Increasing Returns, Institutions, and Capital Flows

Abstract

This paper empirically tests one prominent explanation for why capital has not flowed from the rich to the poor countries: institutions. In contrast to the study by Alfraro, Kalemli-Ozcan, and Volosovych in 2008, institutional quality does not explain the Lucas Paradox. Like them, institutional variables are found to be a very important factor, but in contrast to their findings, initial Gross Domestic Product (GDP) still plays a role in capital flows. In addition, poor countries may have different determinants of capital flows from rich countries. The evidence suggests a threshold income level, where a country receives significantly more capital flows if given a sufficiently high income.

APPENDIX

Data description and sources

Capital Inflows: Average annual per capita values of FDI and Portfolio Investment from 1970 to 2008. The data are obtained from the International Monetary Fund's (IMF) and IFS. As a measure of FDI, this paper uses Foreign direct investment in reporting economy, n.i.e. (IFS line 78bed). Direct investment includes equity capital, reinvested earnings, other capital, and financial derivatives associated with various intercompany transactions between affiliated enterprises measured in current US dollars. As a measure of portfolio investment, this paper uses Equity securities liabilities (IFS line 78bmd), which includes flows of shares, stock participations, and similar documents that denote ownership of equity measured in current US dollars. (The IMF classifies direct investment as involving ownership of at least 10 percent of the local firm's equity. Other equity purchases are included in this category.) The inflows are in constant 1996 US dollars, and to convert to per capita measures, they are divided by the population in each year. Capital inflows can be negative since they are net of repatriation of capital and repayment of loans.

Population: 1970–2008. Total population from World Bank, World Development Indicators 2009.

Consumer Price Index (CPI): US CPI with base year 1996=1. CPI with a base year of 2005 was obtained from World Bank, World Development Indicators, but it was adjusted to 1996.

Real GDP Per Capita: GDP per capita in 1970 in constant 1996 dollars obtained from Penn World Tables version 6.1.

Institutional variables: The institutional variables come from the Economic Freedom of the World 2009 Annual Report (which can be found at www.freetheworld.com). Each variable is given a value from 0 to 10. Generally speaking, a higher number represents more freedom or less restriction. This paper takes the average of each variable from 1970 to 2005, where equal weight is put on each 5-year interval. The following provides the components of each institutional variable, but for a detailed description of each variable, please see the appendix of the Economic Freedom report.

• Institutions: A composite variable, which is the average of all the other institutional variables.

• Institutions (not including government size and taxes): A composite variable, which is the average of all the other institutional variables, except Size of Government: Expenditures, Taxes, and Enterprises.

• Size of Government: Expenditures, Taxes, and Enterprises (labeled as Government Size and Taxes in the paper): A composite variable, which is the average of the following variables:

  • ° General government consumption spending as a percentage of total consumption

  • ° Transfers and subsidies as a percentage of GDP

  • ° Government enterprises and investment

  • ° Top marginal tax rate

    •  –  Top marginal income tax rate

    •  –  Top marginal income and payroll tax rates

• Legal Structure and Security of Property Rights (labeled in the paper as Property Rights and Legal Structure): A composite variable, which is the average of the following variables:

  • ° Judicial independence

  • ° Impartial courts

  • ° Protection of property rights

  • ° Military interference in rule of law and the political process

  • ° Integrity of the legal system

  • ° Legal enforcement of contracts

  • ° Regulatory restrictions on the sale of real property

• Access to Sound Money (labeled in the paper as Sound Money): A composite variable, which is the average of the following variables:

  • ° Money growth

  • ° Standard deviation of inflation

  • ° Inflation: Most recent year

  • ° Freedom to own foreign currency bank accounts

• Freedom to Trade Internationally (labeled in the paper as Trade Freedom): A composite variable, which is the average of the following variables:

  • ° Taxes on international trade

    •  –  Revenues from trade taxes (percent of trade sector)

    •  –  Mean tariff rate

    •  –  Standard deviation of tariff rates

  • ° Regulatory Trade Barriers

    •  –  Non-tariff trade barriers

    •  –  Compliance cost of importing and exporting

  • ° Size of the trade sector relative to expected

  • ° Black-market exchange rates

  • ° International capital market controls

    •  –  Foreign ownership/investment restrictions

    •  –  Capital controls

• Regulation of Credit, Labor, and Business (labeled in the paper as Business Regulation): A composite variable, which is the average of the following variables:

  • ° Credit market regulations

    •  –  Ownership of banks

    •  –  Foreign bank competition

    •  –  Private sector credit

    •  –  Interest rate controls/negative real interest rates

  • ° Labor market regulations

    •  –  Minimum wage

    •  –  Hiring and firing regulations

    •  –  Centralized collective bargaining

    •  –  Mandated cost of hiring

    •  –  Mandated cost of worker dismissal

    •  –  Conscription

  • ° Business Regulations

    •  –  Price controls

    •  –  Administrative requirements

    •  –  Bureaucracy costs

    •  –  Starting a business

    •  –  Extra payments/bribes

    •  –  Licensing restrictions

    •  –  Cost of tax compliance

Schooling: Average years of total schooling for those of age 25 and older from years 1970, 1975, 1980, 1985, 1990, 1995, and 2000. Data from Barro and Lee. [2000].

Roads Paved (percentage): Percentage of total roads that are paved, average from 1990 to 2008. Data from World Bank, World Development Indicators.

Agriculture: Agriculture value added, percentage of GDP. Average from 1970 to 2008. World Bank, World Development Indicators.

Landlocked, not in Europe: Indicator for landlocked countries, excluding countries in Western and Central Europe (Austria, the Czech Republic, Hungary, the Former Yugoslav Republic of Macedonia, Slovakia, and Switzerland). Includes Eastern European countries of Belarus and Moldova. Data obtained from Gallup et al. [1999].

Distance: Air distance in kilometers to one of the three capital-goods-supplying regions: the US, Western Europe, and Japan, specifically measured as distance from the country's capital city to New York, Rotterdam, or Tokyo. Data obtained from Gallup et al. [1999].

Log European Settler Mortality: The logarithm of the historical European settler's mortality rates from Acemoglu et al. [2000]. Mortality rates are deaths per annum per 1000.

Table A1

Table A1 List of countries from selected tables

Table A2

Table A2 Summary statistics for selected variables