the supplied public goods. The degree of polarization is parameterized by 7. The closer 7 is to 0, the more the two governments disagr aver fiscal policy For simplicity, without loss of generality. [assume that government revenues in period | are exogenously given, equal to ¢,. Hence, the government's budget constraint in period | is simply eh FA) (6) where [(Z) is the cost (investment in legal infrastructure) of choosing the efficiency level +, and where /, < 0, 1;, 2 0. I capture the greater inertia in reforming the legal system by assuming that Z must be chosen one period in advance. For the government, the two tax bases i and d differ. Due to higher tax- collection costs in the informal sector. a fraction xx. jee (0, 1]. of tax revenues from this sector is wasted in tax-collection costs, Thus, the government's budget “However. in the empirical analysis I (ake the possibility of reverse causattion into account1322 J. Svensson ‘ European Beonomic Review 42 (1998) 13171341 constraint in period 2 is given by of — Ari + (1 — nd] = 2 a The parameter is exogenous throughout this paper, determined by existing technology and the level of development in the country. 2.2. Market equilibrium in period 1, the representative agent chooses a level of total savings, sand the allocation between investment in the modern sector and nonmarketable pro- duction. | assume perfect competition so that the rate of return to domestic investment is equal to the marginal product of capital The representative agent maximizes the utility function, Eq. (1} subject to the two budget constraints [Eqs. (2) and Gy]. taking + as given. The first-order conditions are (arse (8) Caen BU es) rye 9) where s* is the expected tax rate. Eq. (8) states that in equilibrium the return to domestic investment and nonmarketable production is equal, The inetlicient property rights structure, captured by the variable 4, drives a wedge between the marginal product of capital and the opportunity cost of investment. Eq. (9) is \ condition for optimal intertemporal allocation. In equilibrium, # ~ + The first-order conditions [Eqs. (8) and (9)]. together with the budget con- straints [Eqs. (2) and (3)]. implicitly define the endogenous variables i and « as functions of the eflicieney variable 2 and parameter vector x i 1x), == 10) where v = [Fa]. Applying the implicit function theorem to Egs. (8) and (9). and using the savings constraint s= i 4d, yield the following proposition Proposition | (1, <0.1, 20.1, >0 (iil D, 1, > 0,D,20, y= = Thus, st less efficient legal system discourages domestic investment and shifts savings towards nonmarkelable production or capital flight. The reason for this is that low investment in legal infrastructure. resulting in poorly enforced property rights. lowers the privately appropriated marginal product of capital Moreover, the higher the opportunity cost of investment. F, the lower the level of domestic investment and the higher the level of foreign saving. An inerease in the productivity of capital. captured by the parameter @, raises fas the relativeJ. Stenson European Economic Review 42 (1998) 1317-1341 1303 return to investment rises. The effect of a change in F on d* depends on the usual balancing of income and substitution effects. 2.3. Economic policy with a given legal system To solve the policy problem | start in period 2 and derive the equilibrium values of the endogenous variables as funetions of 4, In period 2. / is given and the incumbent policy maker solves the static problem of maximizing second be the equilibrium when type A is in ymmetry. the solution for government B is the same for », while are found by replacing (1 ~ 2) with ~. and vice versa. period utility subject to Eg. (7). Lonly de office. By solutions for g§ and ¢ Using Eq, (81 to simplify. the first-order conditions for this problem are® ght =(1— az, and g3* ay itd | (1 yd) Fg, (12) compares the marginal utility of public and private consumption. Even though, ex post. a tax on total savings is not distortionary, at an optimum the marginal utility of public consumption, unity. exceeds the marginal utility of private consumption, Cue). This is a resull of the wasted resources in collecting taxes, captured by the parameter y.. The lower i relative d, the more resources are wasted in tax collection costs for every level of government spending. The equilibrium values of r. ¢) and 2; as functions of / are implicitly defined by Eq, (12), together with the budget constraints [Eqs. (3) and (7). and the behavioral constraints Eq. (10)] eT) t= Zinc (12) Cy 113) Applying the implicit function theorem to Eqs. (3), (7) and (12 proposition 1, 1 arrive at the following lemma. and using Lemma 2.) T, <0, 2; <0, C; > 0. Hence. a less efficient legal system discourages the government in period 2 from collec ing laxes as More resources are wasted in Ltx-collection costs for a given amount of tax revenue, The efficiency of the legal system affects the level of public spending through two channels. First, a less efficient legal system reduces government spending. since the equilibrium tax rate falls. Second, as more resources are driven (o the informal sector, less revenue is generated for ever Noite also that a lower ta rate increases private consumption.” The second-order condition is always satisfied, because of the concavity af niet © As the Giles) function is line: all income elfeets of a larger / fall on public consumption. IT the Gey fametion was concave, some additional assumptions would have to be made for Lemma 210 hol1324 J. Srensson » European Keonomic Review 42 (1998) 1317-1341 2.4, The equilibrium level of investment in legal infrastructure The problem for the government in period | is to maximize expected utility with respect to 4. Again I only characterize the equilibrium when type A is in office in period 1 Solving for the optimal composition of public spending for government B, and substituting the solution into Eq. (5), yield the expected welfare as of period 2 for government A. By plugging the incentive constraints given in Eq. (13) into the second period utility function, expected welfare can be written as a function of / only. Maximizing expected welfare results in the following first-order condition;” Gg: + BU feriC; + fekx, 22. (4 where 0 (m2) + mat) ~ »). Eq. (14) compares the marginal gain of a less eflicient legal system, taking the form of higher levels of government spending in period | and increased private consumption in period 2, with the expected marginal cost, taking the form of reduced public spending in period 2 ‘The equilibrium legal system as a function of the political variables. x and 2. and the parameter vector, t, is implicitly defined by the first-order condition [Eq. (14)] = Atm. 4.0) assy where # = [yf ae,]. Thus, | have the following proposition.* ) = 0. and Ar, 4.0) = 0 for all v. 0. (VI) F# > 0, Proposition 3. (i) If A) =0V4. then AU. (i) If 28 > 0. then A, < 0. (ii) If 7* > 0. then A, <0. (iv) A 9 > 0, such that A> 0 for any x x < Hoven if HA) = OW, If there are no costs associated with a reform of the legal system. and if the current government is certain to remain in ollice next period, that is 7 = tor if there is no polarization, that is x ~ 4. it is optimal for the government in office in period | to choose the most eflicient legal system. However, the more polarized or unstable the system, the less investment in legal infrastructure is carried out by the government in period 1. The reason for this is twolold. First, less efficient legal institutions promote nonmarketable production or capital flight and discourage domestic investment. thereby affecting future governments’ tax bases. The higher share of total private saving held in the informal sector or abroad, the higher collection costs of taxing the private sector. Hence. by not J assume the second-order condition is satisfied. AS i all optimal taxation problems. this tequizes some assumptions of the third derivatives of Cle) and fi * Proof available on requestJ. Svensson Buropea Economie Review 42 (1998) 1317-1341 1328 reforming the legal system, the incumbent discourages future governments from collecting taxes and spending them on goods that are not valued by the current government. This effect is independent of the cost of reforming the legal system Second, the government in power in period 1 fully internalizes the cost of reforming the legal system, but not the future benefits. The lower 7 or the lower x, the lower the expected marginal gain of a legal reform. On the contrary, the cost of a legal reform is independent of these political variables. Note also that initial income or revenue, ¢,, affects the level of investment in legal infrastructure positively through this last effect Combining Propositions 1 and 3 yields the central results of the model governments in unstable and polarized societies tend to invest little in legal infrastructure, resulting in poorly enforced property rights and. thus. lower levels of domestic investment Two remarks about these results are in order, First, political instability is here 4 synonym to executive instability (ef. Alesina and Perotti, 1993a). Second, the political variables 7 and x only affect the level of private investment through the quality of property rights, and hence the return to capital. In the model. the variance of the pre-tax as well as the after-tax marginal product of capital is zero. This is so because, by arbitrage, the marginal product of capital in the formal sector is equal to the given return in the informal sector. and due to the assumption of symmetry, both government types will choose the same tax rate in period 2. Hence. x and x affect the first moment of the return to capital through the incentives to invest in legal infrastructure. 3. The empirical evidence 3.1. From model w an empirical test In this section, | will test the positive implications of the model on a sample of 101 countries for the period 1960-1985, The two key equations in the model are the investment function (10) and the equilibrium legal system Eq. (15). Assuming that the parameters #. a, 4. and e, randomly differ across countries, it is possible to derive the following linear approximations: Xiph + Bri + ah (16) Beatin ~ Dy ailes + my. 7) where fi, 7). and > are vectors of coefficients, x; = [Fa], 0) = [Fa jeg] and 1, 1, are unobservable error terms. Subscript refers to country "The effects of 7,14, ine y,0n /¥ depencl on how these parameters affect the marginal gain ofa less cilficient legal system, and are in the model ambiguous (see Svensson, 1994),1326 J, Stensson European Economie Review 42 (1998) 1317-134) 3.2. Measurement Below, the data used to proxy for the variables in Eqs. (16) and (17) is described. To minimize problems of reverse causation, the explanatory va ables. unless otherwise noted, are measured at the start of the sample period. The sample of countries used is determined by data availability. Appendix B reports data sources and Appendix C summary statistics, Private investment. i, The dependent variable in Eq. (16) is private domestic investment, which is proxied with the ratio of real private domestic investment to real GDP. IN VP. Unfortunately, private investment data is only available for the time period 1970-85 and only for a limited number of countries. Therefore, in the base specification. f use the ratio of real domestic investment to real GDP. denoted by INI Efficiency of legal institutions, 2, In the model, 4 is meant to capture the quality of property rights. In previous empirical studies on capital accumulation, property rights protection has been proxied with variables such as counts of revolutions, coups. assassinations. subjective indexes of civil liberties and politi- cal freedom (see e.g. Barro, 1991; Alesina and Perotti, 1993b). However. none of these variables bear direct relation 10 the quality of property rights. Rather, they are proxies for potitical disturbances and social and political freedom. Knack (1993), on the other hand, employ institutional indicators obtained from wo private international risk services. ICRG based in New York, and BERI based in Washington. The data provided by ICRG and BERI are meant to capture various dimension of the investment climate and are closely related to those institutions emphasized by North (1981).7! ICRG provides five different institu- tional indicators for 118 countries. namely: “rule of law”, “corruption in govern- ment”, “quality of the bureaucracy”, “expropriation of private investment”, and “repudiation of contracts”. BERT provides four indicators for 5] countries, namely: “bureaucratic delays”. “nationalization potential”, “contract enforeea- bility”. and “infrastructure quality”. The first rating published by ICRG is trom 1982, while BERT first published their scores in 1972, With the presumption that a single point around the middle of the sample period measures the average quality of institutions at least as well as an average value derived from the later part of the period. initial values of the institutional indicators are summed to eale (WO composite indexes, [ORGS and BERIS. respectively.'* Part af the @Since dita on Hie return to capital (and vauiances is not available, it is not possible to discriminate between the ts of properly rights quality on the first and second moment of the turn to capital, and hence. their effeets on the level of private investment “The subjective indicators are Iramed by experts to sslisfy mainly the demand of international investors. Therefore it is aot necessarily so Ut they reflect the re investors have about the quality of property rights, According t0 Knack (19931 both perception private domestic wdexes are relatively stable over time.J. Srensson * Buropectn Economie: Review 42 (1998) 1317-1341 1327 rationale for aggregating the indicators into composite subindexes is that there may be measurement errors in each individual indicator, and averaging the individual indicators may yield a better estimate on the quality of property rights. In the base specification, I use ICRGS as a proxy for 2, since [CRG provides data on more counirie: Political instability. a. In the model, x is a measure of political instability, defined as the propensity of an imminent government change. This probability is not (directly) observable. Therefore. I choose to estimate m by means of a probit model. In a probit regression. the dependent variable takes the value | for years in which there is a government change and a value 0 otherwise. The explanatory variables are a subset of political. economic and structural variables designed to capture the likelihood of an imminent government change. By using pooled time-series cross-country data, I estimate the probabilities of government change over the period 1960-82. The political instability index is then found by averaging the estimated probabilities of government change for each country over the relevant time period. 1 use two different dependent variables. The first one, GCHANG: government change, is the one used in several other studies and codes as | any regular or irregular transfer of executive power. The second variable. MCH ANG: major government change, obtained from Alesina et al, (1992), is an attempt to climinate government changes that do not involve a substantial turnover of leadership. Since it is political instability in polarized societies that drives the result in the model above. MCHANG is & more appropriate measure. The explanatory variables used in the probit model as well as the base probit specification, are described in Appendix A. The resulting estimated probabilities sire used to create two executive instability indexes denoted by PGOV-CH and PMAJCH Political polarization, x. The model also suggests that the quality of the property rights depends on political polarization. A problem with this predic- tion is that it is difficult to find indexes of polarization for empirical work However. as mentioned above, by distinguishing between PGOVCH. which picks up all types of turnovers including changes in coalition governments, and PMAJCH. which only codes major changes. we obtain a crude measure of tion, The first one. INCOME. is the ratio between the share of total personal income before tax received by the poorest 40% to the richest 20% of the population. The presumption is that income inequaility increases polarization. | also use an indicator of social unrest and political violence, denoted by POLAR. with the presumption that domestic mass violence is likely to be higher in polarized societies. POLAR is created by applying the method of principal components to the variables 18S ASS. the number of politically motivated assassinations per million popula- tion; DEATH, the number of people killed in conjunction with phenomena of domestic mass violence per million population: EXECU. the number of polarization, Lalso try several proxies for pokari1st 1328 J Seemsson European Beonomic Reviews 42 (1998) 1317 politically motivated executions; and DEMOCY, a dummy variable for democracies. The last variable is included because of reporting problems. In most dictatorships. the government controls the press and restricts the diffusion of information. Hence, measures such as ASSASS and EXECU are likely to be underreported. Alesina and Perotti (1993a) use a measure similar to POLAR as a proxy for socio-political instability. The main difference is that they include variables capturing illegal transfers of executive power. thereby capturing both executive instability (of one type) and socio-political unrest. By only including proxies for social unrest and political violence I want to separate executive instability from socio-political disturbances. The presumption is that the latter is a phenomena which is likely to be correlated with political polarization. However. since POLAR only is an indirect measure of polarization, the effects of POLAR must be interpreted cautiously. In particular, mass violence «nd social disorder can have direct effects on the quality of property rights and therefore on the return to investment. Other variables. As « proxy for F use the PPP value of the investment deflator in 1960, denoted by PPPI.'* The parameter «. which is a measure of productiv- ity, is proxied with PRIM, primary school enrollment rate in 1960, while the empirical counterpart to jis URBAN, urban population as percentage of total population.* The presumption is that tax-collection costs are likely to be higher in rural areas than in urban areas. nally, real GDP per capita in 1960 (GD P60) is included to proxy for the ble ey 3.3. Results Eqs. (16) and (17) define a recursive system. As long as the error terms are uncorrelated, least squares applied to each equation is a consistent and eflicient estimator, The results of OLS estimations applied to each separate equation are shown in Tables 1-3, In the benchmark specification on investment, column (1a), all variables have the right sign and are significant at the 1% level. In the base regression on property rights protection, column (1d) and (1el, both proxies for political instability, PGOVCH and PMAJCH, also have the right signs and are significant at the 3% and 1% level, respectively. As expected, the effect of major government change is much stronger. The point estimate is more than "Thus, the proxy for & is not « direct measure of the opportunity cost of capital, but rather & indicator of the rekitive return te investments, “This interpretation of a aevords well with recent growth models, such as Lucas (988) and Rebelo (1991), that assume constant returns to a broad concept of reproducible capital Cineluding human capital. and Romer (1990), where human eapital is the key input to the researchJ. Svensson * European Economie Review 42 (1998) 13171341 1329 Table 1 Cross-section regressions on mnvestin INT INT FCRGS Expl var (ay ‘lb Const ons eae asna"t saat (0.020 ody Ww.0rsy 15.604) 14.175) ICRGS OISE-20 1TE 28 SUE (Sb d.62b-3 10.0083) PRIM ogo" Hn9se* coos 1198 v.00" 020 0224 10.027) 3.921 216) PPL A006" 066" oun 5.930" 3940) 1.416% aro counsy 787) 83 GDPoO ESTP oon 3.7654" Dist wah (46E-21 (0.735 10Hap URBAN 2.066, or (0.060) 10481 PGOLCH 4330" cssay PMAICIL [ro 2 138,38) jot 2 101 w as uss 056 we dl ertoss in p ieance at the $111 level Ps denotes sig four times larger in absolute values, The magnitude of this effect is considerable. A one-standard deviation reduction in the political instability measure, PM AJCH, is associated with an increase in the property rights index with 4.8) units. The point estimate on GDP6O, capturing the fact that rich countries can allord to invest more in legal infrastructure, is positive and highly significant The coefficients on PRIM are positive and significant in both regression. while PPP is negative and significant at the 5% level in (1d), but insignificant in (Le) URBAN has no significant effect on institutional quality. Note that without farther restrictions on the model, the last three proxies have ambiguous eflects on the quality of property rights. In (1b), I include GDP64 to control for convergence. The point estimate is actually positive, but the coefficient is not significantly different from zero. All other variables. including JCRGS, remain significant at the 1% level. In (1c) the dependent variable is private domestic investment rather than total domestic investment. As expected, the effect of JCRGS on private investment is much stronger. The coeliicient is almost twice as large and highly significant. Again. ihe magnitude of this effect is considerable. A one-standard deviation increase in1330 J. Svensson ! European Economie Review 42 (1998) 1317- 1341 Cross-section regressions on investment and institutional quality BERIS—BERIS— ICRGS—ICRGS_—-ICRGS_—_ICRGS (2b) (2c) fen) (2c) ef 28h out lois here ag2* 24 0 (0.02) (124) (824 (7.46) id 389) BERIS O.7R-2¢* W0.25F-2) PRIM ole 345% 237 110 598 610 556 0.08) 11.33) 40.92) 20 49) GSN PPL doer 002 049 ger 992 3.85 1 won (o.x04 1052) 4.500 1264) Q.S7P 12.08) GpPon asi O5ce* = 368 1768 ate 6a fO15) 105) 0.96) 70) (OD URBAN ear 0.08 az 0.08 0.08 Woy Os) 408) (0.06) 40.05) PGOVCH 404 Bes) PMAJCH Aled 161" 144e* lay 0, 74) INCOME 2378 690) 04 1802) POLAR ati 34g way 82) No, obs, 49 o 9 49 49 ox 98 Adj. R 0.68 9.60 0.80 089 069 0.64 on Note: OLS regressions, standard errars in parenthesis, ificance at the 5 (1) % level the property rights index is associated with an increase in the investment rate by 4.02% of GDP. In Table 2, columns (2a)-(2ch I have replaced ICRGS with BERIS. The results are very similar to Table |. except that PGOV'CH is no longer significant at the 5% level. Summarizing the basic results, political stability is conducive to capital accumulation due to the fact that it creates necessary incentives for the government to define, enforce and protect property rights ‘The model also predicts that political polarization affects the quality of property rights. In (2d) (2e) INCOME is included among the regressors. In (2d). the coefficient on INCOME is positive and significant at the 5% level. Le, the more equal distribution of income, the stronger property rights enforcement However in (2c), the point estimate on JNCOM E is insignificantly different from zero. One possible explanation for this. as discussed in previous section, is that social cleavages driven by an unequal distribution of income are alreadyJ. Srensson European Economie Review 42 (1998) 1317-1341 ian Table 3 Cross-section regressions on investment INI INV INT Expl var Gay Bet ia Constant onset O168 9.096" 07 10.034) «@.0361 10.032) jen2ay FORGS OSE" 1 ost E- (0.523) (0,003 (o.77E-3) 1002E- PRIM 1098" ost 0.100%* eunsee oD conn (o.02% 40021) PPPL wom Hoos 0.03 Bus worry W016 (0.026, (0.016) PGOVCH HOSS HLT IO PMASCH ait 10.2301 INCOME 0.089 40.061) POLAR No. obs, rol tor 49 ow Adj. R? uss oss 059 usa Note: OLS regressions, standard errors in parenthesis *(°*) denotes significance at the $41) % level captured by the variable PM AJCH. That is, everything else equal. the probabil ity of a major government change is higher in countries with high income inequality. This interpretation is supported by the fact that PGOVCH becomes insignificant at the 5% level when INCOME is included among the regressors, A similar result is found in column (2) (2g). Including POLAR as a regressor. PGOVCH is no longer significant at conventional levels. The coefficient on POLAR is signiticant at the 1% level in both regressions. capturing the direct effects of socio-political disturbances on the quality of property rights. Table 2 highlights an important result of the model, namely that the relation between political instability and quality of property rights is limited to highly polarized countries, ic. countries with high probability of major government change and socio-political disturbances Another very interesting result that supports the basie idea of this paper is found when the variables for political instability and polarization are included in the investment equation. As shown in Table 3, 1CRGS remains significant in all different: specifications, while both PGOVCH, PMAJCH and the proxies for polarizittion are insignificant. A similar result is found when the | variables are included in regression (Ie) with INVP as dependentmR J Svensson; European Eeonomnc Review 42 (1998) 1317-1341 variable.’ In all cases, the political variables, except PGOV CH. have significant effects on INV when ICRGS is excluded. These results suggest that the linkage between political instability and investment indeed goes through the quality of property rights as predicted by the model. This may be an important observa- tion, Previous empirical studies have found reduced-form evidence between different political variables and capital accumulation (see e.g, Barro, 1991; Alesina and Perotti, 1993b). The results in Table 3 suggest that the quality of property rights is the mechanism through which political instability influences private investment. Thus, a possible link between the political and socio- political environment and investment is identified. Note finally that the overall fit is relatively good: the model explains consider- ably more than half the variance in the dependent variables in all cases. 34. Sensitivity analysis In this subsection, | discuss several possible problems with the regressions reported above. An outline of the identifying assumptions in previous section, as well as the test statistics used in this section, is provided in Svensson (1994), Contemporanvous correlation. In previous section, 1 pursued the econometric analysis under the null hypothesis of no contemporaneous correlation between the errors in the two equations. If this is not true, OLS yields inconsistent estimates, since the error term in Eg, (16) will be contemporancously correlated with the regressor I}CRGS, However, testing for contemporaneous correlation using the Lagrange multiplier statistic, suggested by Breusch and Pagan (1980), gives no support to the alternative hypothes Reverse causation. A second possible objection to the results presented above is that they could be due to reverse causation. As emphasized by Alesina et al. (1992) and Londegran and Poole (1990), political instability may be a function of economic conditions in the country, and possibly also of the rate of private investment. If this is the case. PMAJCH is an endogenous variable and the model should be estimated using a simultaneous equation approach. A rough test for contemporancous correlation between the error term and [CRGS is the omitted-variable version of the Hausman test (OV-test). The result of such a test on Eq. (16) is that the null hypothesis of no contemporaneous correlation cannot be rejected at the 5% significance level. An alternative way to deal with the problem of reverse causality is to jointly estimate political instability and investment. This could be done either by °° The only difference is that INCOM Eis also significant at the 5% level with IN VP as dependent variable. One explanation for this ws that there are other mechanisms than through property rights protection in which inequality can affect capital accurnulation (see e.g. Persson and Tabellini, 1994aJ. Stensson ° Furopewn Economic Review 42 (1998) 1317-1341 1333 Table 4 Simultaneous equation on investment and political instabil y INT Expl var (day PMAICH INV ICRGS (er (4g) (4) Constant 10" ast ou alo 259" vot (0.02) 3.90) 1O.GE-2) (0.02) 941 (ok-2 ICRGS 0.29F.20* O27E-2* (o.7r- TE-3) PRIM 0.08 S57 03E-2 oss 1o.g7* wu Gov (0.78.2) 02 B77 PPL 0.06"* an oe 443 10.02} (2.00 0.02) (asap PMAICH iat 128.6) PREMCH 1o7** (309) GDPan 24g OTTER 3.0%" 5 WOSSE (w.70) URBAN 9.09 ITE = 0.10 (oss (O.8SB-41 (0.06) INy 91.04 8.06 (0.04) wor POLAR 450" 4-2" i) 10.146 LATIN 006+ 11.06%" W3E-2) (0.02) IERICA OTIE2F an O38 DATMAL 10.06) REPRAL 0278-3 (3E.31 EXADAV 61.06) 1.08) GRSVST rs wis No. abs. os oN on 99, 99 ow Note: ISLS regressions, standard errors in parenthesis * () denotes significance at the 5 (1) % level adding a third regression equation combining the variables PMAJCH and INV, or by using average values of the variables in the probit specification and jointly estimate the dependent variables INV. ICRGS and the actual frequency of major government change, FREMCH. The results of the first method with PMAJCH as a proxy for instability i shown in Table 4. columns (4a}(4c). The equation mapping investment to1M 1. Sreusson + European Economic Reviews 42 (1998) 1317 1341 political instability is taken from Alesina and Perotti (1993b). The signs of ICRGS and PMAJCH are as predicted by the model, and both of them are significant at the 1% level. The point estimate of INV is, however, not signifi- cantly different from zero. even though with the right sign, reinforcing the OV-test above. The picture is similar when polarization is proxied with INCOME instead of POLAR. In columns (4d}-(4f ), the results from the second simultaneous method are shown, Again, the highly significant effect of political instability, proxied with FREMCH. on property rights protection, and of ICRGS on investment. continue to hold. The hypothesis of reverse causation between investment and political instability is rejected. Measurement errors. An important question is whether the previous findings are robust to possible measurement errors, In the benchmark model, at least two variables are likely (o be measured with errors, namely ICRGS and the political instability measure, However, for /CRGS in Eq. (17), the existence of measure- ment errors causes no statistical problem, since these errors are incorporated in the disturbance term. Moreover, since the OV-test is a general test of contem- poraneous correlation between the error and the regressor, it is also a test of measurement errors in /CRGS in Eq, (16). An alternative way is to re-estimate the model with instrumental variables. The instruments for PGOVCH and PMAJCH are the actual frequency of government change. FREGCH, and major government change. FREMCH. The results of this specification are shown in Table 5, columns (Sa} (Sb). FREMCH is still significant with the right sign, while FREGCH becomes insignificant at conventional levels, Specification, Another important question is whether the results are robust to alternative specifications. and particular observations, An examination of the residuals reveals a few outlying observations. However, dropping these coun- Iries from the sample makes no difference to the results. Alternative specifications of the probit model. for example including all explanatory variables defined in Appendix A. yield results similar to. those reported in Table |. In particular. the strong negative effect of major political instability on ICRGS is independent of the probit specification. Including other variables in the investment equation to proxy for the variables # and o in the model, such as secondary school enrollment rate, SEC60, and deviation from the sample mean of PPPL. PPPIDEYV, does not change the qualitative result either The effects of dropping the predetermined variables. t, from Eq. (17) are that PMAJCH is still highly significant, while PGOVCH becomes insignificantly different from zero at the 5% level when PPP/, GDP60 or PRIM are excluded All results continue to hold when I exclude one or two of the five [CRG indicators from ICRGS, or if 1 only use the ICRG-indicator “rule of law” as a proxy for /, Moreover. including other proxies for polarization, such as ethnic and linguistic fractionalization, ETHLINF, ot including more variables in the index POLAR. such as number of armed attacks. ATTACK and number of riots, RIOT. do not change the qualitative results either. ETHLINF turned outJ. Svensson ! European Economic Review 42 11998) 1317-1341 1335 Table 5 Cross-section regressions on investment and institutional quality ICRGS——ICRGS-— NY INVP ICRGS Expl. var (Sal (Sb) (Sel (5d) (50) 65t) Constant 16.9% oe ast aos 3a2e 33.2% (3361 G2 (0.03) (003) (5:70) 14.56) JCRGS QISE2¢ 3.2" (O7E3) (OSE) PRIM lose wit gore ogee Aa 105 (3881 GIy (02 (0.03) (4.20) (392) PPPI 379 333 0.06" goa Tet 434 oH 259) (002) (0.02) (272 es PGOVCH = sage 093) PMAICH iar (34.1) GoPon 358e* aad 0.0 105 (074) 7) u 1119) URBAN oad 0s a2 0.08 10.86) (0961 (00?) 10.06) FREGCH 9.10 (68h FREMCH 1983) No. obs. tor or "7 9 n Adj. R? 054 056 042 asa 020 Note: OLS regressions, standard esrors in parenthesis, #1") denotes significance at the 5 11) % level. to be insignificantly different from zero at conventional levels in all specifica tions, while the results for POLAR generally worsen when including ATT ACK and RIOT. Furthermore, | included region specific dummies, LATIN, AFRICA and ASIA, to control for cultural differences that might be picked up by ICRGS and PMAJCH. The results are that in the investment equation, the significant positive effect of property rights protection on investment continues to hold, and only LATIN is significant at the 5% level. In the legal investment equation, the political variables also remain significant, PGOVCH on the 5% level and PMAJCH on the 1% level. All three dummy variables are significant at the 5% level when estimated jointly, while only AFRICA is significant when estimated individually. This result suggests that cultural factors may play a role in the design of legal infrastructure Lalso tried a different measure of institutional quality, bureaucratic efficiency (BE), described in Mauro (1995). The BE index is highly correlated with 1CRGS, the simple correlation coefficient being 0.80. Overall, the qualitative results do136 J. Stensson Buropean Economic Review: 42 (1998) 1317-1341 not change when replacing ICRGS with BE. In particular, the results reported in Tables | and 3 are robust to the measure of institutional quality employed. reinforcing the model's prediction. The results are also robust to alternative specifications of the sample of countries. In Table 5, columns {5c} (Sf), the estimates for non-industrialized countries are shown! The highly significant effects of political instability on institutional quality. and of institutional quality on investment, continue to hold Generated reyressors. The political instability measures are generated re gressors. As such. the estimates of the standard errors may be biased. However under the null hypothesis that the estimated coefficient of the political instability variable is zero. the standard errors are unbiased. Thus, the f-statistie for the null hypothesis is not invalidated (Pagan, 1984), Unfortunately, there could be at problem of interpreting the t-statistics for the other variables. I deal with this problem by using average values of the variables in the probit specification and jointly estimate political instability, investment and institutional quality. ‘The results shown in Table 4. columns (4d) (46), are oasistent with previous findings. Heteroscedasticity. The White (980) test on the covariance matrix of the residuals accepts the hypothesis of no heteroscedasticity, except for r ession (He), where I reject the hypothesis on the 5% significance level. However, when [ re-estimate the mode! using White's heteroscedasticity-consistent estims sully are very close to those reported in Table | the I conclude from the sensitivity analysis above that the empirical results are indeed robust to an ample of potential statistical problems. 4. Conclusion In a political-economy model. [ have shown that it could be optimal for the government in office not to reform the legal system, resulting in poor quality of property rights and, consequently. low private investment. The reason for this result is twofold. First, poor quality of property rights leads to a reallocation of resources away from taxable activities. This in turn reduces future governments’ tax revenues, and therefore their ability to spend, Second, the incumbent fully internalizes the cost of reforming the legal system, but not the future benefits, Both these effects are more pronounced in more unstable and polarized societies, The empirical implicattons of the model is that governments in unstable and polarized political systems tend to invest little in legal infrastructure, resulting in Noo-industriatized counts fe defined here ay all non-OECD countries in the sumpleJ. Seensson ' European Economie Review 42 (1998) 1317-1341 7 lower levels of domestic investment. These predictions hold up when confronted with cross-country data for around 100 countries. In particular. once I control for institutional quality, the political and socio-political variables have no direct effects on investment. Thus. a possible link between political instability and investment is identified. These findings are worth stressing, since earlier empiri- cal studies have not identified quality of property rights as the linkage between political instability and investment. Furthermore, extensive sensitivity analysis shows that the empirical results are robust to an host of prospective statistical problems. Froma broad policy perspective, the main implication of these findings is that creating and reforming political institutions that would reduce political instabil- ity and polarization in developing countries should have an important priority in the agenda for policy reform. Such measures would not only have direct effects on the countries’ political landscape but would also have an impact on the quality of property rights and. thus. the welfare of the citizens in many developing countries. Acknowledgements. Lam grateful for many useful discussions and suggestions by Torsten Persson, and for comments by Nils Gottfries, Gunnar Jonsson, Stefan Mellin, Peter Svedberg, Thierry Verdier and participants in seminars held at Stockholm University and the Institute for International Economic Studies. | have bene- fited from presenting the paper at the European Economic Association Meeting in Prague. | also thank two anonymous referees for constructive comments. Alberto Alesina and Steve Knack kindly made their data available, Views expressed here do not represent official opinions of the World Bank Appendix A. A probit model of government change GCHANG = Dummy variable taking the value of one each year in which there is a change in executive leadership, ie. either a coup or a regular govern- ment transfer, and zero otherwise [source: Jodice and Taylor (1983)]. MCHANG = Dummy variable taking the value of one each year in which there is a major change in executive leadership, ie. either a coup or a major regular government transfer, and zero otherwise (source: Alesina et al. (1992)] GRGDP = Annual growth of real per capita GDP [source: Alesina et all (1992) constructed from Summers, R. and A. Heston (1988), Review of Income and Wealth, 34:1, 1-25) GDP = Log of real per capita GDP [source: Alesina et al. (1992) constructed from Summers and Heston (1988)}1338 J Svensson European Beonomie Review 42 (2998) 1317-1341 EX ADJ = Dummy variable taking the value of one in years which there is a change in the composition of the executive not resulting in a government transfer, and a value zero otherwise [Source: Jodice and Taylor (1983)] Dummy variable taking the value of one in years which there is an unsuccessful attempt at changing the government, and a value zero otherwise [source: Jodice and Taylor (1983)] REPR = Government imposed sanctions to neutralize, suppress or eliminate perceived threat to the security of the government or the regime [source: Jodice and Taylor (1983)] DEMOCY = Democracy variable taking the value of | in democratic re- gimes, 2 for regimes mixing democratic and authoritarian features. and 3 for authoritarian regimes [source: Alesina et al. (1992)] LATIN = Dummy variable for South and Latin America. AFRICA = Dummy variable for Africa. Probit model of government change, 1960 $2 HANGL MCHANG) EXADJI AFRICA LATIN Dep. var art GCHANG = —5S 136 0. ota aay) C8511 (5.55) (2.65) ‘ MCHANG — 138 181 b6 021 (09 (382) 11.651 B18) (0.25) Note: Probit estimation, (statistics im parenthesis, There sre 2689 observations, and the log likelihood in the two equations are: — 15475 and ~ 92500, respectively, The average estimated probabilities of a government change from these regressions are used to create the indexes PGOVCH and PM ASCH. A variable followed by the number I indicates thit the variable is lagged one period Appendix B. Variable definitions INV = Average from 1960 to 1985 of the ratio of real domestic investment (private plus public) to real GDP [source: Barro, R. and H. Wolf (1989), Data Appendix for Economic Growth in a Cross Section of Countries] INVP = Average from 1970 to 1985 of the ratio of real private domestic investment to real GDP [source: Barro and Wolf (1989)]. ICRGS = Index of institutional quality, sum of the institutional indicators: rule of law, corruption in government, quality of the bureaucracy. expropria- tion of private investment, repudiation of contracts (source: International Country Risk Guide. ICRG (1982), New York, see Knack (1993) for a detailed definition].sun Eurapean Beonomic Review 42 (1998) 1317-1342 naw BERIS = Index of institutional quality, sum of the institutional indicators bureaucratic deltys, nationalization potential, contract enforceability, infras- tructure quality [source: Business Environmental Risk Intelligence, BERT (1972), Washington D.C., see Knack (1993) for a detailed definition] PRIM = 1960 primary-school enrollment rate [Source: Barro and Wolf (1989)], PPPI = 1960 PPP value of the investment deflator (US = 1.0) [source: Barro and Wolf (1989)]. GDP60 = 1960 value of real per capita GDP (1980) base year) [source: Barro and Wolf (1989)} URBAN = Urban population as a percentage of total population in 1960 (source: UNDP. 1991, Human Development Report, New York. Oxtord University Press] INCOME = The ratio between the share of total income before tax received by the poorest 40% and the richest 20% of the population, around 1960 [source Paukert (1973), Income Distribution at Different Levels of Development A Survey of the Evidence, International Labor Review, 108, 97-125.] POLAR = Index created by applying the method of principal components 1 the variables: ASSASS. the number of politically motivated assassinations per million population, average 1960 85 (or subsample) (source: Barro and Wolf (1989); DEATH, the number of people killed in conjunction with phenomena of domestic mass violence per million population, average 1960-77 (source: Jodice and Taylor (1983): EXEC. the number of politically motivated executions. average 1960-82 [source: Jodice and Taylor (1983)] and DEMOCY | FREGCH = Average Irequency of government change from 1960-82 [source: Constructed from Alesina et al. (1992)] FREMCH = Average frequency of major government change from 1960-82 {source: Constructed from Alesina et al. (1992)] PPPIDEV ~ Magnitude of the deviation of PPP from the sample mean in 1960 [source: Constructed from Barro and Wolf (1989)} SEC60 = 1960 secondary-school enrollment rate [source: Barro and Wolf (19894), ETHLINE ~ Ethnic and linguistic fractionatization around 1960 [source: Taylor C.L. and M.C. Hudson. 1972 World Handbook of Social and Political Indicators, Yale University Press] BE ~ Average of bureaucratic efficiency [source: Mauro (1995)] {1 TACK = the number of armed attacks. average 1960-82 [source: Jodive and Taylor (1983)], RIOT = the number of riots, average 1960 82 [source: Jodice and Taylor (1983)] A variable followed by AF. indicates average data from 1959 8}1340 J Stonsson European Eeonamte Review 42 (1998) 1317 1394 Appendix C. Summary statistics Descriptive statistics of regression variables STDEY ICROS 12.97 8.00 soo BERIS 299) 3.00 14s INI 0.079 Oe 91369) NTP 0070 0.029 0.364 PMAICH wan? 0.069 O19 Poorcn 066 on? 0392 PRIM 332 as Lad PPPt 337 0254 Das URBAN yy 200 190.0 GDPoG rt 0.208 738 POLAR 10 Lo 591 INCOME n28 o.10l 0,639 FREGCH wast on 0.799 FREMCH lon oud 1089 00 0391 References Alesina, A., Tabellini. G.. 1989, External debt. capital flight and political risk, Journat of fterna- tional Economies 27. 199 200. Alesina. A, Orler. S.. Roubini, N.. Swagel. P.. 1992, Political instability and econos Working paper no. 4172. NBER. Cambridge. MA. Alesina, A.. Perott, R.. 1994, Income distnbution, political instability, and investment, Working paper no, 4486, NBER, Cambnidge, MA Alesina, A. Perotti, R.1993b. ‘The politics of growth: «survey. Mimeo. Harvard University. Cambridge, MA, Barro, R.. 1991, Eeonomic growth in a cross section of countries, Quarterly Journal of Beonomics ig, 407-443 Bates. 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