# I. Introduction<sup>1</sup>

The last 35 years of developing country experience should persuade: policies do matter for economic growth. Since 1960, the most successful economies have tended to maintain undistorted domestic prices, a stable macroeconomic framework, open trade regimes, and steady investments in people (World Bank 1991; Sachs and Warner 1995). While pointing in one direction, this experience leaves plenty of room for interpretation--no **t** o mention disagreement--among policy makers and scholars over the importance of economic policies relative to exogenous variables and institutional factors (Mauro 1995, Knack and Keefer 1995), the evidence on causality, and the types of economic policies that matter most (Summers and Pritchett 1993). Theoretical and empirical analyses that specify channels through which national policies may affect long-run growth rates (e.g., Lucas 1988; Romer 1986, 1990; Barro 1990, 1991; King and Rebelo 1990; Mankiw, Romer, and Weil 1992) are often contradictory as well as econometrically problematic (Levine and Renelt 1992).

In many ways, this lively debate on the possible sources of economic growth has obscured one of the key rationales for policy reform: increasing investment productivity. Consider both publicly- and privately-financed investment projects in the developing world. Their aggregate performance, along with the performance of firms, farms, and private entrepreneurs, will over the long-term determine a country's growth rate. Insofar as project investment performance is a contributor to economic growth, the effect of the policy environment on project performance suggests the overall importance of policy reform.

For some years, there has been a limited consensus that the policy environment can affect project-level performance (World Bank 1989). Yet many questions on this linkage have remained unanswered. How important is the policy environment for project-level success? What type of policy distortions are particularly important? How does the importance of policies compare to other factors? Can certain type of projects be designed to be insulated from policy distortions? Could other mechanisms affect both projects and policies?

I Kaufmann: Chief of Resident Mission, Kiev, Ukraine; The World Bank, 1818 H Street, Washington, DC 20433; dkaufmann @worldbank.org. Isham: Research Associate; the IRIS Center at the University of Maryland, Morrill Hall, College Park, MD 20742; isham@econ.uind.edu. This research began during the preparation of _The World Development Report 1991._ The authors benefited from comments and suggestions from many World Bank staff as well as seminar participants at the National Bureau of Economic Research, MIT, and the AEA annual meetings. The authors owe special thanks to Ajay Chibber, Angus Deaton, Paul Duane, Eduardo Engel, Stanley Fischer, Albert Fishlow, Gobind Nankani, Manuel Penalver, Lant Pritchett, Sarath Rajapatirana, Dani Rodrik, Andre Schleifer, Joel Slemnrod, Kenneth Sokoloff, Larry Summers, and Vinod Thomas. In addition, we thank staff of the Operations Evaluation Departmnent of the World Bank and the evaluation unit of the International Financial Corporation for their generosity with data and advice.