Are Institutions More Important than Integration

The purpose of this paper is to empirically examine the contribution of trade liberalisation upon poverty via its impact on per-capita income levels. In addition we compare this with the relative contribution of institutional capacity to prosperity, as well as the role of human capital accumulation in that respect. We employ several concepts of institutional quality, trade policy and openness variables following various definitions prevalent in the literature. For example, we take into account the six different classifications of institutions identified by Kaufman et al (2002), namely rule of law, political stability, regulatory quality, government effectiveness, voice and accountability and control of corruption. On the international economic integration front, we have carefully chosen three specific measures of openness. The ratio of nominal imports plus exports to GDP is the conventional openness indicator, we use two others: overall trade penetration and overall import penetration. Neither of these measures are direct indicators of trade policy of a country, pointing only towards the level of its participation in international trade. There are indicators of trade restrictiveness acting as measures of trade policy, including import tariffs as percentage of imports, tariffs on intermediate inputs and capital goods, trade taxes as a ratio of overall trade and total import charges can all be considered as good proxies of trade restrictiveness and have also been employed in this study. Other measures which capture restrictions in overall trade are non-tariff barriers. Additionally, we have also used composite measures of the overall trade policy stance to examine how openness influences per-capita income. Our study employs 6 institutional and 11 openness variables in an attempt to undertake a comprehensive analysis of how institutional quality and exposure to increased international trade affects the economic performance of a country. Unlike in the comparable study by Rodrik et al (2004) we have (a) included a role for human capital, (b) employed six institutional variables compared to one only in Rodrik et al (rule of law), (c) included trade policy variables and not just openness indicators and (d) expanded the set of openness measures employed. To summarise our findings, we discover that opening up domestic markets to foreign competition by revoking trade restrictions and trade barriers can be good for economic performance. Secondly, developing human capital is as important as superior institutional functioning for economic wellbeing. Indeed, the accumulation of human capital stocks via increased education might lead to improved institutional functioning, and the utilisation of policies like trade liberalisation. Policies aimed at educational improvement yield a double dividend: they improve institutions in the longer-run and in the shorter-run they will allow for greater gains to the economy from trade liberalisation. With regard to the role of international integration versus institutions we have found that openness counts for little per se in explaining income differences across countries. This is because it is an outcome and not a cause. Trade policies, and liberalisation, on the other hand, are not insignificant in explaining cross-country per-capita income variation. With regard to trade policies we can safely say that the overall policy stance, particularly those associated with black market premia in foreign exchange markets and export taxes, are most important in explaining differences in income across countries. The presence of these two phenomena are also closely related to poor institutional performance. Tariffs and quotas on imports, however, are of secondary importance, indicating that they are less growth retarding.