Development Roast

Why don’t all countries adopt good institutions?

"The only justifiable purpose of political institutions is to ensure the unhindered development of the individual." Albert Einstein

Having good institutions that guarantee citizens a large degree of economic freedom has been shown to be strongly correlated with the usual development indicators, such as GDP per capita, life expectancy, and literacy rates, and negatively correlated with poverty, child labor, child mortality and informality (1) 1.

Why do some countries tangle their citizens in red tape, waste people's time with dozens of national holidays, and clog up the streets with patriotic parades? Why does it have to take months and cost a small fortune (150% of average annual per capita GDP) to set up a formal enterprise in Bolivia, when in Denmark and Canada it can be done in half an hour at no cost? (2) 2.

Why don't all countries adopt good institutions? (3) 3

One reason is that institutions in general cannot be adopted. What we call institutions are not only the physical institutions (such as an independent central bank or a supreme court), but also the more subtle habits, conventions and unwritten rules in a society. Such institutions grow from within, in response to the needs and demands of the inhabitants. If a small minority has the power to create institutions that serve their own interests, inefficient and limiting institutions can grow like a cancer in a society.

If you try to impose some nice, simple institutions, that seem to work great elsewhere, on top of the local institutions, you easily end up with contradicting and conflicting institutions, which spawn additional institutions to deal with the inherent conflicts. The result is a mess of institutions which severely limit the productivity of people.

For example, Bolivia has a tax-system, which on the face of it is admirably simple and has low levels of marginal taxation. People are supposed to pay just 13% of their income in either value added tax or income tax, whichever they prefer. A form has to be filled out every month, but it takes less than half an hour, and there are accountants in the streets that will do it for less than a dollar. If that had been the only tax, things would have been wonderful. Unfortunately the taxation of formal firms messes things up. According to the World Development Indicators (confirmed by personal experience) the effective tax rate on firms' profit is 80% (plus the huge costs of becoming and staying formal). So, if at all possible, firms will stay informal, which means that their workers and their products will also be informal, and in the end few taxes will be paid. The following table shows the effective total tax rates in Bolivia, by quintile of consumption.

Table 1: Effective total tax rate in Bolivia, by quintile of consumption
Quintile Effective total tax rate
1- poorest 7.7%
2 9.7%
3 10.9%
4 12.7%
5 - richest 12.8%
Source: Fernando Cossio: "Informe de Equidad Fiscal en Bolivia 5 4".

If we deduct the most direct public subsidies received (public education, public health services and pension payments), the table looks like this:

Table 2: Effective tax rate (net of transfers), by quintile of consumptionQuintileEffective total tax rate 1- poorest-48.0%2-22.1%3-11.9%4-7.8%5 - richest2.8%Source: Fernando Cossio: "Informe de Equidad Fiscal en Bolivia 5 4"

Not even the most efficient set of institutions in the World could generate lower net-taxation rates than that (and the government is even running a budget surplus)! No wonder Bolivians are reluctant to change the status quo. It is difficult to imagine a set of alternative institutions that would let everybody keep at least 97% of their income.

Know of any ways countries can adopt good institutions? Leave a reply below.

(*) Director, Institute for Advanced Development Studies, La Paz, Bolivia. The author happily receives comments at the following e-mail:

(1) Gwartney, J., R. Lawson & E. Gartzke (2005) "Economic Freedom of the World: Annual Report 2005".
(2) World Development Indicators, 2005.
(3) This was the main question of a conference organized jointly by MpD and INESAD last week in La Paz. The main presenters were Antonio Saravia and Fernando Untoja, and the present newsletter is inspired by their talks and the subse
quent discussion.

  1. #footnote
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  4. dFiscal_bolivia.pdf
  5. dFiscal_bolivia.pdf