Does institution matter for human capital development?
A fundamental proposition of new growth theories is that human capital is a key driver of economic growth. Development of human capital for the people of a country encompasses not only the diffusion and assimilation of available knowledge but also the generation of new knowledge – the source of innovation and technological change – which boosts economic growth.
It is rather a challenging task to measure a country’s stock of human capital. Popular indicators, used to measure human capital, include adult literacy rate, school enrolment rates, average years of schooling, quality of schooling, etc. The Penn World Table version 8.1 provides a dataset on an index of human capital (HCI) for 134 countries over a period of 6 decades. HCI is an index of human capital per person which is related to the average years of schooling and the return to education. In 2010, the United States had the highest HCI value (3.62) and Mozambique had the lowest one (1.27). In that year, among the 134 countries, 33 countries had HCI values higher than 3; 48 countries had values between 2.5 and 2.99; 28 countries had values between 2 and 2.49, and 25 countries had values less than 2. In South Asia, in 2010, the HCI values for Bangladesh, India, Nepal, Pakistan, and Sri Lanka were 2.07, 1.93, 1.71, 1.99 and 3.16 respectively.
Why do some countries have a higher level of human capital than others? The empirical literature has looked at different factors such as spending (both public and private) on education and health, and differences in income levels; but hardly there has been any emphasis on differences in institutional capabilities among the countries. However, the quality of the institution, as it affects the economic growth process, can also have a bearing on the quality of human capital. Therefore, a valid question can be asked: does institution matter for human capital development? Of course, there could be a bi-directional causality between human capital and quality of the institution, where the quality of institutions could also be influenced by the level of human capital. Nevertheless, leaving aside the causality, here we are more interested to know about the association between these two.
The scatter-plot, as presented in the graph, has been generated using the data of the index of human capital and index of the institution for 93 countries over a period of 1984-2010 with over 2500 observations. We have constructed the index of the institution using the data of six major ICRG (www.prsgroup.com) variables, namely bureaucracy quality, control of corruption, investment profile, democratic accountability, government stability, and law and order. As values of these six ICRG variables have different scales, we have rescaled them between 0 and 10. The aggregate institution index is the average of these six indicators with the range between 0 and 10, where 0 and 10 respectively indicate the lowest and highest levels of quality of the institution.
The scatter-plot suggests a very strong positive association between the quality of institution and level of human capital, which signifies the importance of better institutions for higher levels of human capital. Interestingly, if we compare Bangladesh with Malaysia, levels of both institution and human capital of Bangladesh in 1990 (1.62 and 1.52 respectively) were much lower than those of Malaysia in 1990 (6.05 and 2.31 respectively). Despite the fact that during 1990 and 2010, Bangladesh made some notable progress in both fronts, by 2010, the levels of these two indices of Bangladesh (5.52 and 2.07 respectively) were below what Malaysia had in 1990!
Results from a more sophisticated cross-country panel econometric regression reinforce this association. In this regression, the index of human capital has been considered as the dependent variable. We have also created two institutional indices: an economic institution and political institution. The economic institution index is comprised of three ICRG indicators – bureaucracy quality, control of corruption and investment profile; whereas the political institution index consists of the other three ICRG indicators – democratic accountability, government stability, and law and order. Other explanatory variables include initial GDP per capita, public expenditure on education as a percentage of GDP, and under-five mortality rate. The regression results indicate that after controlling for initial GDP per capita (which has a positive significant association with human capital index), public expenditure on education has a statistically significant positive association and the under-five mortality rate has a statistically significant negative association with the human capital index. The highly significant and positive coefficients of both economic and political institution indices suggest strong positive associations between these institutional variables and the human capital index. The z-score regression analysis, however, refers to the larger importance of political institutions over the economic institutions in human capital development.
The aforementioned analysis points to the fact that better economic and political institutions matter for human capital development. While countries need to make critical spending for human capital development, improvement in the institutional environment is unequivocally essential.
Published at the Thinking Aloud on 1 July 2016
Published at The Financial Express on 18 July 2016
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