Governance and Economic Performance: A Survey

This paper presents a framework for analyzing the determinants and effects of public governance and a survey of recent theoretical and empirical studies pertaining to developing and transition countries. It explains how informational, transactional and political constraints on government activity lead to trade-offs between efficiency and the extraction of rents by private firms, politicians and government agents, thus producing welfare-increasing or welfare-decreasing outcomes. It also discusses how political rules and law both constrain and facilitate economic activity. The common feature of the studies reviewed here is their analytical approach based on incentive theory and institutional economics. Governments are not benevolent dictators maximizing social welfare, but complex governance structures characterized by agency relationships. When agency problems and political and legal institutions are taken into account, it becomes easier to understand how markets and government, acting interdependently, produce social and economic outcomes that are, in many cases, inefficient and/or inequitable. The efficiency of the use of public resources as well as their targeting is seen to depend crucially on institutional features of the state and on incentive schemes in public organizations. Reforms should concentrate not only on defining objectives, instruments and parameters of public policy (regulation, taxation and redistribution), but also on designing processes and incentive schemes in such a way that credible commitment is possible and that agents actually implement policies that maximize social welfare. It is also crucial that reforms effectively prevent rent-seeking and the capture of the state by powerful elites, whose interests are at odds with those of the general public. Section 1 introduces the issues. Section 2 presents the analytical framework and discusses successively basic theoretical concepts (2.1); the interactions between economic, political and legal systems (2.2); the relationships between public institutions and concepts of authority (2.3); the interdependence of government and markets (2.4) and the provision of public goods (2.5). Section 3 discusses four political economy themes: first, the relationship between governance and income distribution (3.1); second, models of rent-seeking (3.2); third, how outcomes are enforced in a democracy (3.3) and, finally, sociopolitical instability (3.4). Section 4 turns to legal systems, first discussing the notion of "economic constitution" (4.1) and then issues of the "cost of rights" and the conflict between fiscal sustainability and the respect for basic rights, taking as an example constitutionally guaranteed entitlements (4.2). Three sub-sections then expand on the theme of efficient legal institutions and their role in development. The issues that are discussed are: whether formal or informal legal systems are more efficient (4.3), the meaning of the rule of law, and private enforcement of laws when there is no rule of law (4.4) and whether legal systems belonging to different 'families' are more efficient (4.5). Section 5 reviews empirical issues in assessing the links between governance and development. First, methodological problems are addressed: data issues, choice of model, and estimation problems (5.1); then cross-country studies on governance are surveyed (5.2) and, finally, empirical research within the context of individual countries is discussed, taking as an example a study on market-preserving federalism in Russia (5.3). Section 6 provides some conclusions, including remarks on a possible research agenda (6.1) and implications for international development policy (6.2).