Article Summary: “Institutional development, transaction costs and economic growth: evidence from a cross-country investigation” Mitja Kovač and Rok Spruk

Summary of JOIE article (Volume 12(1) 2016) by Mitja Kovač, Associate Professor, Faculty of Economics, University of Ljubljana and Rok Spruk, Assistant Professor, Faculty of Economics, University of Ljubljana. The article is open access and available on the JOIE website

Understanding why some countries grow and others fail to do so is one of the most remarkable puzzles in modern literature on economic growth. New institutional economics has addressed precisely these fascinating issues and begun to take shape as ambitious discipline. Despite the voluminous literature on new institutional economics, a theoretical consensus on the impact of transaction costs on cross-country economic growth is still beyond reach. Namely, without the concept of transaction costs it might be impossible to understand how an economic system works, analyze many of its problems and examine the effects on economic growth. Ronald Coase for example suggests that one should pay attention to the world of positive transaction costs where the law should play a crucial role in determining how resources are used and thus could have a crucial impact on growth. North on the other hand states that ‘the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the third World’ whereas Williamson and Matthews stress transaction costs’ vital importance in long-term relationships and argue that institutions do matter and are susceptible to analysis.

Our work contributes to the new institutional economics literature by considering the interrelationships between economic growth and transaction costs generated by different legal systems. This sub-category of overall transaction costs actually represents an external fraction of transaction costs that are generated by different legal systems (e.g. administrative, procedural costs) and imposed upon the system of economic exchanges. Given the importance of institutions for economic growth and the allocation of resources, transaction costs may be an important additional mechanism affecting cross-country patterns of growth.

Our article also attempts to make several contributions to the literature. First, it incorporates the concept of transaction costs, i.e. external costs of the legal systems, generated by legal institutions, for economic exchange into the standard growth theory and provides a cross-country panel data regression analysis. Second, it attempts to estimate the effect of cross-country differences in transaction costs on economic performance over time employed in the Solow growth model. Third, in line with Coase’s proposition, the article offers further empirical insights into the world of positive transaction costs, and suggests that cross-country differences in the cost of contract enforcement may be considered as some of the most important determinants of large income and welfare gaps between countries. It provides support for Coase’s, North’s and Williamson’s arguments that in the world of positive transaction costs the legal system might play a crucial role in the pursuit of efficiency and economic growth.

Our estimates highlight negative and robust relationship between transaction costs generated by legal institutions and cross-country economic growth. The evidence suggests strong effects of rising transaction costs on economic growth. For a country with 10 basis points higher extent of transaction costs relative to those that do not increase the costs, according to our measurement, we expect it to be between 3.12-fold and 4.66-times poorer which roughly corresponds to the per capita output gap between Switzerland and Argentina. The underlying institutional framework for market exchange is possibly the key to understanding why some societies have been plagued by institutional failures and remained mired in poverty, while others have forged ahead and attained high welfare levels. Such transaction costs are also intrinsically insightful since they are common among firms within a single country but differ across countries. They represent a static reflection of the fraction of transaction costs rather than the entire spectrum of costs.

In other words, our paper represents an attempt to quantify the level of transaction costs generated by the formal legal institutions (e.g. administrative and procedural costs) and examine the effects of increasing transaction costs on economic growth between countries and over time. Specifically, we focus on the level of transaction costs triggered by the formal institutional framework that involves the quality of contract and property rights enforcement, costs of market participation and regulatory barriers to economic exchange. We exploit the variation in institutional indicators of cross-country transaction costs from the World Bank’s Doing Business Report for the period 2003–2012 and establish specific institutional measures of transaction costs created by the legal and economic institutions for 139 countries.

Moreover, in our paper we construct and estimate a simple empirical model of cross-country economic growth with transaction costs to examine the effects on the path of economic growth over time. Our evidence suggests that transaction costs impede the growth path through institutional channels, ranging from higher costs of starting a business, costlier dealing with construction permits, greater administrative burden of paying taxes, more expensive and inefficient contract enforcement and more inefficient debt enforcement regime. We address the measurement error and excessive sampling variation in the constructed transaction cost indicators across countries by weighing the longitudinal time series of each country based on the respective sample size of country-specific surveys in Doing Business Report on the annual basis used to address varying degrees of survey reliability and indicator accuracy stemming from differences in the number of respondents per country which inevitably drives the variation in each underlying indicator. Alternative weighing schemes are adopted to tackle the differences in both the quality and reliability of the surveys and prevent potentially high-leverage observations from exhibit disproportionate effects on the estimated relationship between transaction costs and cross-country economic growth.

Furthermore, the negative effects of rising transaction costs on the path of economic growth remain robust to the alternative data weighing function and do not seem to be confounded by the structural determinants of cross-country economic growth such as human capital accumulation, physical capital stock and population growth. The negative relationship between transaction costs and economic growth does not appear to be driven by unobserved heterogeneity.

In addition, obtained results emphasize the distortionary effects of persistent transaction costs on the path of economic growth over time. To this end, we calibrate the long-run growth model to investigate whether transaction costs can encourage cross-country per capita output convergence. The evidence from the model calibration suggests that decreasing transaction costs activate the cross-country convergence process in the long run when initially high-cost poor countries move toward lower transaction costs.

The main implication of our study sheds an additional perspective on the interaction between new institutional economics and economic growth. Poorer countries are significantly more likely to embark on a sustainable path of structural transformation if legal institutions establish lower transaction costs. The results in this study clearly suggest that addressing transaction costs can persistently improve the rate of economic growth. Legal institutions that support markets, protect private property, enforce contracts and promises, and assure the integrity of business organizations and innovation are hence the institutions that might matter most for the economic growth. Our paper attempts to answer the question whether transaction costs matter for economic growth. However, reducing those transactions costs may be easier said than done and the normative question of how countries could reduce the transactions costs associated with using their legal systems is open to future research. The institutional, historical, cultural and legal measures driving the underlying differences in the extent of transaction costs across and within countries provide a good starting point for future research to examine why and how some countries manage to establish low-cost environment whilst others do not.

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