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Discussion: My name is ____________ and I will be presenting the paper by James Gwartney, Randall Holcombe, and Robert Lawson entitled “Economic Freedom, Institutional Quality, and Cross-Country Differences in Income and Growth.”

Slide 2

Discussion: Explaining cross-country differences in income and growth rates is one of the oldest challenges in economics. As illustrated by the cases of South Korea and Liberia, countries that start with similar income levels can end up with very different outcomes. Understanding how to replicate the success of South Korea and avoid the fate of Liberia is crucial in order to help raise countless people out of poverty. In “Economic Freedom, Institutional Quality, and Cross-Country Differences in Income and Growth,” Gwartney, Holcombe, and Lawson investigate the role that institutions play in fostering or hindering economic growth.

. and Robinson (2001) and Hall and Jones (1999).Slide 3 Discussion: The importance of institutions has been suggested in earlier research. but has relied on using proxies. Not only do Gwartney. most notably by Landes (1998) and North (1990). However. their use of the Economic Freedom of the World index (EFW) allows them to do so more directly than in earlier research. as is the case in Acemoglu. Other work has taken a more quantitative approach. Johnson. and Lawson attempt to quantify the quality of institutions. Holcombe. neither concerns themselves with specifically how much institutions can affect income and growth rates.

The second explanation. The first of these explanations uses production functions in the spirit of Solow (1956) and suggests that differences in the factors of production explain variation in income and growth. based on Sachs (2003). Gwartney. and the factors of production interact with and influence each other. geography. focuses on differences in geography and location. Holcombe. By bringing these three explanations together into the same models.Slide 4 Discussion: In addition to examining the importance of institutions. and Lawson take into account two other hypotheses for cross-country income differences. . the authors are able to study the way institutions.

the rate of investment.Slide 5 Discussion: In addition to analyzing cross-country income and growth rates. and the productivity of investment. . This includes examining the stock of capital. this paper investigates several other issues. but also the amount of time needed before the effect of those changes can be realized. The authors are able to investigate not only whether institutional changes impact growth over time. They are also interested in the way institutional change might affect income growth. The authors consider the indirect effects of institutions and geography on a country’s level of human and physical capital.

labor. Each country is rated from 0-10 on a variety of factors. exchange with foreigners. Data is included for 99 countries throughout 1980-2000 in five year intervals. 0 signifying no economic freedom and 10 indicating full economic freedom. The five aspects of institutional quality measured by the EFW are: size of government. access to sound money. see Berggren (2003). and regulation of capital. . For a review of the EFW index and its use in academic research. and business. legal structure and security of property rights.Slide 6 Discussion: The use of the Economic Freedom of the World index is based on the Gwartney and Lawson (2003).

. The data for the variables Kpw and Hpw are found in Baier. Specifically. and the percentage of the country’s population living within 100 kilometers of an ocean coastline. respectively.Slide 7 Discussion: The authors used geographical variables in the same manner as Sachs (2003). The authors also incorporate physical capital per worker (Kpw) and human capital per worker (Hpw) into their models. and Tamura (2002). Air Distance. the variables Tropic. Dwyth. and Coastal represent the proportion of a country’s geographic area located in a tropical region. the minimum air distance (in kilometers) of a country from one of the world’s major trading centers.

The geography model accounts for a respectable 50. each model was tested separately.8% of the variation of GDP per capita in 2000. However. with EFW2 accounting for 63.2% of income variation. the EFW index does look to be a powerful determinant of GDP per capita. However. which accounts for 92. and the factors of production are interrelated. Three regressions. one for each major theory of growth.Slide 8 Discussion: The authors begin their investigation of cross-country differences in income levels by examining each of the three proposed models. institutions. As measured by R2. it is quite possible that geography.8% of the variation of GDP per capita in 2000. are presented in Table 1 with GDP per capita in 2000 as the dependent variable. its importance seems dwarfed by the factors of production model. In this first set of regressions. .

The regressions show that roughly three-quarters of the level of physical capital and nearly two-thirds of the amount of human capital can be attributed to institutions and geography. First Kpw and then Hpw are regressed upon EFW2. shown in Table 3. . to attribute both the direct and indirect effects of institutions and geography on GDP per capita to their respective variables. This allows a new regression.Slide 9 Discussion: Table 2 investigates the possibility that the levels of physical and human capital levels are partially determined by institutions and geography. The residuals from these regressions capture the amount of variation in physical and human capital not accounted for by institutions and geography. Tropics. institutions and geography affect GDP per capita both directly in and of themselves and indirectly through their influence on physical and human capital accumulation. and Coastal. In other words.

0 would increase GDP per capita by $6. the coastal variable is statistically insignificant and exhibits a negative relationship with GDP per capita. the three models explain over 93% of the variation in income. a one unit increase in EFW2 increases GDP per capita in 2000 by roughly $100 whereas in regressions 4 and 6. Of particular interest is the difference between the regressions that use Kpw and Hpw (regressions 3 and 5) compared to the regressions that use the residuals from the regressions in Table 2 (regressions 4 and 6). the dependent variable is GDP per capita in 2000.0 to 7. In other words. As in Table 1. The impact of an increase in the Topics variable falls from roughly -$2. these new regressions imply that a country that could increase its EFW rating from 6. a comparable increase in EFW2 increases GDP per capita by approximately $500.Slide 10 Discussion: Table 3 presents the first set of regressions that bring together all three models. In regression 6. Combined.500. Coastal becomes statistically significant and its influence switches from negative to positive.000 in regressions 3 and 5 to approximately -$8. In regressions 3 and 5. In regression 5. .000 in regressions 4 and 6.

Institutions become a particularly important factor once their indirect influence on capital levels is taken into account.Slide 11 Discussion: Institutional differences clearly play an important role in cross-country differences in income. This relationship between institutions and capital formation is further examined in the next few sets of regressions concerning growth. .

it may seem as though the factors of production have much more explanatory power than institutions or geography. 23.2%. and growth of the factors of production explained 42. a similar result might hold for the growth of capital. . Both Air Distance and growth in human capital are statistically insignificant.6% can be attributed to average EFW Rating. was chosen to minimize the effects of business cycles. Once again. Therefore. Of the variation in growth rates. The dependent variable. one for each model. However. the authors begin with a set of three separate regressions. shown in Table 4. At first glance. average annual growth rate of GDP per capita from 1980–2000. geographic factors account for nearly 22%. the regressions in Table 2 have already shown that capital and labor stocks are themselves functions of institutions and geography. the relationship demonstrated between institutions and income should also hold between institutions and long-term growth rates.Slide 12 Discussion: Higher income in the present is the product of higher growth rates in the past.

with investment per worker and FDI per worker as the dependent variables. and Coastal. . Across the first four regressions. GDP per capita in 1980 is added to the list of independent variables to adjust for differences in initial per capita income.Slide 13 Discussion: Table 5 presents five new regressions. EFW is statistically significant in explaining variations in capital formation. each with a different measure of capital formation as its dependent variable. the geographic variables are statistically insignificant. However. None of the four variables are statistically significant in the fifth regression with Hwp as the dependent variable. With this additional evidence that institutions impact the rate of investment as well as the stock of capital. The results of this line of inquiry are presented in Table 6. both geographic variables have explanatory power towards Investment/GDP. In addition to EFW. and Tropics is useful in explaining growth in Kwp. Tropics. the authors turn to the possibility that productivity is also influenced by institutions and geography. In the first two regressions.

but also increased productivity.7% more than countries rated below five. negative influence on growth. between five and seven). a higher EFW rating will yield a larger. In both cases. Regressions 3 and 5 add in geographic variables. Coastal is statistically insignificant. Indeed.Slide 14 Discussion: The dependent variable is once again average annual growth rate of GDP per capita from 1980–2000. For example. positive impact on growth for a given change in investment. Regardless of the divisions used.6% more than those with a rating between five and seven and 31. but Tropics exerts a strong. zero otherwise.e. The other four regressions multiply I/GDP by one if a country’s EFW rating falls within a specified range (i. in regression 2 a one unit increase in I/GDP for a country with EFW ratings of seven or greater resulted in longrun GDP growth per capita of 13. it can explain 43. This shows that better institutions not only lead to greater investment. . The first regression in Table 6 tests the importance of I/GDP in explaining variation in growth.5% of the variation.

Coastal. In particular. .24 percentage points to the growth rate. and initial level of GDP per capital are all augmented and the variables’ t-values are boosted. average EFW rating. Coastal. Table 5. allowing both the direct and indirect effects of the institutional and geographic variables to be accounted for in their coefficients. Because of this. and initial GDP per capita explain nearly 60% of the variation in GDP per capita growth rates. Tropics. Note that regression 3 uses growth in Kpw as an independent variable.81 percentage points in regression 3 but a comparable increase in regression 4 added 1. Kpw is replaced by the residuals from Equation 4.Slide 15 Discussion: The regressions in Table 7 bring together elements of the three preceding tables. a one unit increase in the average EFW rating increased the long-run growth rate by 0. Combined. Again. growth in capital levels. The coefficients on average EFW rating. In regression 4. Tropics. the dependent variable is average annual growth rate of GDP per capita from 1980–2000. the coefficients on average EFW rating and the geographical variables will only register the direct effects of these factors.

it pays to improve institutions.32 percent. After 30 years. Raising the EFW rating one unit adds 1. The next section examines the effects of institutional change. nearly doubling that mean growth rate. that one-unit increase in a country’s EFW rating would result in roughly 43% higher GDP per capita.Slide 16 Discussion: Better institutions lead to higher growth.24 percentage points in growth. Clearly. . partially through their influence on investment and productivity. Mean growth in GDP per capita for the 99 countries in the core dataset over this period was 1.

The two tables use the same dependent variable. Change in EFW Rating. Table 8 does introduce two variables that measure changes in institutions. which is replaced in the fourth regression with residuals.7 percentage points throughout the regressions in Table 8. However. the first for the 1980’s and the second for the 1990’s. and initial GDP per capita are amplified now that both direct and indirect effects of these variables are incorporated. their third regressions use growth of Kpw. 1990-2000 just fails to be statistically significant while Change in EFW Rating. Again. This timing issue is further explored in Table 9. such changes take time before their full impact is felt. Moreover. This suggests that a change in the quality of institutions not only affects growth but continues to exert an influence over a long period of time. Tropics. 1980-1990 is statistically significant.Slide 17 Discussion: The authors begin testing the effects of institutional change on income growth with a set of regressions very similar to those in Table 7. . the coefficients and t-values of average EFW. a one-unit increase in EFW during the 1908’s increased growth in GDP per capita by roughly 0.

which equals one for the 1990s. In contrast. Tropics and the factors of production are included in regressions 2 and 4. the Change in EFW rating. but the effect has diminished somewhat. . The regressions use a dummy variable to indicate the decade. the Change in EFW Rating. Similarly. In all of Table 9’s regressions. The first two regressions use the EFW rating at the beginning of the decade. five years before decade variable is also significant. first five years of the decade variable consistently shows up as statistically significant.Slide 18 Discussion: Table 9 breaks down the data into decades. second five years of the decade variable is statistically insignificant. the Change in EFW Rating. This set of four regressions looks at the EFW rating and changes in EFW rating at various 5 year intervals. creating two dependent variables: average annual growth rate of GDP per capita in the 1980’s and 1990’s. this is replaced in the last two regressions with the EFW rating 5 years before the decade.

Researchers trying to understand the effects of institutional change must be prepared to study a long time period. Beyond that. the initial effects are quite small.Slide 19 Discussion: These results help clarify the timing of the effects of institutional change. such changes will continue to effect growth. albeit at a lower rate. a one point increase in the EFW rating in the first five years will add more than one percentage point to growth throughout the decade. Improving institutions does impact growth. These results have both academic and policy implications. Policymakers must be able to commit to their policies for a sufficient duration before their effects can be realized. The full impact of institutional change will lag about 5-10 years after implementation. . However.

this is particularly impressive compared to the 1. Holcombe.16 percentage point increase in I/GDP and a 1.24 percentage points. a one-unit increase in EFW results in 2. Gwartney. The . Indeed. capital levels and accumulation are themselves influenced by institutions and geography.32 percent average annual growth rate exhibited by the countries in the data set. their work finds that better institutions increase growth rates by promoting investment and raising productivity of resource use.24 percentage point increase in the annual growth rate of capital per worker. Additionally. A one-unit increase in the EFW rating increases growth of GDP per capita by 1. and Lawson provide substantial evidence supporting the importance of institutions in explaining variation in cross-country income and income growth. Their findings suggest that institutional arrangements consistent with economic freedom lead to higher growth rates and income levels. This is a particularly important point for those advocating the factors of production as a main determinant of income and income growth.Slide 20 Discussion: In this paper.

they estimate that it will take 5-10 years before the full impact of the change will be felt. However.Slide 21 authors also show that countries that improve their institutions are rewarded with higher future growth rates. .

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