Cross-country Income Differences Research Articles

The Deep Determinants at More Subtle Stages of Development: The Example of the Middle-Income Trap Phenomenon

The so-called ‘deep determinants’ of economic growth and development (namely, geography, institutions, and integration) have been found to be decisive for the break out of stagnation and for explaining cross-country income differences by many empirical studies. However, so far, very little has been done to examine to which extent they are also crucial at more subtle stages of economic development. Our paper aims to close this gap by focusing on the phenomenon of the middle-income trap (MIT) which has reached increasing attention in the last 15 years. In particular, we test whether the results of the empirical studies conducted by Acemoglu et al. (2001), Rodrik et al. (2004), and Easterly and Levine (2016) also remain valid when analyzing the MIT. We are the first to analyze the relationship between the deep determinants and the MIT, especially regarding the causal effect of institutional quality on the probability of experiencing a growth slowdown at the middle-income range. Our analysis reveals that while, in general, the deep determinants also seem to play an important role for the middle-income transition (and the question of whether a country falls into an MIT), some differences compared to the results of the standard literature become apparent.

Human Capital and Development Accounting: New Evidence from Wage Gains at Migration*

We reconsider the role for human capital in accounting for cross-country income differences. Our contribution is to bring to bear new data on the pre- and post- migration labor market experiences of immigrants to the U.S. Immigrants from poor countries experience wage gains that are only 40 percent of the GDP per worker gap. This fact implies that “country†accounts for only 40 percent of cross-country income differences, while human capital accounts for the other 60 percent. Our work deals with two well-known problems in the literature. It controls for selection by using data on the wages of the same individual in two different countries. We provide evidence on the importance of skill transfer by comparing pre- and post-migration occupations. Occupational downgrading at migration is common; corrections for this imply that human capital may account for as little as 50 percent of cross-country income differences.

What Is the Extent of Misallocation?

Measures of institutional quality are strong predictors of cross-country differences in income and productivity. The institutional economics literature has long maintained that one way institutions influence economic growth is by impacting the efficient allocation of production factors across firms. In this study, we measure the effect of bureaucracy, labor regulations, family management and financial frictions on input misallocation across firms using a unique dataset that combines firm-level financial data with a large survey administered to company managers. We use a general equilibrium model and a new econometric methodology that is robust to production function mis-specification to infer the size of the distortions induced by these frictions in six large European Union economies. For each of the countries included in our sample, we find that the amount of output that is lost as a result of these frictions is less than 1% of aggregate manufacturing production. This is relatively small compared to previous estimates, partly because we implement a number of methodological innovations to reduce upward bias in our measurements.

Delays in Public Goods

In this paper, we analyze the consequences of delays and cost overruns typically associated with the provision of public infrastructure in the context of a growing economy. Our results indicate that uncertainty about the arrival of public capital can more than offset its positive spillovers for private-sector productivity. In a decentralized economy, unanticipated delays in the provision of public capital generate too much consumption and too little private investment relative to the first-best optimum. The characterization of the first-best optimum is also affected: facing delays in the arrival of public goods, a social planner allocates more resources to private investment and less to consumption relative to the first-best outcome in the canonical model (without delays). The presence of delays also lowers equilibrium growth, and leads to a diverging growth path relative to that implied by the canonical model. This suggests that delays in public capital provision may be a potential determinant of cross-country differences in income and economic growth.

Delays in Public Goods

In this paper, we analyze the consequences of delays and cost overruns typically associated with the provision of public infrastructure in the context of a growing economy. Our results indicate that uncertainty about the arrival of public capital can more than offset its positive spillovers for private-sector productivity. In a decentralized economy, unanticipated delays in the provision of public capital generate too much consumption and too little private investment relative to the first-best optimum. The characterization of the first-best optimum is also affected: facing delays in the arrival of public goods, a social planner allocates more resources to private investment and less to consumption relative to the first-best outcome in the canonical model (without delays). The presence of delays also lowers equilibrium growth, and leads to a diverging growth path relative to that implied by the canonical model. This suggests that delays in public capital provision may be a potential determinant of cross-country differences in income and economic growth.

The Deep Determinants at More Subtle Stages of Development The Example of the Middle-Income Trap Phenomenon

The so-called 'deep determinants' of economic growth and development (namely, geography, institutions, and integration) have been found to be decisive for the break out of stagnation and for explaining cross-country income differences by many empirical studies. However, so far, very little has been done to examine to which extent they are also crucial at more subtle stages of economic development. Our paper aims to close this gap by focusing on the phenomenon of the middle-income trap (MIT) which has reached increasing attention in the last 15 years. In particular, we test whether the results of the empirical studies conducted by Acemoglu et al. (2001), Rodrik et al. (2004), and Easterly and Levine (2016) also remain valid when analyzing the MIT. We are the first to analyze the relationship between the deep determinants and the MIT, especially regarding the causal effect of institutional quality on the probability of experiencing a growth slowdown at the middle-income range. Our analysis reveals that while, in general, the deep determinants also seem to play an important role for the middle-income transition (and the question of whether a country falls into an MIT), some differences compared to the results of the standard literature become apparent.

The Deep Determinants of the Middle-Income Trap

The fundamental, underlying factors of development are often neglected when analyzing the question why countries experience a growth slowdown at the middle-income range. Although these so-called ‘deep determinants’ such as geography and institutions have been found to be decisive for the break out of stagnation and for explaining cross-country income differences by many empirical studies, so far, very little has been done to examine to which extent they are also crucial at more subtle stages of economic development. Our paper aims to contribute to close this gap by focusing on the phenomenon of the middle-income trap (MIT) which has reached increasing attention in the last 15 years. In particular, we are interested in whether the deep determinants have positive or negative impacts on the possibility of a country to experience a prolonged stay within the middle-income range. We focus especially on exogenous variables to avoid endogeneity/reverse causality problems. By using simple statistical hypothesis testing, we show that not all findings of the deep determinants literature can be easily transferred to the MIT phenomenon, especially regarding institutional variables. This may raise the question whether we need new deep determinants of growth for the MIT or at least a modified version taking into account the specific circumstances and characteristics of middle-income countries.

Human Capital and Development Accounting: New Evidence from Wage Gains at Migration

We reconsider the role for human capital in accounting for cross-country income differences. Our contribution is to bring to bear new data on the pre- and post- migration labor market experiences of immigrants to the U.S. Immigrants from poor countries experience wage gains that are only 40 percent of the GDP per worker gap, which implies that “country accounts for 40 percent of income differences, while human capital accounts for 60 percent. Our approach handles selection by comparing the wage of the same individual in two different countries. We also provide evidence on and a correction for skill transfer.

The Balassa–Samuelson relationship: Services, manufacturing and product quality

The Balassa-Samuelson relationship, i.e. the positive relationship between a country's per capita income and its national price level, represents an apparent violation of Purchasing Power Parity (PPP) and is not expected to hold for manufactures according to the explanation of this relationship proposed by Balassa and Samuelson. This paper shows that at the level of the products used in constructing national price levels, the relationship is present in both ‘services’ and ‘manufactures’ and the specification of the relationship is different for the two. It further offers a new candidate explanation for the B-S relationship in manufactures, which is based on an appeal to product quality. This explanation yields a second, distinctive, testable prediction: controlling for per capita income, a non-monotonic relationship should exist between a country's income inequality and its national price level. The second prediction is shown to be consistent with empirical evidence. The explanation also implies that mismeasured quality exaggerates the B-S relationship and hence the observed cross-country income differences are likely to be underestimated.

Spatial growth with exogenous saving rates

Economic growth has traditionally been analyzed in the temporal domain, while the spatial dimension is captured by cross-country income differences. Data suggest great inequality in income per capita across countries, and a slight but noticeable increase in inequality across nations between 1960 and 2000. Seeking to explore the mechanism underlying the temporal evolution of the cross sectional distribution of economies, we develop a spatial growth model where saving rates are exogenous. Capital movements across locations are governed by a mechanism under which capital moves toward locations of relatively higher marginal productivity, with a velocity determined by the existing stock of capital. This augments the capital accumulation equation by a nonlinear diffusion term. Our results suggest that under diminishing returns, the growth process leads to a stable spatially nonhomogeneous distribution for per capita capital and income in the long run. Insufficient savings may lead to the emergence of persistent poverty cores where capital stock is depleted in some locations.

Early Childhood Human Capital and Development

A growing literature stresses the importance of early childhood human capital. I ask whether variation in early childhood investments can help explain cross-country income differences. I provide new empirical evidence: the adult outcomes of refugees are independent of age at arrival to the United States up to age six, despite dramatic improvements in income and environment upon arrival. A standard model is consistent with this finding if parents but not country are important for early childhood development. This finding limits the mechanisms for generating cross-country early childhood human capital differences. I also provide suggestive evidence on parental inputs. (JEL I24, I26, I32, J13, J15, J24, J31)

Labor Mobility, Structural Change and Economic Growth

This paper develops a two-sector growth model in which the process of structural change in the sectoral composition of employment and GDP is jointly determined by non-homothetic preferences and labor mobility cost. This cost, paid by workers moving to another sector, limits structural change. Our model can explain the following patterns of development of the US economy throughout the period 1880-2000: (i) balanced growth of the aggregate variables in the second half of the last century; (ii) structural change in the sectoral composition of employment between agriculture and non-agriculture sectors; (iii) structural change process in the sectoral composition of GDP between these sectors; and (iv) wage convergence between the two sectors. We outline that the last two patterns can only be explained if labor mobility cost is introduced. Results reveal that mobility cost generates a misallocation of production factors. This implies a loss of GDP which amounts to over 30% of the GDP throughout initial periods according to the calibrated model. During the transition, the loss of GDP decreases and eventually vanishes. Thus, the elimination of the misallocation explains part of the increase in the GDP. Additionally, this study points out that misallocation introduces a mechanism through which cross-country differences in sectoral composition may account for cross-country income differences.

ENTRY COSTS, FINANCIAL FRICTIONS, AND CROSS-COUNTRY DIFFERENCES IN INCOME AND TFP

This paper develops a model to assess the quantitative effects of entry costs and financial frictions on cross-country income and total factor productivity (TFP) differences, with a primary focus on the interaction between entry costs and financial frictions. The model is calibrated to match the establishment-level statistics for the U.S. economy, assuming a perfect financial market. The simulations based on the calibrated model show that entry costs and financial frictions together account for 55% and 46% of the cross-country variation in output and TFP in the data. Moreover, a substantial portion of the variation is accounted for by the interaction between entry costs and financial frictions. The main mechanism is that financial frictions amplify the effect of entry costs.

Capital Goods Trade and Economic Development

Almost 80 percent of capital goods production in the world is concentrated in 10 countries. Poor countries import most of their capital goods. We argue that international trade in capital goods has quantitatively important effects on economic development through two channels: (i) capital formation and (ii) aggregate TFP. We embed a multi country, multi sector Ricardian model of trade into a neoclassical growth model. Barriers to trade result in a misallocation of factors both within and across countries. We calibrate the model to bilateral trade flows, prices, and income per worker. Our model matches several trade and development facts within a unified framework. It is consistent with the world distribution of capital goods production, cross-country differences in investment rate and price of final goods, and cross-country equalization of price of capital goods and marginal product of capital. The cross-country income differences decline by more than 50 percent when distortions to trade are eliminated, with 80 percent of the change in each country’s income attributable to change in capital. Autarky in capital goods results in an income loss of 17 percent for poor countries, with all of the loss stemming from decreased capital.

Capital Goods Trade and Economic Development

We argue that international trade in capital goods has quantitatively important effects on economic development through two channels: (i) capital formation and (ii) aggregate TFP. We embed a multi country, multi sector Ricardian model of trade into a neoclassical growth model. Barriers to trade result in a misallocation of factors both within and across countries. Our model matches several trade and development facts within a unified framework. It is consistent with the world distribution of capital goods production, cross-country differences in investment rate and price of final goods, and cross-country equalization of price of capital goods. The cross-country income differences decline by more than 50 percent when trade frictions are eliminated, with 80 percent of the change in each country's income attributable to change in capital.

Development accounting with wedges: the experience of six European countries

The paper interprets the growth experience of three Western European countries (France, Germany and the UK) and three Central-Eastern European economies (the Czech Republic, Hungary, and Poland) through the lens of the neoclassical growth model. It combines the methodologies of Development Accounting (Caselli, F. 2005. “Accounting for Cross-Country Income Differences.” In Handbook of Economic Growth , Chapter 9, 679–741.) and Business Cycle Accounting (Chari, V. V., P. J. Kehoe, and E. R. McGrattan. 2007. “Business Cycle Accounting.” Econometrica 75 (3): 781–836.) to calculate distortions – “wedges” – in production efficiency, and in the labor and capital markets. The exercise sheds light on the extent and evolution of factor market distortions between 1996 and 2009. The main result of the paper is that capital and labor market distortions do not explain income differences across the two country groups, but are important to understand income differences within groups. In addition, observed labor and capital taxes are related to the measured wedges, but significant unexplained components remain. Reducing labor and capital market distortions would lead to significant output gains in all countries.

An Eaton-Kortum Openness Index

Economists have argued that rich and poor countries face asymmetric trade costs. In this short note, we propose a simple trade cost function to model trade cost asymmetry at the trade barrier level. Our trade cost function can greatly improve the performance of the gravity model and shed light on the nature of some important parameters that have been used in applications on cross-country productivity and income differences.

International Evidence on the link between Foreign Direct Investment and Institutional Quality

Multinational corporations (MNCs) are known for their huge investments in research and development activity. They are also known for superior patents, trade secrets, brand names, management techniques and marketing strategies. The provision of incentives (i.e., tax incentives and/or subsidies) and the adoption of FDI-stimulating policies stem from the expectations that FDI brings enormous benefits such as the transfer of new technology. Numerous empirical studies have demonstrated FDI has a positive impact on economic growth of the host countries. However, it should be noted that the distribution of FDI across countries is not uniform with some countries receive more FDI than the others. This observation raises the question of whether it is possible to identify a set of policies that might enhance the attractiveness of host countries as destinations for MNCs. In the investigation of factors that influence FDI flows, existing studies have mainly focussed on the traditional factors such as market size, trade openness, infrastructure and human capital. The role of other factors such as the quality of institution in the host country was largely ignored. Institution can be defined as the humanly devised constraints or rules of the game that structure political, economic, and social interaction. Institutions provide the incentive structure of an economy. Specifically, it affects security of property rights, prevalence of corruption, distorted or extractive policies, and thereby affects the incentive to invest in human and physical capital, and hence economic growth. The role of institutional quality in the development process has been extensively examined and economists have reached a consensus on the importance of good domestic institutions in explaining cross-country differences in both growth rates and income per capita. Following recent literature that emphasize on the importance of institution, this paper examines whether domestic institutional quality has any important role in attracting FDI. Instead of investigating the direct effect of institution on growth, this paper focuses on the indirect effect that institution may bring via FDI inflows. Arguably, countries with better institutional quality should be able to attract more investment because it improves productivity prospect, reduces the cost of doing business and uncertainty. In order to test the hypothesis, data from 77 countries over the period of 1981-2005 is utilised. Methodologically, this paper uses a system generalised method-of-moment panel estimator to address some of the weaknesses encountered in the previous literature on FDI-institution link. Specifically, this estimator is able to formally address biases induced by the inclusion of lagged dependent variable, country-specific effects and endogeneity problem. There are several important conclusions emerging from this analysis. First, institution appears to be important determinant of FDI inflows. This finding is a line with the view that improvements in the quality of domestic institution will reduce the cost of doing business, reduce uncertainty, and improve productivity prospect. This will eventually lead to more investments. Second, FDI is also seeking human capital and trade openness. The availability of quality workforce in the host countries is an important pre-condition for the successful operations of MNCs as they need people who are able to understand and work with new technology. Trade openness is important because most FDI is export oriented in nature such that MNC will invest in countries that pursue trade-promotion policies. In addition, MNCs investment decision also depends on the amount of existing FDI invested in the countries. This is consistent with the view that the success of MNCs in the host countries is an important signal for further investments by MNCs. Finally, FDI is not influenced by market size and infrastructure quality. This is not surprising and in fact consistent with recent literature. Importantly, the finding on the important role played by domestic institution in attracting FDI is robust and is not driven by outlier observations, or problems caused by weak instruments and simultaneity bias. DOI: http://dx.doi.org/10.5755/j01.ee.23.4.2569

Appropriate Technology, Human Capital and Development Accounting

Over the past decade, research explaining cross country income differences has increasingly pointed to the dominant role of total factor productivity (TFP) gaps as opposed to factor accumulation. Nevertheless, it is a widely held belief that a country's ability to absorb and implement technologies is tied to its human capital. In this paper, we implement this idea in a novel specification and explore its quantitative implications within a development accounting framework. In our model, intermediate goods production takes place over a range of industries, and human capital ratios in a country influence industry specific productivities asymmetrically. As a result, in human capital abundant countries, production is concentrated around industries with high TFP, while in low human capital countries, production is concentrated around industries with low TFP. Development accounting exercises for a range of parameter values suggest that this human capital-technology complementarity may account for eighteen to twenty five percent of differences in GDP per worker which is higher than the combined direct contribution of factors of production.

Sector-Specific Capital, Labor Market Distortions and Cross-Country Income Differences: A Two-Sector General Equilibrium Approach

This paper highlights the significance of labor market distortions in explaining cross-country income differences using a two-sector general equilibrium model that incorporates modern intermediate inputs used in agriculture together with sector-specific human and physical capital. Using the best available information, I construct new sectoral data on quality-adjusted human capital and PPP-adjusted physical capital. Although both types of capital - physical capital in particular - play important roles, using a sample of 43 countries, I find that in terms of capturing the observed disparities, either in relative labor productivity in agriculture or aggregate output per worker between the rich and the poor countries, the role of labor market distortions outweighs the role of either sectoral human or physical capital.