role that human capital plays in economic development, it is important to understand why these differences in returns arise and persist across countries.

T. W. Schultz (1975) advanced an important hypothesis for why returns to schooling might vary across markets. He noted that human capital is most valuable in the presence of unexpected price, productivity or technology shocks that require managerial decisions to reallocate time and resources. If skilled individuals are not exposed to shocks that require resource allocation decisions or if they are denied the freedom to make those decisions, then they will not be able to capture the economic returns from their skills. If countries impose economic or political institutions that either blunt the impact of shocks or hinder individual economic choice, then we should find lower returns to skill in countries that limit exposure and/or individual responses to disequilibria.

A cursory inspection of the data yields support for the hypothesis. Figure 2A divides data from 86 developing countries into three groups based on their relative ranking in the Heritage Foundation’s Economic Freedom Index,<sup>3</sup> with 25% each placed in the least and most free economies and the rest being placed in the middle. We then plot the relationship between estimated returns to schooling and real gross domestic product per capita, a measure of each country’s level of economic development. Private returns to schooling for the freest economies average 9.7% per year of schooling, 3 percentage points higher than the average returns in the most restrictive economies.<sup>4</sup> Returns for the middle group fall between the two extreme groups.

We repeat the exercise in Figure 2B for private returns to years of potential experience. Again, average returns are highest in countries rated as the most economically free (5%) versus the middle (4.7%) and least free (4.2%) countries. These results are broadly consistent with the proposition that freer economic institutions raise individual returns to human capital.

T. P. Schultz (1998) found that about 70% of the income inequality in the world is due to country-specific fixed effects that would include the impacts of country-specific political and economic institutions on earnings.<sup>5</sup> Acemoglu and Robinson (2005) argued that these institutions were formed in response to exogenous influences existing at the time of a country’s founding, and that these institutions tend to persist across generations. We use measures of economic and political institutions to determine if they can alter returns to human capital across countries sufficiently to explain some of the persistent cross-country income inequality reported by T. P. Schultz. We find that, consistent with the T.W. Schultz hypothesis, human capital is significantly more valuable in countries with greater economic freedom. Furthermore, the positive effect is observed at all wage quantiles. Economic freedom benefits the most skilled

> 3 Information on the Heritage Foundation Index is available at

> <u>http://www.heritage.org/research/features/index/chapters/pdfs/Index2006_Chap5.pdf</u>

> 4 We use private returns to schooling as those are the ones that motivate individual time allocation choices. Countries may dictate individual educational choices and time allocations in ways to maximize social returns to schooling, but that would not correspond to T.W. Schultz’s focus on the returns to individual choice.

> 5 Similar findings that 60-70% of world income inequality is due to income inequality between rather than within countries results are reported in reviews by Firebaugh (2003) and Milanovic (2006).  Firebaugh (2003), p. 92) argues that between country inequality has fallen recently, but that the between-nation component of global inequality is still “as much as three times the size of the within-nation component.”

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