Investment in human capital can have little impact on growth unless people can use education in competitive and open markets. The larger and more competitive these markets are, the greater are the prospects for using education and skills. The policy environment could also help to induce quality improvements in education and to calibrate the distribution of education to achieve the greatest welfare improvements.

# **I.** Issues **and Evidence**

Studies have shown the handsome returns to various forms of human capital accumulation: basic education, research, training, learning-by-doing and capacity-building. Education enriches people's understanding of themselves and the world. It improves the quality of their lives and leads to broad social benefits to individuals and society. Education raises peoples' productivity and creativity and promotes entrepreneurship and technological advances, demonstrated in countries from Malaysia to Bolivia to Ghana (World Bank 1991).

We also know that education alone does not guarantee sustainable economic growth. The former Soviet Bloc attained universal literacy decades ago. But because these countries were closed to ideas and products from the outside, their economies stagnated. The Philippines, Sri Lanka, and the Indian states of Kerala and West Bengal have experienced periods of lackluster growth even though their education levels outstripped those of countries and states that matched them in other ways. The real question, then, is when and how education can bring high payoffs.

Using panel data from 12 countries from 1970 to 1994, this paper investigates the relationship of education, policy reforms, and economic growth. We hope to shed light on the iimportance of the distribution of education to economic growth and on how the interaction of education and reforms facilitates economic and productivity growth. We draw on cross-country experience to show how policy reforms bolster returns from education and to highlight the conditions under which investment in both physical and human capital is likely to pay off.

## The Education Puzzle

In the earlier neoclassical models, education was not considered a major input for production and hence was not included in growth models.<sup>1</sup> In the 1960s mounting empirical evidence stimulated the "human investment revolution in economic thought" (Bowman 1966). The seminal works of Schultz (1961) and Denison (1962, 1967) led to a series of growth accounting studies pointing to education's contribution to the unexplained residuals in the economic growth of western economies. Other studies looked at the impact of education on earnings or estimated private rates of returns (Becker 1964; Mincer 1974). A 1984 survey of growth accounting studies covering 29 developing countries found estimates of education's

- Arnold C. Harberger described this period in a recent paper, "Many, maybe even most, economists expected that increments of output would be explained by increments of inputs, but when we took our best shot we found that traditional inputs typically fell far short of explaining the observed output growth....". ".. as the newly discovered residual loomed large in our professional thinking, our discussion centered on two potential explanations: 'human capital' and 'technical advance."' (Harberger, AER, 1998 p.1-2)

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