Does institution matter for human capital development?

graph_human capital

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, 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 higher level of human capital than others? Empirical literature have 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, quality of institution, as it affects 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 institution, where quality of institution 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 index of human capital and index of institution for 93 countries over a period of 1984-2010 with over 2500 observations. We have constructed the index of 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 institution.

The scatter-plot suggests a very strong positive association between quality of institution and level of human capital, which signifies the importance of better institution for higher level 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 progresses in both fronts, by 2010, the levels of these two indices of Bangladesh (5.52 and 2.07 respectively) were below than what Malaysia had in 1990!

Results from a more sophisticated cross-country panel econometric regression reinforces this association. In this regression, the index of human capital has been considered as the dependent variable. We have also created two institutional indices: 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 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 indicates 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 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 human capital index. The z-score regression analysis, however, refers to larger importance of political institution over economic institution 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 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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