{"id":4829,"date":"2020-11-18T14:07:02","date_gmt":"2020-11-18T19:07:02","guid":{"rendered":"https:\/\/journals.law.harvard.edu\/hblr\/?p=4829"},"modified":"2025-02-27T21:47:16","modified_gmt":"2025-02-28T02:47:16","slug":"economic-growth-income-inequality-rule-of-law","status":"publish","type":"post","link":"https:\/\/journals.law.harvard.edu\/hblr\/economic-growth-income-inequality-rule-of-law\/","title":{"rendered":"Economic Growth, Income Inequality, and the Rule of Law"},"content":{"rendered":"
Introduction<\/strong><\/h6>\n

Economic growth has been a dominant concern for senior global leaders and policy makers for the past century; understandably, the determinants of economic growth has preoccupied economists for the past several decades.\"\"<\/a><\/p>\n

The figure above shows the share of world GDP by select countries and regions for the period, 1820-2008, based on data from the Maddison Project Database<\/a> (2018).<\/em><\/p>\n

Today, U.S. has the highest percentage of the world GDP compared to other countries. In 1820, the situation was quite different; China accounted for a third of the world GDP and the U.S. barely registered.<\/p>\n

\"\"<\/a><\/p>\n

The figure above compares the GDP per capita in 1990 dollars (to account for inflation) for the U.S., Argentina, and Australia for the period 1900-2008, based on data from the Madison Project Database (2018).<\/em><\/p>\n

These graphs above raise several practical questions. Why such different economic growth rates for U.S. and Argentina for the past century?1<\/a><\/sup>One difference between these two countries is based on geography: U.S. is in the northern hemisphere, Argentina is in the southern hemisphere. However, Australia has also enjoyed significantly higher economic growth rates than Argentina in the past century; yet, both countries are in the southern hemisphere.<\/span> Why such different economic growth rates for the U.S. and China during the past two centuries? Economists have studied three broad categories of determinants of economic growth: geography, history (including culture and religion), and . Douglass North<\/a> provides a useful definition of economic institutions: \u201cInstitutions are the humanly devised constraints that structure political, economic and social interaction\u2026 Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline.\u201d Economic institutions involve the rule of law, and respect for and enforcement of private property rights, since each of these have the ability to incentivize (or constrain) certain economic activities.<\/p>\n

A previous paper<\/a> by Rodrik et al focuses on the role of economic institutions on economic growth in 137 countries in 1995. They measure economic institutions as \u201cRule of Law\u201d compiled by Kaufman et al<\/a> for the World Bank. They explain: \u201cthe Rule of Law reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.\u201d Rodrik and colleagues consider Rule of Law, geography (distance from the equator), openness to trade, and colonial history as potential determinants of economic growth. They find that only<\/em> Rule of Law explains economic growth. We consider 134 countries during the period 1984-2019 and find a significant positive relation between Rule of Law and GDP per capita. Notably, this positive relation is getting stronger with time. We consider an alternative measure of Rule of Law developed by a commercial vendor, the PRS Group\u2019s International Country Risk Guide; Additionally, we document that lesser corruption in the political system is correlated with higher levels of GDP per capita.<\/p>\n

Besides the size of the national pie, which is measured by GDP, senior policy makers and the media across the globe are increasingly concerned about how this pie is sliced, that is, about income inequality. We find that countries with greater adherence to Rule of Law are characterized by less<\/em> income inequality. Additionally, we find that countries with greater GDP per capita are characterized by less income inequality; however, once we control for Rule of Law in the country, we do not observe this negative correlation between GDP per capita and income inequality. This further highlights that adherence to the Rule of Law relates to reducing income inequality.<\/p>\n

Economic institutions and economic growth<\/strong><\/h6>\n

Robert Solow suggested<\/a> that an economy\u2019s output growth is a positive function of physical and human capital growth. Under the twin assumptions of constant returns to scale and competitive markets, deviations of an economy\u2019s actual output growth from the implied growth can be attributed to changes in technology and institutional change, such as, abrupt changes in law and order (and property rights) brought about by armed conflict and political upheavals.\u00a0 Hence, economic institutions play an important role in promoting economic growth.2<\/a><\/sup>Adam Smith in Wealth of Nations provides an earlier characterization of this argument, \u201cCommerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law\u2026\u201d<\/span><\/p>\n

Where do economic institutions come from? Some scholars propose\u00a0a theory<\/a> of political institutions. They argue that different individuals have distinct preferences over economic institutions since these institutions play a role in resource allocation. In general, people\u2019s preferences over economic institutions do not converge, since different institutions benefit different people. Those who have political power have the ability to choose the economic institutions. Political power can be de jure<\/em> (based on the constitution, law, and electoral rules) or de facto<\/em> (based on the circumstances, such as the ability to generate non-violent and\/or violent protests and demonstrations). Those with greater economic resources tend to wield more de facto<\/em> political power. De jure<\/em> and de facto<\/em> political power jointly determine today\u2019s economic institutions and future political institutions. In summary, political institutions lead to economic institutions.<\/p>\n

As Solow has noted, economic growth has three primary factors: physical capital growth, human capital growth, and technological innovation. If individuals are less confident their private property rights will be enforced, they are less likely to invest in physical capital (business facilities, manufacturing plants and equipment) since physical capital can be expropriated. This expropriation can be led by the state if the country does not have a rule of law, or if the rule of law does not enforce respect for private property rights. If a country has rule of law but does not enforce respect for private property rights, then expropriation can occur in the form of looting by non-state individuals using physical force and threat of armed violence on the owners of the physical capital.<\/p>\n

Human capital is more difficult to expropriate than physical capital. The primary reason most individuals invest in human capital (education, trade apprenticeship, professional training) is it enhances their ability to generate income and create wealth. Income and wealth can be expropriated almost as easily as physical capital. Hence, if individuals are less confident their private property rights over their income and wealth will be enforced, they are less likely to invest in human capital. The usual way most individuals use their human capital to generate income and create wealth is by starting businesses, selling to customers, employing workers, growing their busines, selling to more customers, hiring more employees; with this self-reinforcing positive impact on job and wealth creation. Hence, as individuals stop or decrease investing in their human capital, this has a negative multiplier effect on job creation and economic growth.<\/p>\n

Technological innovation is a key driver of economic growth. Technological innovation is primarily driven by the intellectual and creative efforts of those with significant human capital.\u00a0 Hence, as individuals stop or decrease investing in their human capital, this dampens technological innovation which has a negative multiplier effect on job creation and economic growth.<\/p>\n

Data and empirical results<\/strong><\/h6>\n

We use multiple sources of data to establish our analysis. We obtain GDP per capita (GDPPC) from the International Monetary Fund<\/a>, World Economic Outlook Database, October 2019. To measure the effects of the rule of law on GDP and income inequality, we obtain data on Rule of Law (RuleOfLaw) and Control of Corruption (CC) from the Worldwide Governance Indicators, 2019 Update.3<\/a><\/sup>\u201cThe Worldwide Governance Indicators (WGI) are a research dataset summarizing the views on the quality of governance provided by a large number of enterprise, citizen and expert survey respondents in industrial and developing countries. These data are gathered from a number of survey institutes, think tanks, non-governmental organizations, international organizations, and private sector firms.\u201d Kaufman, Kraay, and Mastruzzi (2010).<\/span> RuleOfLaw reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. CC reflects perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as “capture” of the state by elites and private interests. We obtained an alternate set of data on country governance variables from the PRS Group\u2019s International Country Risk Guide<\/a> (ICRG). The PRS Group\u2019s Law and Order (LAW) index is focused on their assessment of the strength and impartiality of the legal system, and the popular observance of the law. ICRG\u2019s corruption index (CORRUPT) is its assessment of corruption within the political system \u2013 patronage, nepotism, favor-for-favor, secret party funding, and close ties between politics and business. Higher index values of LAW and RuleOfLaw indicate better adherence to and effectiveness of rule of law. Higher index values of CORRUPT and CC reflect less<\/em> corruption. We obtain the MILITARY index from ICRG; a higher MILITARY index reflects a smaller degree of military participation in politics. We use the index constructed by the World Bank<\/a> to measure income inequality. GINI index measures the extent to which the distribution of income among individuals or households within an economy deviates from a perfectly equal distribution. A GINI index of 0 represents perfect equality, while an index of 100 implies perfect inequality.<\/p>\n

\"\"<\/a><\/p>\n

The figure above illustrates the correlation between GDP per capita and Law and Order for the 134 countries in our sample for each of the years between 1984 and 2019. Law and Order index is from the PRS Group\u2019s International Country Risk Guide; this index is focused on their assessment of the strength and impartiality of the legal system, and the popular observance of the law. Higher index values of Law and Order indicate better adherence to and effectiveness of rule of law.<\/em><\/p>\n

The correlation between GDPPC and Law and Order index (LAW) is significantly positive for each of the years during 1984-2019. Also, there is a strong increasing trend of the correlation between GDPPC and LAW in this period; from 0.40 in 1984 to 0.70 in 2019.<\/p>\n

Here are some salient examples of how Law and Order and GDP per capita are related:<\/p>\n

In 1990, India\u2019s GDP per capita ranked it in the 15.0 percentile compared to the GDP per capita of the other countries in the world; its Law and Order index was at 1. (Recall higher Law and Order indices reflect better adherence to the rule of law.) In the early 1990s, India liberalized its international trade and deregulated its industries; by 2015 its Law and Order index was at 4.5, and its GDP per capita rank was at 26.1 percentile. Another view of the data shows that from 1990 to 2015, several hundred million Indians went from abject poverty to a quasi-middle class standard of living.<\/p>\n

China\u2019s case is even more dramatic. In 1984, its Law and Order index was at 3, and GDP per capita rank was in the 3.3 percentile. After extensive adoption of free market policies, its Law and Order index was at 4.5 in 2006 and its GDP per capita rank was in the 31.3 percentile. Again, a more relevant way of looking at the above data shows that from 1984 to 2006, almost a billion Chinese people went from subsistence living to a quasi-middle class standard of living.<\/p>\n

Argentina enjoyed a GDP per capita rank in the 64.9 percentile and Law and Order index of 5 in 1999. Subsequently, with changes in their political regime, greater regulation and less free markets, their Law and Order index in 2017 stood at 2, and the GDP per capita rank in the 57.1 percentile.<\/p>\n

Venezuela enjoyed a GDP per capita rank of in the 62.6 percentile and Law and Order index of 4 in 1999. Subsequently, Chavez and his successor Maduro nationalized major industries, and significantly increased government spending. As oil prices fell, they resorted to printing money. This led to hyperinflation. Venezuela imposed price controls which led to severe shortages and social unrest. In 2017, Venezuela\u2019s Law and Order index was 1 and its GDP per capita rank was at the 37.6 percentile. While Venezuela\u2019s decline in GDP per capita is significant, it should be viewed in the light of the shattered lives of the tens of millions of Venezuelans during the past two decades.<\/p>\n

Similarly, another way to analyze the results is by using the RuleOfLaw metric:<\/p>\n

\"\"<\/a><\/p>\n

The figure above illustrates the correlation between GDP per capita (GDPPC) and RuleOfLaw for the 134 countries in our sample for each of the years between 1996 and 2018. Data on RuleOfLaw are from the Worldwide Governance Indicators, 2019 Update.\u00a0 RuleOfLaw reflects survey perceptions of the extent to which agents have confidence in, and abide by, the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. Higher index values of RuleOfLaw indicate better adherence to and effectiveness of rule of law.<\/em><\/p>\n

The correlation between GDPPC and RuleOfLaw is significantly positive for each of the years during 1996-2018. Also, similar to the earlier figure , there is a strong increasing trend of the correlation between GDPPC and RuleOfLaw in this period; from 0.62 in 1996 to 0.76 in 2018. Not surprisingly, both of the rule of law metrics, LAW and RuleOfLaw, are highly positively correlated for each of the years during 1996-2018. The average correlation between LAW and RuleOfLaw is 0.79.<\/p>\n

\"\"<\/a><\/p>\n

This figure illustrates the correlation between GDP per capita (GDPPC) and CORRUPT for the 134 countries in our sample for each of the years between 1984 and 2019. CORRUPT is the corruption index of The PRS Group\u2019s International Country Risk Guide; CORRUPT is their assessment of corruption within the political system \u2013 patronage, nepotism, favor-for-favor, secret party funding, and close ties between politics and business. Higher index values of CORRUPT reflect less corruption.<\/em><\/p>\n

The correlation between GDPPC and CORRUPT is significantly positive for each of the years during 1984-2018. (As noted above, higher index values of CORRUPT reflect less<\/em> corruption.)\u00a0 Additionally, there is a strong increasing trend of the correlation between GDPPC and CORRUPT in this period; from 0.40 in 1984 to 0.73 in 2019.<\/p>\n

\"\"<\/a><\/p>\n

This figure shows the correlation between GDP per capita (GDPPC) and control of corruption (CC) for the 134 countries in our sample for each of the years between 1996 and 2018. Data on CC is from The Worldwide Governance Indicators, 2019 Update. CC reflects perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as “capture” of the state by elites and private interests. Higher index values of CC reflect less corruption.<\/em><\/p>\n

The correlation between GDPPC and control of corruption is significantly positive for each of the years 1996-2018. (Recall, higher index values for CC reflect less <\/em>corruption.) Also, similar to the relationship between CORRUPT and GDPPC, there is a strong increasing trend of the correlation between GDPPC and CC in this period; from 0.58 in 1996 to 0.77 in 2018. AS the above figures suggest, CORRUPT and CC are highly positively correlated for each of the years during 1996-2018; the average correlation between CORRUPT and CC is 0.87.<\/p>\n

Before turning to the panel regression results, it would be instructive to observe the relationship between GDP per capita and the Law and Order (LAW) index for 2018 for 50 countries with the largest populations.<\/p>\n

\"\"<\/a><\/p>\n

This figure shows GDP per capita as a function of Law and Order for the 50 most populous countries in our sample for 2018. Law and Order is from The PRS Group\u2019s International Country Risk Guide; this index is focused on their assessment of the strength and impartiality of the legal system, and the popular observance of the law. Higher index values of Law and Order indicate better adherence to and effectiveness of rule of law. Countries are labeled with the three alphabet World Bank code.<\/em><\/p>\n

Similar positive relation is observed for our full sample of 134 countries, and for every year in our sample period of 1984-2019.<\/p>\n

Using panel regression, we document a significant positive relation between ICRG\u2019s Law and Order index (LAW), and the log of GDP per capita.4<\/a><\/sup>chrome-extension:\/\/efaidnbmnnnibpcajpcglclefindmkaj\/https:\/\/journals.law.harvard.edu\/hblr\/wp-content\/uploads\/sites\/87\/2020\/11\/Rule-of-Law-Appendix.pdf<\/span>\u00a0This relation is robust to alternative measures of law and order, and for the sample of countries with a population greater than 10 million in 1996. This means that the relationship between LAW and GDP per capita can handle variability and still remain accurate. Also, countries that are less corrupt and where the military is less involved in politics enjoy a significantly higher GDP per capita.<\/p>\n

Furthermore, our regression analysis shows a significant negative relationship between GDP per capita and the GINI index. Moreover, we observe a significant negative relation between the law and order (LAW) index and the GINI index. However, when both GDP per capita and LAW are included as explanatory variables, only LAW is significant. This highlights the positive role of law and order in decreasing income inequality.5<\/a><\/sup>Chong and Gradstein thoroughly document the relationship between rule of law and income inequality for 130 countries during 1960-2000. They do not control for GDP per capita in their analysis.<\/span> Conceptually, as law and order improves in a country, its citizens have greater confidence that they can enjoy the benefits of their investment in physical capital and human capital; increased incentive to invest in physical and human capital leads to more income for the broader citizenry resulting in less income inequality. The regressions also confirm the positive role of rule of law in decreasing income inequality by using an alternative measure of rule of law (namely, RuleOfLaw), an alternative measure of income inequality (ratio of income of highest quintile to lowest quintile), and for the sample of countries with 1996 population greater than 10 million.<\/p>\n

Summary and conclusions<\/strong><\/h6>\n

Economic growth has been a dominant concern for senior global leaders and policy makers for the past century; understandably, the determinants of economic growth has preoccupied economists for the past several decades. We consider 134 countries during the period 1984-2019 and find a significant positive relation between Rule of Law (law and order provided by police and courts, respect for private property rights) and GDP per capita. Notably, this positive relation has improved over time. We consider an alternative measure of Rule of Law; the earlier positive relation between Rule of Law and GDP per capita is robust to this alternative measurement. Additionally, we document that lesser corruption in the political system is correlated with higher levels of GDP per capita.<\/p>\n

Besides the size of the national pie, which is measured by GDP, senior policy makers and the media across the globe are increasingly concerned about how this pie is sliced, that is, about income inequality. We find that countries with greater adherence to Rule of Law are characterized by less<\/em> income inequality. We find this to be a very robust relation \u2013 robust to alternative measures of income inequality, alternative measures of Rule of Law, and for countries of different sizes. Moreover, we find that countries with greater GDP per capita are characterized by less income inequality; however, once we control for Rule of Law in the country, we do not observe this negative correlation between GDP per capita and income inequality. This further highlights the positive role of\u00a0 Rule of Law in attenuating income inequality.<\/p>\n

On the basis of the above empirical results we have the following policy recommendations. Political leaders in various countries around the globe ought to focus on ensuring respect for private property rights, an effective police force, and fair courts. The leadership of international organizations like the United Nations and World Bank should encourage the political leaders of the countries around the world, especially the developing countries, to prioritize ensuring respect for private property rights of their citizens, an effective police force, and fair courts; this will enhance economic prosperity for their citizens and<\/em> diminish income inequality across the globe.<\/p>\n

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Abrantes-Metz & D. Daniel Sokol: In late June 2012, Barclays entered a $453 million settlement with U.K. and U.S. regulators due to its manipulation of the London Interbank Offered Rate (Libor).","rel":"","context":"In "International Business Law"","block_context":{"text":"International Business Law","link":"https:\/\/journals.law.harvard.edu\/hblr\/category\/international-business-law\/"},"img":{"alt_text":"","src":"","width":0,"height":0},"classes":[]},{"id":3134,"url":"https:\/\/journals.law.harvard.edu\/hblr\/toward-an-economic-model-for-the-taxation-of-derivatives-and-other-financial-instruments\/","url_meta":{"origin":4829,"position":5},"title":"Toward an Economic Model for the Taxation of Derivatives and Other Financial Instruments","author":"wpengine","date":"March 14, 2013","format":false,"excerpt":"David S. Miller: On January 24, the Chairman of the House Ways and Means Committee, released the discussion draft of a bill that would tax derivatives under a mark-to-market system of taxation. This proposal would replace our entire federal system of taxing derivatives with a radically different but infinitely simpler\u2026","rel":"","context":"In "Derivatives Regulation"","block_context":{"text":"Derivatives Regulation","link":"https:\/\/journals.law.harvard.edu\/hblr\/category\/us-business-law\/derivatives-regulation\/"},"img":{"alt_text":"","src":"","width":0,"height":0},"classes":[]}],"jetpack_sharing_enabled":true,"authors":[{"term_id":381,"user_id":0,"is_guest":1,"slug":"sanjai-bhagat","display_name":"Sanjai Bhagat","avatar_url":"https:\/\/secure.gravatar.com\/avatar\/?s=96&d=blank&r=g","0":null,"1":"","2":"","3":"","4":"","5":"","6":"","7":"","8":""}],"_links":{"self":[{"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/posts\/4829","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/users\/5"}],"replies":[{"embeddable":true,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/comments?post=4829"}],"version-history":[{"count":0,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/posts\/4829\/revisions"}],"wp:attachment":[{"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/media?parent=4829"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/categories?post=4829"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/tags?post=4829"},{"taxonomy":"author","embeddable":true,"href":"https:\/\/journals.law.harvard.edu\/hblr\/wp-json\/wp\/v2\/ppma_author?post=4829"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}