The closest conceptual measure of the economic environment that an individual confronts comes under the umbrella of economic freedom. There are many potential mechanisms that a government can use to suppress economic shocks in ways that lower the need for managerial decisions. Similarly, there are many government policies that restrict the scope of individual economic decisions. The impact of these policies are often studied individually, including the effects of corruption (Bardhan (2005); Murphy, Schleifer, and Vishny (1991); Murphy, Schleifer, and Vishny (1993); Schleifer and Vishny (1993); property rights Acemoglu, Johnson, and Robinson (2001), Acemoglu, Johnson, and Robinson (2001), Acemoglu, Johnson, and Robinson (2005); Acemoglu and Johnson (2005)); rule of law or contract enforcement (Bardhan (2005); Acemoglu and Johnson (2005)) constraints on entry (Djankov, Lopes-de-Silanes, and Schleifer (2002)); privatization of state enterprises (Frydman and others (1999); Djankov and Murrell (2002)); or monetary policy (Acemoglu and others (2003)). However, these policies are plausibly mutually reinforcing, suggesting that they work more in conjunction with one another than in isolation. For that reason, it may be more convincing to look at an aggregation of policies affecting economic freedom rather than only one or two.

We use the Heritage Foundation’s Index of Economic Freedom as our measure of the institutions governing individual economic decisions. The Heritage Foundation has generated a consistent annual series since 1994 across 163 countries on various aspects of economic freedom: the ease with which the team can open or close a business; openness to trade; taxes relative to income; the importance of government in the economy; the quality of monetary policy; openness to foreign investment; the lack of government restrictions on financial or credit markets; protection of property rights; and the lack of corruption in government.<sup>12</sup> Although we do investigate the individual effects of the subcomponents of the index, it seems clear that they are not independent. A single factor loading from a factor analysis of the subcomponents of the Heritage Index explains 92% of the common variance among the components. Nevertheless, we can test whether the individual subcomponents have an effect on returns to skill that differs from the aggregate index.

# **_B. Globalization_**

International trade and exposure to international capital flows increases the country’s exposure to shocks. That alone could have an impact on the returns to schooling. However, there are other avenues through which integration into the international community could affect returns to schooling. Foreign Direct Investment provides access to new technologies that can complement domestic human capital. Xu (2000) argues that countries can only attract foreign direct investment if they have a sufficient base of human capital. Acemoglu, Johnson, and Robinson (2005) argued that openness to trade strengthened the property rights of merchants in Europe, increasing their incentives to invest. Hanushek and Woessmann (2008) provide evidence that openness to foreign trade raises the impact of average cognitive skills on economic growth. It is plausible that openness to trade may also raise returns to human capital.

> 12 We used the Heritage Foundation indices that matched most closely the date of each country household survey. For five countries which were not covered in the Heritage Foundation Index, we use the fitted values from regressions of the index on the six measures included in the World Bank’s Governance Indicators (Kaufmann, Kraay, and Mastruzzi (2008)).

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