Friday, September 17, 2010

Economics 17/9/10: Free markets are good for human capital

World Bank Policy Research Working Paper 5405, titled “Economic Freedom, Human Rights, and the Returns to Human Capital: An Evaluation of the Schultz Hypothesis” by Elizabeth M. King, Claudio E. Montenegro and Peter F. Orazem published in August 2010 is a very insightful read into the role of proper market institutions and rights in economic development. Paper link here.

T.W. Schultz postulated, back in 1975, an important hypothesis for why returns to schooling might vary across different markets. According to Schultz, human capital is most valuable when individual workers face unexpected price, productivity or technology shocks that require managerial decisions to reallocate time and resources.

In other words, in Schultz’s view, human capital acts as a hedge against such uncertainty. If skilled individuals are not exposed to shocks that require resource allocation decisions or if they are denied the freedom to make those decisions, then they will not be able to capture the economic returns from their skills.

It stands as a logic corollary that if a country imposes economic or political institutions that cushion the shocks or hinder individual economic choice, then we should observe lower returns to skill in countries that limit exposure and/or individual responses to uncertainty.

In the case, relevant to Ireland, this logic extends not only to traditional factors, such as:
  • Degree of labour force unionization
  • Extent of social welfare safety net
  • Existence of the minimum wage laws
  • Restrictions on mobility into public sector jobs and protected professions jobs
  • Structures of pay and promotion divorced from productivity considerations
  • Visa restrictions
and other buffers, but also more novel factors such as
  • Negative equity
  • Housing markets access restrictions (e.g. birth-right to development of homes in some areas)
  • Cultural restrictions (e.g. Gaeltacht)
  • Lack of credit supply, etc
Per World Bank study cited above:

“A cursory inspection of the data yields support for the hypothesis. … [dividing] data from 86 developing countries into
three groups based on their relative ranking in the Heritage Foundation’s Economic Freedom Index, with 25% each placed in the least and most free economies and the rest being placed in the middle. … Private returns to schooling for the freest economies average 9.7% per year of schooling, 3 percentage points higher than the average returns in the most restrictive economies. Returns for the middle group fall between the two extreme groups. [The authors] repeat the exercise … for private returns to years of potential experience. Again, average returns are highest in countries rated as the most economically free (5%) versus the middle (4.7%) and least free (4.2%) countries. These results are broadly consistent with the proposition that freer economic institutions raise individual returns to human capital.”

Furthermore:

“T. P. Schultz (1998) found that about 70% of the income inequality in the world is due to country-specific fixed effects that would include the
impacts of country-specific political and economic institutions on earnings. Acemoglu and Robinson (2005) argued that these institutions were formed in response to exogenous influences existing at the time of a country’s founding, and that these institutions tend to persist across generations. [World Banks study] use measures of economic and political institutions to determine if they can alter returns to human capital across countries sufficiently to explain some of the persistent cross-country income inequality reported by T. P. Schultz. [The study found] that, consistent with the T.W. Schultz hypothesis, human capital is significantly more valuable in countries with greater economic freedom. Furthermore, the positive effect is observed at all wage quantiles. Economic freedom benefits the most skilled who get higher returns to schooling; but it also benefits the least skilled who get higher returns from experience.”

Now, this has three basic implications for Ireland.

Firstly, the study results show that higher human capital returns (in other words greater incentives to invest in human capital) are associated with less restrictive labour market policies, greater extent of basic human rights protection, more pluralist system of social organization and lesser emphasis on equalization of outcomes in economic environment. In other words, market wins, crony capitalism (Irish model) and socialism (Swedish model) lose.

Secondly, the study also implies that if Ireland were to be focused on developing a viable knowledge economy (aka human capital-intensive economy), the
country needs more market, more freedom, less protectionism and lower restrictions in the labour market.

Thirdly, the study suggests that environments with lower tax burden on labour and lower Government/State interference in private activities are more likely to
produce better human capital base.

Instead of farcical Mr Top Hat Kapitalist, it looks like free markets and societies benefit Ms Advance Degree Holder.

4 comments:

  1. Which is fine as long as Mz Adv. Degree-Holder is a fair and true reflection of society's ablest and is not benefiting from social stratification or garnering disproportionate returns from societal investment.....

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  2. The tricky part for your argument, arteid is that, as I mention, the same environment that benefits high end human capital (formal education etc) also benefits ordinary human capital (that lower earners acquire via on-the-job training and through experience). So in addition to Mrs Adv Degree, freedom benefits also Mr Hard Hat Brickie - as long as he is willing to invest in his own skills/aptitude/ability... It's that egalitarian, unlike, say, the Unions - whose sole objective is to benefit their members...

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  3. Jason LoughreySeptember 17, 2010

    The actual consequences of high tax rates on highly skilled workers needs to better appreciated for sure.

    The results for this paper obviously depend quite a bit on the heritage index that is used to measure economic freedom.

    People need to have a closer look at how this is actually calculated. The overall score is essentially the average of ten indicator scores.

    http://www.heritage.org/index/Explore.aspx

    In terms of the heritage commentary for Ireland.

    http://www.heritage.org/index/country/Ireland

    On Labour Freedom, Ireland is 38th of the 178 countries.

    "Labor regulations are flexible. The non-salary cost of employing a worker is low, and dismissing an employee is relatively easy. Restrictions on work hours are flexible."

    Ireland ranks 15th in terms of trade freedom but the comments indicate that there is room for improvement in many areas.

    On monetary freedom Ireland is 20th. This is surprising given the scale of the financial bubble and bust. Inflation Rate and Price Controls seem to be the only variables included. No account for quality of regulation it appears.

    Gov Spending is Irelands lowest (113th) but the commentary seems to place more emphasis on the decline in economic activity than any of its components.

    "Total government expenditures, including consumption and transfer payments, are moderate. In the most recent year, government spending equaled 35.7 percent of GDP. Public expenditures on an aging population and the slowdown in overall economic activity have contributed to a growing fiscal deficit."

    A critique of heritage index can be found here:

    http://baselinescenario.com/2010/05/27/heritage-index-good-government-vs-less-government/

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  4. To add to your criticism - I have fought for years a losing battle to get international indices like Fraser's and Heritage's to recognise that Ireland's performance cannot be measured via GDP. There are plenty shortcomings in all such indices, but that does not mean the picture they paint is not a truthful one. It is just not 100% accurate to each individual country case. Then again, nothing is.

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