Does Rule of Law Affect Economic Growth Positively?

Abstract

Efficient institutional structure resolves the uncertainties in the market and the problem of asymmetric information, and thus creates a positive exogeneity, ensures the efficient distribution of the resources and makes a positive impact on the functioning of the economy. In addition to this, especially rule of law forms the basis of the socio-economic development. In the presence of the factors such as prevention of corruption and freedom of expression, institutional structure has a significant impact on economic growth. However, there are empirical studies that state that institutional efficiency boosts economic growth in developed countries, whereas it doesn’t have an impact or has a negative impact on economic growth in developing countries. For all these reasons, the impact of institutional efficiency on economic growth in developed, developing and underdeveloped countries will be analyzed in this study. In this study, the effect of institutional effectiveness on economic growth has been analyzed in both three country groups from 2002 to 2015 by using GMM. Dependent variable is GDP and the independent variables are institutional variables (rule of law, fight against corruption, voice and accountability). Based on our primitive findings we expect that developed institutions effect economic growth positively in develop countries unlike developing countries.

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Published by Sciedu Press 107 ISSN 1923-3981 E-ISSN 1923-399X
Does Rule of Law Affect Economic Growth Positively?
Aslı Ozpolat1, Gulsum Gunbala Guven1, Ferda Nakipoglu Ozsoy2 & Ayse Bahar1
1 Oguzeli Vocational School of Higher Education, University of Gaziantep, Turkey
2 Department of Global Politics and International Relations, Faculty of Economics & Administrative Sciences,
University of Gaziantep, Turkey
Correspondence: Aslı Ozpolat, Asst. Prof., Oguzeli Vocational School of Higher Education, University of Gaziantep,
Turkey.
Received: June 14, 2016 Accepted: June 20, 2016 Online Published: June 22, 2016
doi:10.5430/rwe.v7n1p107 URL: http://dx.doi.org/10.5430/rwe.v7n1p107
Abstract
Efficient institutional structure resolves the uncertainties in the market and the problem of asymmetric information,
and thus creates a positive exogeneity, ensures the efficient distribution of the resources and makes a positive impact
on the functioning of the economy. In addition to this, especially rule of law forms the basis of the socio-economic
development. In the presence of the factors such as prevention of corruption and freedom of expression, institutional
structure has a significant impact on economic growth. However, there are empirical studies that state that
institutional efficiency boosts economic growth in developed countries, whereas it doesn’t have an impact or has a
negative impact on economic growth in developing countries. For all these reasons, the impact of institutional
efficiency on economic growth in developed, developing and underdeveloped countries will be analyzed in this study.
In this study, the effect of institutional effectiveness on economic growth has been analyzed in both three country
groups from 2002 to 2015 by using GMM. Dependent variable is GDP and the independent variables are institutional
variables (rule of law, fight against corruption, voice and accountability). Based on our primitive findings we expect
that developed institutions effect economic growth positively in develop countries unlike developing countries.
Keywords: institutions, institutional effectiveness, rule of law, economic growth, GMM
1. Introduction
North (1990) defines institutions as: “Institutions are the rules of the game in society or, more formally, are the
humanly devised constraints that human interaction.” In determining the rules mentioned in the definition, it is
expressed that one of the most effective tools is law. The relationship between institutional structure and economy is
also one of the points to be considered. Institutional structure eliminates the market distortions caused by imperfect
data. Therefore, ensuring efficient decision-making of individuals and institutions by eliminating distortions is one of
the significant impacts of institutional structure on economy. Institutional structure ensures that economic
transactions between economic units are done in a cheaper and safer way. By this means, efficient institutional
structure that increases efficiency and quality, also contributes to the development of industry and the revival of trade.
Also, it may be claimed that it prevents waste of resources with the effect of reducing the inefficient use of resources
by the combination of institutional stability and economical and political stability. Institutional structure contributes
to economic growth by providing use of resources in productive and efficient areas (Yapraklı, 2008: 301-317).
Besides, prevention of corruption, transparency and accountability are also significant for the institutional structure
to function effectively and efficiently. Rule of law principle, which is the cornerstone of rule of law and democracy,
is the greatest assurance needed by people both individually and as a society. Factors like limiting the power of the
state by law and protecting the individual rights and freedoms, ensuring an equal and fair environment, accepting the
superiority of law over any individual create rule of law principle. Although there is not a universal consensus on the
concept of “rule of law”, the main principles of rule of law are defined by the Secretariat General for UN. In the
2004 report of the secretariat, it is considered within the scope of rule of law that all individuals and institutions
including government agencies may be accessible and they may be held accountable under the laws consistent with
the international legal norms and principles (Telli, 2014:314). It is also emphasized in the UN report that the term
“rule of law” involves these principles: equality before the law, accountability to the law, fairness in the application
of the law, separation of powers, participation in decision-making process, legal certainty, avoidance of arbitrariness,
and procedural and legal transparency.

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Law is specific and compelling by its nature (Hafızoğulları, 2002:19). It may cause an individual to be deprived of
various rights and benefits. However, it also protects an individual’s rights and freedoms or economic rights and
benefits from unlawful acts (Kelsen, 1951:706). Economy is the main factor which may affect the community,
starting from the individuals, and even the state positively/negatively. The presence of the close relation between law
and economy keeps the state standing both nationally and internationally. In this respect, the biggest danger that the
state may face is the economic uncertainty. A state in such an uncertainty cannot guarantee the economic activity
with laws and regulations, cannot determine the legal framework or may face a variety of strategies that may set the
development of the country back (Karabacak, 2003:67). Therefore, establishing the necessary legal framework is of
great significance for the development of global markets. In addition, it proves the relation between economy and
law clearly that UN accepts the underlying principle of acts concerning human rights as rule of law, and that World
Bank sees it as a necessary precondition of economic and social progress (Karabacak, 2003:63).
Considering rule of law with other principles like justice, equality, transparency, accountability give more accurate
results in terms of implementation since these principles are not independent or irrelevant from each other. It is
compulsory that the institutions meet the needs, be transparent and act in accordance with rule of law principle for a
fair and equal way of behavior. Accountability is the principle whose absolute presence is needed for ensuring and
sustaining rule of law principle. Fight against corruption which affects both developing and developed countries is
more controllable and effective when rule of law is as it should be (Karabacak, 2003:75). Considering all these
reasons, in this article, the relationship between rule of law, fight against corruption, voice and accountability and the
economic growth. At this stage, countries are divided into 3 groups according to their level of development. It may
be possible to identify if the relationship between the specified variables change according to the institutional
development through comparison between groups. Due to the reasons mentioned above, the relationship between
dimensions of governance and economic growth has been analyzed in this study. The models have been estimated
using yearly data from 2002 to 2015 for country groups. Gross Domestic Product per capita has been considered as
the dependent variable. The independent variables are rule of law index, control of corruption and voice and
accountability. By using the variables above, relationship between the series has been analyzed with Generalized
Method of Moments.
2. Relationship between Dimensions of Governance and Economic Growth
It is accepted in almost all relevant studies that the relationship between economy, institutional structure and rule of
law has a serious place in every stage of life of individuals and the state and that this relationship is an indivisible
whole. Recently, the growing population of the world indicates that the balance between the economy and law is
increasingly sensitive since the level of economy affects the political state of the country seriously, and it even
surpasses politics and plays a key determinant role. Since the countries with rich resources and regular economic
policies are not dependent on outside financial resources, they are also comfortable in terms of human rights. It is
indispensable that developing countries in the circle of poverty and with limited resources are dependent on outside
financial resources, and thus are exposed to strict economic programs. Public opposition emerging in time sometimes
ignores the law and prepares the ground for negative enforcements (Çeçen, 1989:526). Especially in such cases, it
can clearly be seen that there is a very close relationship between economy and rule of law.
In communities in which the law is superior and which is in safety and peace, since the economic rights are
guaranteed, development and growth gains momentum. Nationally, processes such as protection of property rights or
creation of capital markets are factors affecting the economic development, and also creation of a favorable
environment for foreign investors is necessary for creating an economic growth in the legal platform. Similarly,
freedom of expression, accountability and prevention of corruption are also significant variables for economic
growth to take place and to be sustainable. These components of institutional structure affect economy in several
different ways. Firstly, increase in prosperity raises the demand of higher quality institutions (transparency and
accountability). Secondly, high increase in prosperity makes the institutions more affordable. Lastly, economic
development is new agence of change and creates the demand of new institutions (Chang, 2010:476). Acemoğlu,
Johnson and Robinson (2005), relates the effect of institutional structure on economy with 3 institutional
characteristics; economic institutions, political power and political institutions. The process of these institutional
characteristics’ effect on economy is given in Figure 1.

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Published by Sciedu Press 112 ISSN 1923-3981 E-ISSN 1923-399X
countries. In this respect, Yapraklı (2008), in his panel data study for 36 middle income countries, found a negative
relationship between components of institutional structure and economic growth. Londregan and Poole (1990), in
their study for 121 countries between the years 1950-1982, used the variables population, income per capita, riots,
failed coups, successful coups, elections, political executions and deaths due to domestic political violence and
couldn’t find a direct relationship between income and the stated variables. Bienen et al. (1993), Sachs and Warner
(1997), in their study for African countries, stated that the slow growth in Africa is caused by natural causes such as
limited access to the sea, abundance of natural resources, and tropical climate. Besides, in the study, they concluded
that basic economical policies like being open to international trade, government saving and market-supporting
institutions have a significant effect on economic growth. Helliwell (1992) studied the relationship between
democracy and economic growth in his study for 125 countries. In the study, he concluded that there is a positive
relationship between democracy and economic growth countries in high income countries, yet he claims that
democracy has a negative but insignificant effect on growth in countries in low income countries. Doucouliagos and
Ulubaşoğlu (2008), in their study on 84 countries, concluded that there is not a relationship between democracy and
economic growth. As a result of the study for 145 countries grouped as high income, middle income and low income.
Fabro and Aixala (2009) found that institutional quality stimulates economic growth only in high income and middle
income countries. Ata, Koç and Akça (2012), in their study on 30 OECD countries, found a positive and statistically
meaningful results about the relationship between accountability and rule of law and economic growth whereas they
couldn’t find a direct relationship between regulatory quality, prevention of corruption and economic growth.
However, in the studies of Alesina and Perotti (1994); Alesina and Rodrik (1994); Alesina et al. (1996); Chong and
Calderon (2000) and Chang (2003), results show that institutional structure is not as effective as it is in developed
countries and that institutions have a negative effect on growth. In Table 2, there are some of the studies on the
relationship between institutional structure and economic growth.
Table 2. Studies on the relationship between institutional structure and economic growth
Authors Year Country Group Result
Scully (1988) 1960-1980 115 market economies Institutional structure has a
meaningful and significant effect on
the rate and efficiency of economic
growth.
Alberto, et al.
(1996)
1950-1982 113 countries The effect of democratic institutions is
not found statistically significant
Ali and Crain
(2002)
1975-1989 119 countries Different from economic freedom,
political regimes and civil freedom is
not seen significant for growth. Civil
freedom level and political regimes
are not necessary for the infrastructure
of the national economy.
Fabro and Aixalá
(2009)
1996-2000 145 countries While institutional quality variable is
not sufficient for explaining economic
development level of poor countries, it
has quite a significant effect on
explaining economic development
level of high income countries since it
is necessary for institutional quality
level to be over a specific limit.
Valeriani and
Peluso (2011)
1950-2009 181 countries Institutional quality has a positive
effect on economic growth. The size
of the effect differs when it is
considered in terms of developed and
developing countries.

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Willianson and
Mathers (2011)
1970-2004
(using five
year averages:
1981-1984,
1989-1993,
1994-1999,
1999-2004,
2005-2007)
141 countries Culture and economic freedom are
recognized as important for economic
growth. However, economic freedom
is relatively more important for
growth than culture.
Ata, et al. (2012) 2009 30 OECD countries Accountability and the rule of law
have a statistically significant and
positive effect on economic growth.
However, there is no significant
interaction between the institutional
structure and economic growth.
3. Data and Methodology
As regards to the data employed in this study, the annual data is collected for the period 2002-2015 for the country
groups. Country groups are classified according to World Justice Project report in 2015. Each country group includes
20 countries.
The variables used in this study covers real gross domestic product per capita (GDP) in billions of constant 2005 US
$, rule of law index, control of corruption index and voice and accountability index. The data of real (GDP) per
capita is sourced from World Development Indicators 2015 (World Bank), and rule of law index, control of
corruption index and voice and accountability index is sourced from The Worldwide Governance Indicators 2015.
All variables are in natural logarithms.
The Model is written as follows:
,01 ,3 ,4 ,ti ti ti ti
Iny InCC InRI InVA
  

   
(1)
Where:
Y: Reel Gross Domestic Product
RI: Rule of Law Index
CC: Control of Corruption Index
VA: Voice and Accountability Index
Analysis will be estimated by using Generalized Method of Moments (GMM). OLS estimator and GLS estimator
may give biased results in estimating dynamic panel data sets. For this reason, Arrellano and Bond (1991) developed
Generalized Method of Moments model which is a more effective method. In this method, first order differences of
dynamic panel data analysis variables are taken, and past values for dependent variables are used as instrumental
variable (Baltagi, 2001:130-131). The model developed by Arrellano and Bond (1981) is defined as One-step and
Two-step. In One-step model, error term doesn’t have a serial correlation and has a homoscedastic characteristic.
Explanatory variables are uncorrelated with the effect particular to groups in unobservable panel. One-step model is
formulated as follows:
1
'' 1'
11 1
1' 1'
1
()(( )) ()
()(( )) ()
N
N
yWWI GW W y
xy WWIGWWy




 



  




(2)
In the event that error term is heteroscedastic, two-stage GMM estimator is suggested. In the first stage of estimation,
it is assumed that error terms are homoscedastic against time with independent and explanatory variables. Two-step
GMM is formulated as follows:
1
'' '1
21 1 1
() ( () ()
NN
y
WV W y y WV W y






   


(3)
This GMM estimator does not require knowledge related to the first conditions or the distribution of i
vand i

. To
make this estimator functional, v is replaced by differentiated residuals obtained from the estimator 1


.

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4. Empirical Results
In the article, the relationship between rule of law, control of corruption, voice and accountability and economic
growth is studied. Country groups are classified according to their income and development levels by World Bank
Justice Project. The countries in the first group are in the upper levels in the range in terms of both income and
development. Whereas the countries in the second group have a mid-level development in the range, the countries in
the third group are at the bottom of the range.
GMM analysis is used for 3 country groups classified according to their development level. The purpose of
classifying countries according to their development levels is to determine if institutional variables are related to the
development level of the countries.
4.1 First Group Countries
Countries in the high income level are as follows: Australia, Belgium, Canada, Denmark, France, Finland, Germany,
Japan, Korea, Norway, Netherlands, Sweden, Singapore, Poland, Portugal, Spain, the United Kingdom, the United
States and Italy. According to that, the estimation results are plotted in Table 3.
Table 3. GMM results for high income countries
Variable Coefficient Std. Erro
r
t-Statistic Prob.
CC 0.038210 0.013372 2.857570 0.0047
RI 0.047394 0.018714 2.532550 0.0121
VA 0.028874 0.006695 4.312755 0.0021
As a result of the model for high income countries, development of institutional structure in developed countries
have a positive effect on economic growth. Considering the statistically meaningful results, a 1% increase in control
of corruption increases income per capita by %0,03. Similarly, a %1 increase in rule of law increases income per
capita by 0,04 %, and a 1% increase in voice and accountability increases income per capita by 0,02%.
4.2 Second Group Countries
The countries in this group are as follows: Ghana, Croatia, Hungary, Senegal, Malaysia, Bosnia, Jordan, Jamaica,
Tunisia, Macedonia, Bulgaria, Nepal, Belarus, Philippine, Indonesia, Albania, Argentina, Thaliand, Panama, Greece.
According to that, the estimation results are in Table 4.
Table 4. GMM results for middle income countries
Variable Coefficient Std. Error t-Statistic Prob.
CC 0.005236 0.117679 0.044496 0.9646
RI 0.026593 0.080427 0.330643 0.7412
VA 0.030144 0.059826 0.503853 0.6149
As a result of the model, the values obtained are not statistically meaningful. Considering the results in general, in
countries whose institutional structure is not at a specific level, institutional variables do not have an effect on
economic development.
4.3 Third Group Countries
The countries in this group are as follows: Kirghizstan, Zimbabwe, Cambodia, Pakistan, Cameron, Nigeria, Uganda,
Bolivia, Bangladesh, Ethiopia, Iran, Egypt, Turkey, Russia, China, Ukraine, Moldova, Mexico, Lebanon, Belize.
According to that, the estimation results are in Table 5.

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Table 5. GMM results for low income countries
Variable Coefficient Std. Error t-Statistic Prob.
CC 0.122397 0.127378 0.960895 0.3379
RI 0.017933 0.065014 0.275832 0.7830
VA -0.089481 0.181960 -0.491758 0.6235
Similar to the results of the countries in the second group, the results obtained in this group are not meaningful.
Therefore, in countries whose income level and institutional structure are not developed, institutional variables do
not have an effect on growth.
5. Conclusion
According to the view arguing that economics depends on institutions not on individuals, efficient institutional
structure solves the problem of market uncertainties and asymmetric information, creates positive exogeneity, and
provides an efficient distribution of the resources. Institutional structure involves significant factors such as rule of
law, control of corruption, freedom of expression, political stability, quality of bureaucracy and guaranteeing
property rights. These factors increase reliability of economy especially in developed countries and attract
investments, and increases economic growth. Besides this, institutional factors are substantially effective in
eliminating the unfair distribution of income. However, there are empirical studies claiming that institutional
efficiency increases economic growth in developed countries, and has no effect or negative effect in developing
countries. Therefore, it can be stated that institutional efficiency is not a reason of growth but a result of it.
Considering these reasons, in this study, the effect of institutional efficiency on economic growth in developed,
developing and under-developed countries is analyzed. With the data obtained from the countries classified
according to their development levels, the relationship between institutional structure and economic growth is clearly
revealed.
In this paper, the relationship between dimensions of governance and economic growth for 2002-2015 in high
income, middle income and low income countries has been investigated. The empirical results show that rule of law
index, control of corruption index and voice and accountability index are positively correlated with GDP in high
income countries. On the other hand, as a result of the studies on developing and under-developed countries, the
results are not statistically meaningful. The results obtained in this study coincide with the results obtained by Fabro
and Aixalá (2009); Valeriani and Peluso (2011), Londregan and Poole (1990); Bienen et al. (1993); Sachs and
Warner (1997). Fabro and Aixalá (2009) have found evidence that institutional quality variable is not sufficient for
level of poor countries. Besides, institutional quality has quite a significant effect on high income countries. While
institutional quality has a positive effect on economic growth, it shows different size of effect on developed and
developing countries in the results of Valeriani and Peluso (2011). Londregan and Poole (1990); Bienen et al. (1993)
and; Sachs and Warner (1997) also have found evidence that supports our result.
In this study, it tries to respond to questions about whether or not the positive relationship between rule of law and
economic growth in terms of high income, middle income and low income countries. The evidence suggests that this
relation is not relevant to explain the level of economic development of the middle income and low income countries.
In the light of the data obtained from the analysis, it can be stated that the efficiency of institutional structure is not a
reason but a result of growth.
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