[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 6

A Pro-Growth Agenda for the Global Economy


Many developing countries throughout the world have taken important
steps in recent years to promote the growth of their economies. Their
actions have lifted millions out of poverty, improved the health of
their populations, and contributed to progress in addressing
environmental challenges. Other countries, including some of the
world's poorest, have had less success in achieving and sustaining
strong economic growth. Developed and developing countries alike
face the challenge of improving economic performance around the
globe, so that more people can share in the benefits that come with
growth. The United States stands ready to address that challenge.
This chapter lays out some key factors that have been found to promote
and sustain faster economic growth. Although these factors are
important in all countries, the chapter's primary focus will be on
growth and development in low- and middle-income economies. Three
broad principles--securing economic freedom, governing justly, and
investing in people--underlie these key growth-promoting factors and
provide the organizing structure for the discussion. Adoption of
these principles creates an environment where market signals lead
to better economic performance.
Economic freedom promotes growth by encouraging competition and
entrepreneurship. Securing this freedom requires creating a stable
domestic macroeconomic environment with low inflation, regulating
appropriately, encouraging entrepreneurial initiative, and opening
to the global economy. Governing justly means establishing the rule
of law, controlling corruption, and guaranteeing political freedoms;
all of these help develop trust in the accountability and
reliability of the government, which in turn encourages
entrepreneurship. Investing in people means devoting resources to
enhancing the productive capacity and well-being of the general
population, in particular through improvements in education and
health. Countries that ignore this task will see their economic
growth suffer, because people who are in poor health or poorly
educated are less productive.
No one of these principles suffices to guarantee strong growth; all
three are mutually reinforcing aspects of a pro-growth agenda. Actions
by the United States, the broader international community, and the
international financial institutions can help developing countries
improve their economic performance. But creating the proper
incentives for domestic growth ultimately depends on decisions by
those countries' own citizens and governments.
The Administration has undertaken three important international
economic policy initiatives that are consistent with these
pro-growth principles. First, it has sought and obtained from the
Congress authority for the President to negotiate and conclude
trade liberalization agreements with other countries in a
streamlined fashion; the agreements reached under Trade Promotion
Authority will increase the integration of the world's economies,
especially those of developing countries. Second, the Administration
has launched the Millennium Challenge Account program, which will
extend additional developmental aid to the world's poorest countries
provided they have adopted pro-growth policies. Third, the
Administration has called for reform of the multilateral development
banks, including both the World Bank and the regional development
banks, to increase their effectiveness in spurring economic growth
through greater emphasis on measurable results and activities that
increase productivity, including private sector development.
In August of last year, the Congress granted the President Trade
Promotion Authority (TPA) through the Trade Act of 2002. This
legislation authorizes the President to negotiate trade
liberalization agreements with other countries and commits the
Congress to a yes-or-no vote, without amendments, on any agreements
reached under this authority. The President's enhanced ability to
engage in international trade negotiations under TPA will help the
United States conclude agreements that will increase competition,
boost productivity, and promote growth in both the United States
and its trading partners. TPA will enhance U.S. influence and
effectiveness at the trade negotiating table and will bring economic
benefits to American families, workers, farmers, and firms. Current
U.S. proposals for trade liberalization of nonagricultural goods
alone could save Americans about $18 billion a year in import
taxes, resulting in $1,600 worth of benefits annually for an
average family of four. This renewed negotiating authority will
also promote prosperity in our trading partners, including developing
countries. Indeed, those countries that are now the least integrated
into the world economy--including many of the world's poorest--stand
to gain the most in proportion to their current incomes from the
increased openness that TPA makes more likely.
The Administration is already engaged in negotiating trade agreements
in a variety of contexts, including the multilateral negotiations
organized under the auspices of the World Trade Organization as well
as regional negotiations, such as those toward a Free Trade Area of
the Americas, and various bilateral free trade negotiations. All of
these initiatives seek to promote economic growth by decreasing
barriers to trade in goods and services and establishing effective
procedures for settlement of international disputes involving trade.
Moreover, the rules-based trade agreements that are the object of
these negotiations will provide incentives for developing countries
to improve their own domestic institutions to provide greater
transparency, strengthen the rule of law, and improve the protection
of property rights.
The second major Administration initiative, the Millennium Challenge
Account (MCA), will provide grants in aid to those developing
countries that qualify by fostering and maintaining an environment
conducive to economic growth. Funding for the MCA will increase over
3 years to a total of $5 billion in 2006, an almost 50 percent
increase over current U.S. bilateral development assistance.
Recipients of MCA grants will be chosen by their demonstrated
commitment to the three principles mentioned at the outset: securing
economic freedom, governing justly, and investing in people. The
specific MCA criteria associated with each of these principles
are described in more detail later in this chapter.
The Administration's third pro-growth initiative involves reform
of the multilateral development banks (MDBs). Meaningful reform of
these institutions will raise economic growth and prosperity in
poor countries around the world by encouraging the MDBs to focus on
increasing productivity growth in those countries. The MDBs can do
this by fostering innovation to support private sector development,
insisting on measurable results as a condition for continued aid,
and delivering an increased share of total assistance in the form
of grants rather than loans.
The Administration believes that pursuing the pro-growth policies
outlined in this chapter will help restore the flow of investment
to low- and middle-income countries. This flow was interrupted by
frequent and severe economic and financial crises in some of these
countries during the 1990s. Net international private capital flows,
which averaged more than $150 billion a year from 1992 to 1997,
fell to less than $50 billion a year in 1998-2000. Restoring strong
private investment flows into low- and middle-income countries will
help create higher productivity jobs and raise living standards.
The chapter begins by laying out some basic facts about economic
performance and social indicators in the developing world. It then
discusses the three principles enunciated above and how they have
been shown to lead to faster economic growth. Finally, the chapter
discusses the Administration's three major initiatives and how they
embody pro-growth principles.


The Importance of Growth

The term ``economic growth'' can be understood both in narrow,
quantitative terms and in a broader, more qualitative sense.
Economists often measure growth as the annual percentage change in
a country's real gross domestic product (GDP) per capita, that is,
the 1-year change in the country's income, adjusted for inflation
and divided by the number of people residing in the country. By
this definition, growth simply indicates how the income of the
average resident of the country has changed from one year to the
next. In qualitative terms, however, sustained strong growth over
time means prosperity instead of poverty, job creation in place of
economic stagnation, and children who are strong and healthy rather
than malnourished and facing death from illness. Helping countries
boost their economic growth, in other words, is not just a matter
of statistics; it is about improving the lives of human beings.


The Global Growth Experience

Chart 6-1 illustrates the wide divergence in growth paths for several
major world regions from 1980 to 2000 (all of the growth rates that
follow are in terms of real GDP per capita). World income per capita
grew at an annual rate of 1.3 percent, increasing a total of
28 percent over the period. Performance in the East Asia and Pacific
region (East and Southeast Asia plus Australia, New Zealand, and the
Pacific island nations) far exceeded this benchmark: average income
per capita in these countries more than tripled, from $396 in 1980 to
$1,252 in 2000, with growth of more than 6.2 percent a year. In
contrast, incomes per capita in Latin America rose only from
$3,548 in 1980 to $3,856 in 2000, which translates to an annual
average growth rate of less than 0.5 percent. Average annual income
per capita in the countries of Sub-Saharan Africa actually fell by
14 percent during the period, from $658 in 1980 to $564 in 2000,
or by 0.8 percent a year. (Unless otherwise noted, all income
levels in this chapter are reported in constant 1995 dollars.)
Measures of countries' adherence to the pro-growth principles
introduced above, and described in more detail below, suggest
possible reasons for this huge variation. One is the presence or
absence of macroeconomic stability: inflation varied substantially
among the three regions, in a pattern that mirrors their growth
outcomes. Annual inflation in Latin America as a whole remained
relatively high during the 1980s and 1990s, averaging about
25 percent. In contrast, inflation in the fast-growing East Asia
and Pacific region averaged only about 12 percent during these two
decades but fell sharply in many countries over the period.
Inflation in slow-growing Sub-Saharan Africa also averaged only
about 12 percent. However, unlike in East Asia and the Pacific,
inflation in Sub-Saharan Africa rose over the period, from 10 percent
in the 1980s to 16 percent in the 1990s.



There were also important regional differences in the degree of
countries' openness to the global economy. The ratio of total
international trade in goods (imports plus exports) to GDP is a
common measure of this openness. In East Asia and the Pacific this
measure rose from 39 percent in 1980 to 66 percent in 2000; it rose
more modestly in Latin America over that period, from 26 percent to
38 percent. Sub-Saharan African trade as a fraction of GDP rose
only from 55 percent in 1980 to 57 percent in 2000. In short, the
different regions' growth performances are mirrored in the changing
role of trade in their economies.
Investment in people also varied considerably across regions. Only
about half of all children in Sub-Saharan Africa complete primary
school, according to surveys conducted from 1992 to 2000; the
completion rate in East Asia and the Pacific was almost twice as
high. Information for the period from 1995 to 1999 indicates that
average child immunization rates for measles, a key indicator of
health care for children, were 53 percent for Sub-Saharan Africa
versus 85 percent for East Asia and the Pacific.
Pro-growth policies have yielded important success stories in
individual countries as well, with a number of developing
countries in Asia, Latin America, and Africa significantly
outperforming their neighbors in achieving higher standards of
living. The growth experiences of China and India, both of which
have undertaken far-ranging economic reform in recent years, have
been especially impressive. (Box 6-2 later in the chapter discusses
China's reforms.) China's income per capita grew from $167 in
1980 to $824 in 2000, for an average annual growth rate of
8.7 percent. India's GDP per capita grew on average by 3.8 percent
a year over the same period, from $226 in 1980 to $459 in 2000.
Both countries were among the world's poorest at the start of the
period. Their growth rates are even more noteworthy given that the
average growth rate for this period for the poorest countries as a
group (those with incomes per capita of less than $800 in 1980)
was only 0.5 percent. Economic growth in China and India has
helped reduce their combined poverty rate (the percentage of
the population with incomes below $1 a day) from 62 percent in
1977-78 to 29 percent in 1997-98. (Incomes here are evaluated at
purchasing power parity, that is, adjusted such that $1 purchases
the same amount of goods and services in all countries.) The
enormous size of the population in both China and India (21 and
16 percent of world population in 1998, respectively) means that
economic progress in these two countries alone has contributed
significantly to reducing global poverty.
Chile and Botswana are examples of countries in other regions that
have also instituted pro-growth polices with impressive results.
Chile has undertaken major tax reform, opened its economy to
international trade and investment, privatized important sectors
of the economy, and reintroduced democratic governance. Botswana
has protected private property, discouraged corruption, invested
heavily in education and health, and maintained sound fiscal and
monetary policies. Neither country would seem to be particularly
well situated geographically to benefit from an integrating global
economy. Botswana is landlocked and is located in a region with
some of the worst economic performance in the world; Chile is
located thousands of miles from major markets in the United States,
Europe, and Asia, and some of its larger neighbors have suffered
recurrent economic crises. Yet Botswana and Chile recorded average
annual per capita growth rates of 4.6 and 3.7 percent, respectively,
from 1980 to 2000--far better than either the world average of 1.3
percent or the 1.9 percent average for middle-income countries
(defined by the World Bank as those with incomes per capita between
$755 and $9,266, in 2000 dollars). Part of the explanation for
their impressive growth is the relatively stability of their
macroeconomic environments: annual inflation during 1980-2000
averaged 15 percent in Chile and 11 percent in Botswana. Moreover,
Chile's inflation rate fell dramatically over the period, from
29 percent to only 4 percent; the Latin American average for
inflation, as noted above, was 26 percent over the same period.
Despite the successes of Chile and Botswana, there are numerous
stories of countries that have experienced economic stagnation
or even contraction. In 28 countries out of 134 for which consistent
and complete data are available, annual average growth in GDP
per capita ranged between 0 and 1 percent from 1980 to 2000.
GDP per capita fell during that period for another 41 countries
in the sample--in several cases by more than 30 percent over the
period as a whole.
The most troubling data are those that show a number of the
world's poorest countries becoming even poorer over the past two
decades. For example, Sierra Leone (with annual income per capita
of $293 in 1980), Zambia ($584), and Nicaragua ($671) experienced
average annual per capita growth rates of -3.6, -2.1, and
-1.9 percent, respectively, over 1980-2000. Real income per
capita in Niger plunged 38 percent over the same period, to only
$203. In countries such as these, life has become much more difficult
for millions of people, many of whom were already living at the edge
of destitution.
The growth experiences of these desperately poor countries reflect
their failure to promote economic freedom, govern justly, and invest
in their people. Macroeconomic instability has been a serious problem
for most of these countries: in Nicaragua, annual inflation during
the 1980s and 1990s averaged a staggering 1,453 percent; the figures
for Zambia and Sierra Leone, at 53 percent and 47 percent,
respectively, are modest only by comparison. Measures of openness
have been scarcely any better. Sierra Leone's trade as a ratio to
its GDP fell from 56 percent in 1980 to only 25 percent in 2000.
Zambia's involvement in the global economy also declined: its trade
was equivalent to 68 percent of its domestic economic activity in
1980 and fell to 54 percent in 2000.


The Benefits of Growth

Statistics on GDP per capita and its growth fail to capture the full
human tragedy now playing out in the poorest countries. Already-poor
countries experiencing stagnant, or even negative, growth have
difficulty coping with the basic problems of human existence.
Table 6-1 shows that, in 2000, the world's low-income countries
suffered from higher rates of malnourishment, shorter life
expectancies, and dramatically higher infant mortality rates than
did countries with higher incomes. About one-quarter of the
population of the low-income countries was undernourished, according
to a sample taken over 1996-98, compared with only 11 percent of
the population in the middle-income countries. In 2000, mortality
among children under 5 years old reached 115 per 1,000 in the
low-income countries, compared with only 7 per 1,000 in high-income
countries. Life expectancy in low-income countries was 19 years
shorter than in high-income countries (59 years versus 78 years),
a difference that in part reflects the prevalence of epidemics
like HIV/AIDS (Box 6-1).
The positive association between higher levels of income and
improved social indicators highlights the importance of economic
growth for improving the human condition. This relationship was
demonstrated in a



study of 58 developing countries from 1960 to 1985, which found
that a 1 percent increase in income per capita is associated with
a decline in infant mortality of as much as 0.4 percent. This
estimate implies that a 1 percent increase in income per capita
across the developing world could have averted 33,000 infant and
53,000 child deaths annually. Other broad measures of social
outcomes reflect similar patterns. The fast-growing region of
East Asia and the Pacific recorded a 45 percent decline in the
rate of under-5 mortality over the period 1980-2000, compared with
only a 13 percent decline in Sub-Saharan Africa. Undernourishment
fell by 30 percent in East Asia and the Pacific, but rose by
3 percent in Sub-Saharan Africa, during the 1990s.
Economic growth does not just lead to higher average incomes for
poor countries; it also offers hope for those at the margins of
society. A study of 92 developing and developed countries over
1950-99 found that the incomes of the poor (defined as the poorest
fifth of each country's population) rose one for one, on average,
with national income per capita (Chart 6-2). This means that
economic growth did not just benefit societies' richest but helped
the poorest strata as well. Data show, moreover, that worldwide
economic growth over the past 20 years has been accompanied by
the lifting of 200 million people out of poverty (where the poor
are defined as those with incomes of less than $1 a day, in
1985 dollars). Nonetheless, the economic benefits of growth have
not reached to every corner of the world. The World

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Box 6-1. Combating the HIV/AIDS Epidemic in Africa

The impact of the worldwide HIV/AIDS epidemic is perhaps most dramatic
in Sub-Saharan Africa. By the end of 2002 an estimated 29.4 million
Africans were HIV-positive, about 70 percent of the global total.
In the previous year, 9 percent of all adults in Sub-Saharan Africa
were living with HIV/AIDS, compared with 1.2 percent globally. AIDS
is now the leading cause of death in the region. The epidemic has
dramatically reduced life spans: estimates suggest that the region's
average life expectancy of 47 years would now be 62 years if the
epidemic had never occurred.
Although the greatest tragedy of AIDS is the misery and loss of life
it inflicts, the disease has also brought severe economic consequences
to a region already suffering from extremely low incomes per capita
and often-negative growth rates. Estimates suggest that AIDS has cut
annual economic growth in the region by 2 to 4 percentage points.
South Africa, one of the region's most important economies, could
suffer a drop in its economic growth by as much as 2.6 percentage
points as a result of the disease.
The economic consequences arise from a number of sources. Infection
rates are highest among young people, so that the illness is most
prevalent in individuals in their most productive years. Workers are
at risk of having to leave their jobs as they cope with the effects
of AIDS, either their own illness or as a caretaker for a sick
relative. This can be particularly disruptive to growth when skilled
workers are affected. For example, one estimate suggests that up to
30 percent of teachers in Malawi and Zambia are HIV-positive. The
direct and indirect costs of the disease also put strains on governments
struggling with other social needs such as improving education.
Societies will face pressures for increased expenditure on health
care. Public and private investment could decline, both because of
lower expected profits and because of increased economic uncertainty.
One striking indicator of the implications for health care is that
an estimated 50 to 80 percent of urban hospital beds in Cï¿½te
d'Ivoire, Zambia, and Zimbabwe are occupied by HIV-infected patients.
This means that these beds are not available for patients with other
illnesses. The impact on important social needs is shown by an
estimate that treating one AIDS patient costs as much as educating
10 primary school pupils for 1 year.
A few countries have had some success in combating the spread of
AIDS. The government of Uganda was one of the first to recognize and
respond to the epidemic. It invested heavily in an education and
outreach program involving HIV testing, counseling, and treatment.
These programs helped reduce Ugandan infection rates by more than
50 percent from 1992 to 1999. Senegal acknowledged the need to
address the AIDS problem as early as 1986 and instituted education
and outreach prevention programs. These efforts helped keep the
infection rate low (below 1.8 percent), even as infection rates
rose dramatically in the country's neighbors. At the end of 2001,
only about 0.5 percent of Senegalese adults were HIV-positive.
The scope of the epidemic requires a global response, and the
United States has played a major role in this effort. For example,
in May 2001 the United States took a leadership position on the
Global Fund to Fight AIDS, Malaria and Tuberculosis. The
United States now leads the world with the largest pledge,
$500 million, to the Global Fund. In 2001 the United States and
other WTO members agreed to help developing countries that lack
pharmaceutical manufacturing capacity by improving their access
to drugs that combat the disease. This access will be increased
by ensuring appropriate flexibility in the WTO rules that allow
countries to compel licensing of patented medicines in the event
of a domestic health emergency. Although final agreement on
implementing this commitment has not yet been reached among WTO
members, the United States has unilaterally pledged not to challenge
any member that breaks multilateral rules to export drugs produced
under compulsory licenses to poor countries in need. In June 2002
the President announced a $500 million International Mother and
Child HIV Prevention Initiative which will help reduce transmission
of HIV from infected pregnant women to their children in 12 African
and Caribbean nations. In the 2003 State of the Union address, the
President announced the Emergency Plan for AIDS Relief, a five-year,
$15 billion initiative to turn the tide in the global effort to combat
the HIV/AIDS pandemic. This proposal nearly triples the current U.S.
commitment to fighting AIDS internationally.
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Bank estimates that 1.2 billion people, or 20 percent of the world's
population, still lived on less than $1 a day in 1998. Evidence that
economic growth can benefit the poor makes the pursuit of
growth-improving policies and institutions all the more vital.
Of course, the relationship between economic growth and measures of
the human condition can be complicated. For example, evidence suggests
that some measures of environmental quality show consistent improvement
as countries become richer. This appears to be the case, for example,
with such indicators as the availability of potable water and
concentrations of arsenic in water supplies. However, there is also
evidence that other measures of environmental quality initially
deteriorate, on average, as countries go through



the early stages of development, but then improve once these
countries become sufficiently rich. For example, one study finds
that the concentration of sulfur dioxide in the atmosphere rises as
poor countries begin to industrialize, but then falls as income
per capita continues to rise beyond a certain point. Similar results
have been found for deforestation and for atmospheric concentrations
of particulate matter.
This inverted U-shaped relationship between economic growth and
environmental quality could reflect changes in the composition of
output. This could happen if countries undergoing industrialization
initially specialize in goods-producing industries with relatively
high emissions and then eventually shift to services industries,
which typically generate lower emissions. The relationship could
also reflect the greater ability of richer countries to devote
resources to environmental measures, perhaps combined with
increased demand for such measures as average incomes rise and
people's basic material wants become satisfied.


Promoting Growth

The evidence just laid out suggests that economic growth is critical
for improving the lives of millions in the developing world. This
leads to some natural questions for policymakers: What can be done
to improve growth rates? Why have some countries grown while
others remain in poverty? The answers to these questions are
critically important for governments of low- and middle-income
countries as they try to improve the lives of their people. The
answers also have helped the Administration in the design of its
three major international economic initiatives, as will be detailed
below.
For some countries, economic success may simply reflect their
endowment with valuable natural resources such as oil or diamonds.
But even countries with large supplies of such commodities can
suffer poor economic performance. For example, Nigeria was the
fifth-largest petroleum exporter among the OPEC countries over the
1980-2000 period, with average annual oil revenue of $18 billion,
yet its average annual per capita growth rate over this period was
-1.1 percent. Similarly, Saudi Arabia experienced a growth rate of
-2.8 percent over this period despite its immense oil wealth.
Geographic location also influences economic outcomes--the good
fortunes of Chile and Botswana notwithstanding. A country's location
affects the costs of transporting its goods to major markets, the
productivity of its agricultural resources, and the likelihood of
major natural catastrophes such as droughts, earthquakes, or
hurricanes. For example, one benefit of a coastal location is that
it allows access to international sea routes, making transportation
of goods far more efficient. One study suggests that, all else equal,
landlocked countries have growth rates 1.2 percentage points lower on
average than countries with outlets to the sea. Countries in tropical
regions apparently face a similar disadvantage: the same study finds
that their growth rates average 1.1 percentage points lower than
those of countries outside the tropics. The poor average performance
of tropical countries is due at least in part to endemic diseases,
which can create serious health problems that often have a measurable
impact on growth. In Sub-Saharan Africa, for example, health problems
associated with malaria alone have been estimated to reduce average
annual growth by as much as 0.6 percentage point.
Geography also affects growth indirectly through its effect on
institutions, for example through the legacy of European colonization.
In those parts of the world where conditions were relatively hospitable
to Europeans--for example, where settler mortality rates were
low--the settlements that the European countries established tended
to have better institutions, such as effective judicial systems and
strong property rights protections. Conversely, in regions with high
settler mortality rates, such as the tropics, European colonizers
tended to invest less in building these pro-growth institutions. The
weakness of these institutions continues to inhibit economic
performance decades and centuries later.
Clearly, natural resources and geography make a difference for
economic outcomes, but they are not the sole determinants. Sound
policies and institutions, both of which are shaped by the deliberate
decisions of individuals and governments, are also important. In
particular, decisions involving the role of government in the economy
(economic freedom), the development of political and legal institutions
(governing justly), and the health and well-being of the population
(investing in people) are all critical in shaping the environment in
which people work and invest.
Charts 6-3 and 6-4 show that higher incomes are associated with less
burdensome regulation and better protection under the rule of law.
Chart 6-3 shows the relationship between income per capita and an
index of regulatory quality; the latter is a composite measure,
developed by the World Bank, of levels of regulation, government
intervention, and price controls within a country, and thus an
indicator of economic freedom. Chart 6-4 shows the relationship
between income per capita and a similarly constructed measure of
the rule of law, which assesses the strength of property rights and
the prevalence of crime and corruption; this measure captures
aspects of governing justly. Higher positive values of these two
measures correspond to a less onerous regulatory burden or stronger
rule of law, respectively. The solid line in each chart shows a
fitted relationship between the indicated measure and income per
capita. Both charts show a clear positive relationship. Of course,
a positive correlation between measures of good policies and
institutions, on the one hand, and income on the other does not
necessarily demonstrate that the former causes the latter--it could
be that countries with higher average incomes are better able to
afford or demand effective government. But other evidence suggests
that, to an important degree, higher income is driven by good
policies and institutions, not the reverse. In other words,
explicit government decisions, like the decision to enforce the
rule of law and to protect property rights, improve economic
performance.
Table 6-1 above lists some selected indicators of investment in people
and shows their relationship with income per capita. Expenditure on
health and education, measured as a percentage of GDP, rises as
income increases. The increases in public expenditure on health
are particularly dramatic: low-income countries spend less than
1 percent of their GDP on health, compared with 2.9 percent and
6.0 percent for middle- and high-income countries, respectively.
Immunization rates for certain major childhood diseases in
high-income countries are over 30 percentage points higher than in
low-income countries. Public expenditure on education also rises
with income, but less dramatically than the health variables. As
with the variables discussed above, these figures do not indicate
the reason for this positive relationship: whether it is that richer
countries can afford to spend more on education and health, or that
more investment in education and health leads to higher incomes.
But the relationships are suggestive that private and public
investment in health and education can be important for growth.





Pro-Growth Principles

This section lays out three critical areas where countries can
improve economic performance. Promoting economic freedom helps firms,
workers, and consumers respond to market signals. Governing justly
helps create an environment in which entrepreneurs, investors, and
ordinary people can make economic plans with confidence that the
government will not undercut those plans with arbitrary decisions.
Investing in people is important for growth because an educated and
healthy population is critical for taking full advantage of a
society's economic potential.


Economic Freedom: Competition and Entrepreneurship

Economic freedom is fundamental to growth. One of the primary
responsibilities of a government pursuing pro-growth policies is
to nurture a stable, open economic environment in which market
signals direct the allocation of resources. Reliance on the market
provides incentives for entrepreneurs to take risks by starting
new firms and investing capital in existing ones. Competition from
both domestic and foreign sources will require firms to use
resources efficiently. Market signals encourage workers to raise
their productivity, not because a government instructed them to
do so, but because they see it in their own interest. A pro-growth
environment is supported by a stable macroeconomic environment,
appropriate government regulation, and openness to competition
from both domestic and foreign sources, as well as acceptance of
foreign direct investment and financial market liberalization.


Macroeconomic Stability

A stable macroeconomic environment, characterized by low and stable
inflation and responsible fiscal policy, is an important component
of a pro-growth framework. Also important is an exchange rate for
the country's currency that is not set arbitrarily by the government
but reflects market conditions and is sustainable given the country's
economic conditions. Macroeconomic stability also facilitates access
to international capital markets. Foreign lenders will demand a
higher interest rate on loans to an unstable economy, if they lend
at all, and foreign equity investors will avoid countries with
chronic macroeconomic problems that result in poor returns.
High and variable inflation makes it difficult for individuals and
firms to plan for the future; the resulting uncertainty leads to
lower consumption and investment and thus slower growth. This connection
has been found in many studies, even after taking into account other
economic factors such as income, education, investment, and openness
to trade, and social factors



such as life expectancy, fertility,
and inequality. One study suggests that the adverse effects of
inflation on growth in developing countries are greatest when
inflation is high. Chart 6-5 illustrates this point by comparing
inflation and growth for 136 developing and developed countries from
1960 to 1994. Although higher inflation is associated with slower
growth, the effect is most apparent when inflation exceeds 30 percent
a year.
Fiscal deficits have been linked to inflation in developing countries,
because governments may be tempted to print money to finance large
budget deficits. This tendency is particularly problematic in
countries with fixed exchange rates. Under a fixed exchange rate
regime, the monetary authority must buy or sell domestic currency
as economic conditions change, to maintain the official exchange
rate peg. If budget deficits lead to excessive domestic money creation
through central bank purchases of government bonds, there will be
pressure for the domestic currency to depreciate. The monetary
authority will then be forced to buy domestic currency with foreign
currency to maintain the peg. Because its foreign exchange reserves
are necessarily limited, persistent fiscal deficits and the
consequent exchange market intervention increase the likelihood of
a balance of payments crisis and undercut foreign investor confidence.
Economic growth has been shown to be slower in countries with larger
governments, as measured by government purchases of goods and services
as a percentage of GDP. Maintenance of an appropriate size and scope
of government, with efficient mechanisms for both expenditure control
and revenue collection, is vital for economic performance. It is
crucially important to give a high priority to strengthening public
expenditure management. Improved transparency and accountability,
including public expenditure tracking and fiduciary management, are
needed to ensure more effective use of domestic and external resources
and thus make progress in increasing growth and reducing poverty.
Increased government spending can require higher taxes for its
financing, and this has adverse effects on growth, since taxes
distort incentives in a well-functioning economy. In particular,
taxes alter relative prices, leading to efficiency-reducing economic
distortions and slower growth, by interfering with the market's
ability to allocate resources.
When governments must finance large expenditures through high taxes,
those on whom the taxes are imposed will have an incentive to avoid
them. Faced with widespread tax avoidance or evasion, governments
might be tempted to turn to schemes that promise to secure revenue
but are inefficient and particularly costly to the economy. One
such measure now in place in a number of developing countries is
the financial transactions tax, a tax levied on bank account
withdrawals or deposits (or both). Such a tax creates an incentive
for financial transactions to take place outside of the formal
financial sector. This reduces financial intermediation, thus
shrinking the base from which the tax was designed to garner
revenue. Indeed, research on the effects of such taxes in several
countries in Latin America has found that the economic efficiency
loss has ranged from 30 percent of the revenue collected in
Venezuela to 45 percent in Ecuador. Moreover, effective financial
intermediation is important for growth for its own sake, so that the
adverse effects of taxes on financial transactions extend beyond
the direct impact on the efficiency of revenue generation.
Taxes on international trade can be similarly attractive to
governments, because the activity to be taxed is localized at
a relatively small number of border crossings, ports, and freight
yards, making collection relatively easy. But such policies also
shield domestic industries from competition while raising costs
for domestic firms that rely on imported components. When taxes
on imports and exports are high, they create increased incentives
for smuggling, which both reduces government revenue and undercuts
the rule of law.
As already mentioned, fear of macroeconomic instability decreases
the attractiveness of a country to foreign investors. One measure
of the private sector's assessment of the macroeconomic situation
in a country is the country risk ratings developed by credit
analysts. These measures are designed to help investors predict
future investment returns. They are based on various measures of
macroeconomic stability, including government debt and inflation as
discussed above. They also take into account other factors important
to growth, including the country's political situation, the level
of corruption, the quality of the bureaucracy, the balance of the
current account in goods and services, and experience with
government expropriation of private investments. These are discussed
below.


Regulation, Privatization, and Entry

Government interventions that lower growth rates include onerous
or inefficient regulation, government subsidies that distort market
signals, direct intervention in production through government-owned
enterprises, and government-directed lending. A large body of
research has documented the damaging effects of excessive government
involvement in the economy in developed and developing countries
alike. For example, evidence from 85 countries over the period 1960-85
suggests that, holding constant other factors including the initial
level of income, a one-time 10-percentage-point increase in
government consumption as a share of GDP is associated with a
one-time 1-percentage-point decrease in the growth of GDP per
capita.
Privatization of state-owned enterprises has been found to improve
growth. In one study of 23 international airlines over 1973-83,
privately owned airlines were found to be more productive than
their state-owned counterparts: a change from complete state
ownership to private ownership increased an airline's rate of
productivity growth by 1.6 to 2.0 percentage points a year.
Similar results have been found for privatization of public
utilities. In Chile, for example, privatization of electric
utilities led to more widespread access to electricity among
the poor. Before the reform, which began during the mid-1980s,
25 percent of the poorest fifth of the population lacked access
to electricity; 10 years later this figure had fallen to about
6 percent.
An important caveat, however, is that privatization alone is not
sufficient to guarantee benefits to consumers; competition must
increase as well. Otherwise the effect might be simply to replace
a public monopoly with a private one, with continued restraints on
trade and continued high prices. This problem was highlighted in a
study of telecommunications reform in 30 Latin American and
African countries from 1984 to 1997: the study found that the
benefits to consumers, including lower prices and better service,
resulted from increased competition rather than privatization
per se.
Governments can enhance competition by reducing regulation on
domestic firms that hinders their growth. Often, small producers
in an industry, unable to meet the burden imposed by the official
business registration process, choose instead to operate informally,
that is, without official sanction. A drawback to operating in this
way, however, is that these informal producers find it more difficult
to raise capital from financial intermediaries within the formal
sector, such as banks. This prevents them from growing and competing
with the larger, established firms in their industry. In addition,
informal producers are less likely to participate in international
markets, because they have difficulty obtaining the letters of
credit necessary for trade.
In Peru, for example, a study found that about half of all workers
were employed outside the formal sector, in part because of the
onerous registration fees and other entry requirements faced by
their employers. Subsequent research has shown that undue entry
restrictions continue to limit business formation in a number of
countries, and not only developing ones. One study of 85 countries
reports that, in the late 1990s, an entrepreneur starting a new
business in Austria needed to complete nine separate procedures,
which took at least 37 business days and cost the equivalent of
$7,085 in government fees. Bolivian entrepreneurs were required to
complete 20 different procedures, pay $2,682 in fees, and wait at
least 88 business days to acquire the necessary permits. By
contrast, in Canada an entrepreneur could finish the same process
in roughly 2 days, paying $280 in government fees and completing only
two procedures.
Clearly there are many ways in which government involvement in the
economy through regulation can affect economic outcomes. The measure
of regulatory quality introduced in Chart 6-3 incorporates the
impact of a number of domestic government interventions, including
the incidence of price controls, poor bank supervision, and
excessive regulation. The World Bank estimates that a 1-standard-
deviation improvement in this regulatory quality measure is associated
with a threefold increase in growth of GDP per capita.


Openness to International Trade

International trade increases competition and productivity growth. It
also brings greater specialization according to comparative
advantage, lower prices, and a wider selection of products and
services for both consumers and firms. Openness to trade allows
exporters to sell their output in a larger market; workers in export
industries benefit as the resulting higher prices for the goods they
make translate into higher wages and incomes.
Chart 6-6 illustrates the relationship between growth and a measure of
openness as estimated in a recent study of developing countries. A
sample of 72 developing countries was split into ``globalizers'' and
``nonglobalizers,'' with the former defined as the 24 countries in
the sample that achieved the largest increases in their trade-to-GDP
ratio from 1975 to 1995. In the 1960s and 1970s, the nonglobalizers
experienced somewhat faster growth of real income per capita on
average than the globalizers. During the 1980s, however, globalizers
experienced much higher growth rates: real income per capita grew an
average (weighted by population) of 3.5 percent a year in these
countries, compared with 0.8 percent for the nonglobalizers. The
divergence was even greater during the 1990s, with 5.0 percent annual



growth for the globalizers versus 1.4 percent for the rest. To put
these differences into perspective, had the average globalizer and
the average nonglobalizer each begun with an income per capita of
$1,000 in 1980, by 2000 the globalizer's income per capita would have
grown to $2,300, and the nonglobalizer's only to $1,240.
The fact that the latter figure is an average for fully two-thirds
of a large sample of developing countries suggests that enormous
benefits remain to be reaped from further removal of trade barriers
and other distortions that affect trade. These gains are particularly
important for developing countries, which are typically too small
to affect the world prices of the goods they import or export. If
the government of such a country imposes a trade tax, foreigners
will continue to buy and sell at the unchanged world price, since
they have alternative markets. Consequently, the impact of any trade
tax in a small country ultimately is borne by domestic consumers and
firms. The tax will lead to lower productivity, lower standards of
living, and higher costs of producing goods. Higher barriers in
developing countries will also reduce trade with other developing
countries, many of which would be natural trading partners under
free trade. According to an estimate by the World Bank, developing
countries would gain over three times as much from tariff elimination
by other developing countries as they would from tariff elimination
by developed countries.
An important part of these gains stems from improvements in
productivity resulting from lower trade barriers and increased trade.
Efficient firms will have an incentive to expand production and
increase exports. Increased export production, in turn, results in
lower average costs for firms that can exploit economies of scale.
Inefficient firms, unable to export to the international market, or
under increased competitive pressure from imports, will reduce output
or close. A parallel analysis applies to import-competing firms:
those that can continue to produce will have an incentive to become
more efficient, while less efficient firms will leave the industry.
In short, international competition provides incentives to increase
efficiency and productivity, leading in turn to higher income per
capita. (Chapter 1 further explores the links between productivity
and growth.)
Trade liberalization has in fact increased productivity in a number
of developing countries. A study of India for the 1986-93 period
shows that the trade liberalization that began there in 1991 led to
increases in the growth rate of productivity ranging from 3 to 6
percentage points in three out of four industries considered:
electronics, electrical machinery, and nonelectrical machinery, but
not transport equipment, all recorded gains. Similarly, evidence
suggests that productivity growth in Cï¿½te d'Ivoire tripled after
trade liberalization took place there in 1985. Chilean firms also
increased productivity in the wake of trade liberalization in the
1970s and 1980s: industries facing competition from imports
experienced productivity gains 3 to 10 percentage points higher
than those of industries not engaged in trade. Plants that closed
down were on average 8 percent less productive than those that
continued to operate.
A further advantage of international competition, in developed and
developing countries alike, is that it can reduce the ability of
firms to exploit market power, which can reduce productivity and
thus growth. Firms insulated from competition, whether domestic or
international, not only are free to increase prices to consumers,
but also can become inefficient if they restrict output and fail
to take full advantage of economies of scale. Studies of India,
South Korea, and Cï¿½te d'Ivoire suggest as well that domestic
monopoly power fell after trade reform, as shown by a drop in
price-cost markups and an increase in productivity in many
industries. Evidence from India and South Korea indicates that
international competition has increased the benefits from more
fully exploiting scale economies. Opening to the world market
increased production runs and lowered average costs in firms in
these two countries.
Barriers to trade can have unintended consequences for the adoption
of new, potentially growth-enhancing technologies. In 2000, Brazilian
tariffs on data processing and information systems exceeded 20 percent,
raising the cost of personal computers and contributing to a rate
of computer ownership of only 4 percent of the population. That same
year, Costa Rica had a far higher rate of computer ownership
(15 percent of the population) than Brazil, in part because of zero
tariffs on computers, despite similar income per capita in the two
countries ($4,600 in Brazil versus $3,900 in Costa Rica). Brazilian
trade policies clearly add to the cost of realizing the productivity
gains widely associated with computers.
Although increased trade leads to higher incomes and faster growth
for the economy as a whole, it can also mean economic dislocation
for some workers. Some firms will shut down, and some workers will
lose their jobs or face lower wages as international competition
increases. Such dislocation can pose a hardship for those who
lack alternative employment near where they live, or whose
specialized skills are not easily transferred to other employment.
Because such job turnover is an unavoidable part of a growing and
dynamic economy, countries must address the social consequences of
dislocation, including dislocation due to trade, domestic
competition, or technological change. Nor should they do so only
for altruistic reasons: countries that have adequate private and
governmental institutions to deal with such transition costs will
experience fewer pressures to avoid further trade liberalization
or other economic reform. (See Chapter 3 for a discussion of new
approaches to Trade Adjustment Assistance in the United States.)
This is important, because societies that pursue pro-growth policies
such as openness to trade will become richer as a result, and
therefore will have the resources they need to deal more effectively
with these changes. Countries that instead avoid trade liberalization
will face the opposite problem: a fortunate few will see their jobs
protected, but many more will have lost real opportunities for
improving their lives, perhaps without ever knowing it. The economy
as a whole, meanwhile, will experience slower growth and have fewer
resources with which to deal with broad social problems.


Foreign Direct Investment and Financial Flow Liberalization

Economic freedom is also enhanced by openness to the flow of capital
across international borders. Access to global capital flows provides
countries with a means to finance investment projects and the
acquisition of new technologies. At the same time, the ability to
invest capital abroad helps investors spread their risks and aids in
the establishment of new industries. Capital account liberalization,
especially in the context of sound banking supervision and financial
regulation, leads to improved economic growth, especially in
developing countries. One study found that the benefits of capital
account liberalization may be twice as great in non-OECD countries
as in OECD countries. (The Organization for Economic Cooperation and
Development, or OECD, is an association of industrialized market
economies.)
Openness to financial flows, low trade barriers, and a good regulatory
regime can encourage foreign direct investment (FDI, defined as
cross-border flows of capital for the purpose of control of an
enterprise). In particular, if foreign firms are able to freely move
financial assets and profits into and out of a country, and if tariffs
are low on imported inputs, they will be more inclined to set up
plants in that country, thus contributing to its growth. A lack of
burdensome regulation can also encourage foreign investors to make
the commitment to establishing a long-term presence in a country.
On the other hand, FDI may be attracted by high tariffs on final
goods entering the country; this provides an artificial incentive
for foreign companies to avoid the duties by establishing a domestic
presence.
Besides bringing in valuable capital, FDI also spurs growth through
the management skills, know-how, and new technologies that foreign
investors bring into the host country. These advantages have been
shown, in both developed and developing countries, generally to
result in higher productivity in foreign establishments than in
domestic firms, which in turn leads to higher wages in the
foreign-owned plants. Mexican manufacturing data for 1970 suggest
that both value added and gross output per employee were more than
twice as high in plants owned by multinational corporations as in
private domestic plants. Estimates from a study of Uruguay in 1988
found that productivity, measured by value added per worker, was
twice as high on average in foreign firms as in domestic firms.
One study of Indonesian manufacturing found that, in 1996,
foreign-owned firms paid wages as much as 20 percent higher for
white-collar workers and 12 percent higher for blue-collar workers
than did domestic firms.
Financial sector openness coupled with domestic financial
liberalization spurs competition among domestic financial firms and
between them and foreign participants in the financial sector. This
openness exposes the domestic firms to the best practices of
world-class financial institutions and exerts pressure on them to
adapt quickly. Developed countries, including the United States,
have gained from financial market liberalization. In a similar
way, developing countries ``import'' not only the latest bank
management technology, but also the best risk management practices,
the best work force training, and the newest financial products.
Developing countries that are open to the establishment of a
foreign financial presence in their economies reap especially
important benefits: those with open and competitive financial services
markets have growth rates up to 2.3 percentage points faster than
those with closed markets.
For many developing countries, reform of the financial sector will
require liberalization of domestic laws and regulations to allow
foreign firms to provide services in the domestic market on the same
terms as domestic financial firms. Transparency will require a
mechanism by which firms can review and comment on proposed
regulations and obtain easy access to information on existing laws,
regulations and licensing, and other requirements in the financial
sector. In such a highly regulated area, it is critical that all
participants be aware of any changes in the rules or their
administration. In addition, effective planning by firms and workers
requires that government regulations not change arbitrarily or too
frequently. Otherwise investment can be expected to be lower,
because the returns will be more risky. Once again, regulatory
quality can play an important part in creating an environment in
which economic growth can occur.
Efficient financial markets can also help elicit the best results from
FDI. In particular, one argument in support of FDI is that it
enables residents of the host country to acquire knowledge and
learn new techniques while working in foreign-owned plants, and then
go to work for (or start) a domestic firm and apply that knowledge
there. However, empirical studies have found mixed evidence on whether
such technological spillovers systematically occur. If the country's
financial system is not well developed (for example, if credit
extended by financial intermediaries to the private sector is small
in relation to GDP), entrepreneurs may not be able to obtain financing
to apply the new knowledge and technology in a new plant. One study
of developed and developing countries from 1975 to 1995 suggests that
a country's annual growth rate increases by 0.6 percentage point when
FDI is undertaken in the presence of well-developed financial markets.


Governing Justly: Rule of Law and Government Accountability

A growing body of research shows that the quality of institutions
is critical in explaining differences in growth rates across countries.
For example, if domestic legal institutions cannot or do not enforce
contracts, businesses and individuals will be less likely to commit
to long-term commercial relations, absent informal ties such as family
relationships. Government regulation or bureaucratic indifference that
makes it difficult to acquire and retain rights to property can slow
capital formation. Governments that are unresponsive to their
citizens, or that act arbitrarily when making economic decisions, will
lose the trust both of the domestic population and of potential
foreign investors.
Consequently, countries seeking to accelerate their economic growth
must promote institutions that allow individuals and firms to respond
to market incentives. The rule of law is one of the most important of
these institutions, because it directly affects the willingness of
individuals to save and of entrepreneurs to undertake commercial
activities.
If the rule of law is to provide an environment supportive of growth,
it must encompass not just what is commonly thought of as
``law and order,'' but also, more broadly, the protection of property
rights, the ability to make and enforce contracts, and the ability to
settle private disputes fairly and effectively. People must also have
reason to expect that the government will not intervene in legitimate
private transactions by expropriating property, systematically
favoring either debtors or creditors, or supporting one sector of the
economy over another in legal proceedings. Returns on investment have
been found to be higher in countries with strong rule-of-law
protections. For example, one study concluded that rates of return on
World Bank-financed projects over the last several decades were 8 to
22 percentage points higher in countries where the rule of law was
well established than in countries where it was not. Another study
of 115 countries from 1960 to 1980 found that, on average, income
growth was nearly three times as rapid in countries with greater
civil liberties and political freedoms as in countries that were
less free.
Enforcement of property rights is an important aspect of the rule of
law, regardless of a country's income. Legally held assets, legitimate
investments, and profits from legal commercial transactions must be
protected against seizure by criminals--or by governments without
compensation. Countries whose governments do not enforce property
rights can be expected to suffer from slower growth. To see this,
consider the economic effects of a government that routinely seizes
private resources without legal justification or adequate
compensation. Investors, assessing the risk of expropriation of their
assets, will then require a higher rate of return on any projects
they undertake, and some investment that would otherwise bring
economic benefits to the country--higher income, higher productivity,
higher wages--will be forgone.
The poor may be especially hurt by the absence of property rights.
Many of the poor in the developing world lack formal title to what
property they have, which means they cannot use it as collateral to
borrow to expand their informal businesses or establish a new
enterprise. In addition, they often must rely on extralegal means to
insure against appropriation of their investment by others, because
they cannot rely on the formal legal system to protect their property.
Institutions that protect property rights are crucial for economic
growth. One study links the successful development outcomes in East
Asia over the past several decades to the quality of institutions and
property rights there. Examining eight countries in the region over
the period 1960-94, researchers found important contributions from
just three variables: institutional quality, initial income, and
initial education. Those countries with the weakest
institutions--Indonesia and the Philippines--had the slowest growth.
Inadequate legal protections for passive or minority investors also
affect investment and growth. One reason is that, in countries with
weak investor protection, managers may be able to exploit inside
information about their firms, to the disadvantage of outside
investors. Knowing this, investors will be less willing to commit
funds in the first place. A study of individual firms in 38 developing
and developed countries over the period 1988-98 found that countries
with weak protection for outside investors had capital stocks only
half as large as countries with strong investor protections.
The rule of law is particularly important for the development and
efficiency of the financial sector. For example, banks cannot
function effectively without strong institutions that support the
rule of law. Modern banking depends on the confidence of depositors
that banks will safeguard the monies in their trust and that the
government will provide supervision and regulation to ensure the
banks' soundness. Reforms that strengthen creditor rights, contract
enforcement, and accounting practices boost financial development,
and with it economic growth. One study shows that if countries
improve the legal protection of creditors, they will have much
stronger financial development, which in turn accelerates long-term
growth. Another study found evidence that the positive impact of
capital account liberalization on growth (as described above) is
enhanced through institutions that promote the rule of law.
Of course, the nature of laws and institutions matters--the laws
must be appropriate and the institutions effective. The laws and
institutions governing bankruptcy proceedings provide an example.
In a number of developing countries, the lack of sound bankruptcy
law, effective bankruptcy courts, and other institutions effectively
prevents creditors from enforcing their claims on bankrupt debtors,
even when their loans are collateralized. Without the ability to
collect on collateral, financial institutions will require higher
interest rates on any loans they offer, effectively hampering access
to credit for firms throughout the economy. The greatest impact may
well be on smaller firms seeking to grow but unable to finance
investment projects solely from internal cash flow. The importance
of bankruptcy institutions is confirmed in a recent study of 43
countries: researchers found that differences in laws related to
investor protection were attributable to the historical origin of
countries' legal systems (for example, English, French, German,
or Scandinavian), and that these differences had lasting effects.
In those countries whose legal systems make it difficult for creditors
to seize collateral secured against bankruptcy, credit extended to
private firms was lower as a share of GDP than in other countries.
Reduced availability of credit can be expected to translate into
higher real interest rates in these countries, and thus lower rates
of investment and growth.
When the rule of law is weak, corruption can flourish, and this, too,
leads to slower growth. Corruption affects growth through a number
of channels, including tax evasion, distorted investment decisions,
and suppression of legitimate business. Corrupt officials add to the
damage of inefficient regulations, because bribes then determine what
economic activity is approved. Corruption represents a tax on economic
efficiency and social progress and is an enormous barrier to both
domestic and foreign investment.
Corrupt individuals in the private sector may conspire with corrupt
officials to avoid taxes, depriving the government of needed revenue.
The result is likely to be higher tax rates on a smaller base, which
can cause economic distortions. For example, a study of 39 Sub-Saharan
African countries covering the period 1985-96 found that a 25 percent
increase in corruption led to a decrease in tax revenue of 2.1 to
2.8 percent of GDP.
Corruption can harm growth more directly by limiting investment
and entrepreneurial activity. Corruption increases risk and
uncertainty, which reduce the incentives to invest. A further channel
for corruption is the diversion of resources intended for public
infrastructure to the private consumption of corrupt officials. This
leads to less investment and slower growth. One study of 57 developing
and developed countries found that a one-third decrease in
corruption was associated with an increase in the investment share
of GDP of 2.9 percentage points, and an increase in annual growth
in income per capita of 0.8 percentage point. Corruption can also
retard the development of legitimate business. A study of Ugandan
firms using data from 1995 to 1997 found that a 1-percentage-point
decline in the rate of bribery was associated with an increase in
firm growth of about 3.5 percentage points.
The quality of political institutions can also play a role in
economic outcomes. In particular, increasing citizens' voice in
determining political decisions and ensuring the accountability of
public officials fosters a more responsive government and strengthens
the rule of law. A responsive and responsible government will gain
the public's trust and create more incentives for private investment.
One study that attempted to assess the economic impact of these
factors estimated that an increase in a measure of ``voice and
accountability'' was associated with a marked increase in GDP
per capita. Studies using broader measures of government effectiveness
that incorporate individual freedoms, regulatory quality, and the
amount of bureaucracy in a country have yielded similar results: an
increase in a measure of government effectiveness corresponded to a
marked increase in GDP per capita. Strong civil liberties and overall
government effectiveness also have an impact on other social
indicators: countries that score higher on voice and accountability
and on government effectiveness tend to have lower infant mortality
and higher literacy rates.


Investing in People: Health and Education

Investment in human capital is also important for economic growth.
Well-trained and healthy workers are more likely to make the greatest
possible use of the physical stock of capital in any country.
Formal education is a direct way to invest in human capital,
and there is some evidence of a positive relationship between
national income and educational attainment. In 2000 the average
duration of schooling in low-income countries was 4.4 years
(3.3 years for females), compared with 10 years in high-income
countries (9.8 years for females). In a cross-country analysis of
98 developing and developed countries covering 1960-85, a
1-percentage-point increase in the primary school enrollment rate
was associated with a 2.5-percentage-point increase in growth in
income per capita.
Education is most effective in an environment in which the
investment in time, effort, and money devoted to education leads
to higher returns from increased labor productivity. If a society's
high-paying jobs are awarded based on political connections or
family and ethnic ties, those excluded from such jobs will have
less incentive to pursue their education, which in turn will lead
to slower economic growth. Similarly, if a country's best-educated
young people find employment in inefficient state-owned enterprises
or bureaucracies (as was the case in the centrally planned Soviet
Union, for example), the impact of education on labor productivity
will diminish. Empirical results from research on 12 Asian and
Latin American countries over 1970-94 are consistent with this
hypothesis. In particular, the effect of education on growth was
found to be negligible in closed and highly regulated economies;
in countries that had undertaken free market reforms, however, a
5 percent increase in educational attainment was associated with a
0.9-percentage-point increase in the annual growth rate.
There are important caveats to the conclusion that higher educational
achievement necessarily leads to faster growth. One difficulty is
that the links between formal education and growth are complex. For
example some evidence suggests that the positive relationship between
education and growth arises in part because growth leads to increased
schooling. This could happen if the expectation of strong growth in
the future leads to an increase in the demand for schooling today,
as individuals sacrifice current earnings for higher wages in the
future.
Education and the development of good institutions can be mutually
reinforcing. Good institutions and policies can lead to higher returns
on education and faster growth, and in turn, a well-educated
population is an important element in developing good institutions.
An illiterate population, for example, may be less likely to hold
political leaders accountable, because it is hard to acquire
information about poor policies and outcomes if one cannot read.
An educated population is likely to be a well-informed population,
and one that can exert pressure for sound policies and institutions.
Effective health care is also important for improving the quality of
the work force and increasing economic growth. Healthy employees are
absent from work less often, and the resulting higher utilization of
capital leads to lower average costs and faster growth. Healthy
workers also tend to earn higher wages, indeed more so in developing
countries, where manual labor plays a larger role in the economy,
than in industrialized and services-intensive developed countries.
One study of 104 countries found direct evidence linking health and
growth, suggesting that increasing average life expectancy (a
standard indicator of a population's general health) by 1 year can
lead to a 4 percent increase in national income. This result suggests
that countries with severe health problems and lowered life expectancy
will have slower growth than they could otherwise achieve. The problem
is particularly acute in low-income countries that face challenges
associated with infectious diseases such as malaria and HIV/AIDS.
(See Box 6-1 above.)
It is well established that countries with higher incomes have
longer life expectancies, lower maternal mortality rates, and
higher average birth weights. Determining the causal link between
income and health is difficult, however, for reasons similar to those
for income and education: on the one hand, countries with higher
incomes can devote more resources to health care, but on the other,
better health outcomes improve productivity and raise growth rates.
Health and education outcomes, of course, can be interlinked. Sick
children are more likely to be absent from school, and this can
lead to lower educational achievement and lower income later in life.
For example, school-age children are especially susceptible to
infestation by parasitic worms. Recent estimates suggest that as
many as one in four people worldwide are afflicted with various
types of worms; severe infestations can lead to anemia, malnutrition,
and listlessness. A study of a joint public and private project in
Kenya found that treatment with de-worming drugs led to a 25 percent
reduction in primary school absenteeism and was cost-effective: the
net present value of increased wages from increased school
participation far outweighed the cost of treating the children.
This suggests that effective programs to invest in people can lead
not only to healthier children, but also to improved participation
in schooling and ultimately to higher wages.


The Administration's Policies to Enhance Growth

The discussion thus far has made it clear that creating the right
environment for growth in developing countries requires, above all,
actions by those countries themselves. To complement and reward their
efforts, the Administration has put forward three initiatives that
will spur growth in developing countries and elsewhere by helping to
create an environment in which incentives can improve economic
opportunities. Trade Promotion Authority will help the President
conclude trade agreements that will further integrate developing
countries into the global marketplace and increase growth. The
Millennium Challenge Account will increase development aid to
countries that are pursuing policies and building institutions
that adhere to the principles of good governance. The
Administration's proposals to redirect the funds and priorities of
the multilateral development banks will also help developing
countries improve their growth prospects.
All three initiatives are consistent with the pro-growth principles
that this chapter has laid out. The Administration's focus, under
TPA, on trade liberalization within a rules-based system is based
on the principle of openness to goods and capital flows, as well as
the promotion of legal institutions and the rule of law. The MCA
incorporates all of the principles described above by integrating
them into the criteria used to determine the awarding of grants to
developing countries. Reform of the MDBs will encourage private
sector growth and effective economic management in the countries
they serve.


Trade Promotion Authority

The significance of TPA is that it enhances the President's ability
to negotiate trade agreements, by assuring foreign governments with
which the United States negotiates that the Congress will vote yes or
no on those agreements without amendment. The Congress retains its
primary constitutional authority to regulate foreign commerce, and
the Administration will continue to consult Members of the Congress
frequently on matters relating to the course of trade negotiations.
The agreements made possible by TPA will benefit the United States by
creating new export opportunities and lowering prices for imported
goods and services. But TPA will also foster growth in developing
countries by increasing competition. The rules-based agreements
will also promote institutions in developing countries that will
help them take full advantage of trading opportunities.
The increased integration of developing countries into the global
marketplace has already brought those countries enormous benefits.
Research suggests that a 1 percent increase in a country's trade
relative to its GDP is associated with an increase in its income
per capita of 3 percent. Moreover, evidence suggests that it is
increased trade that leads to increased income rather than the
reverse. A recent study suggests that the full implementation of
trade liberalization under the Uruguay Round of multilateral trade
negotiations, completed in 1994, increased developing countries'
income by 0.8 percent, double the percentage increase accruing to
the developed world. India's GDP is estimated to have risen an even
greater 1.1 percent of GDP as a consequence of the same liberalization
commitments.
Further trade liberalization will continue to raise world income.
A recent World Bank study suggests that the elimination of all
tariffs, export subsidies, and domestic production subsidies on goods
would raise annual world income by $355 billion by 2015, with middle-
and low-income countries receiving 52 percent of that increase.
Another study suggests that if world barriers to trade in agricultural
and industrial products and to trade in services were reduced by
one-third, the gains to the United States alone would translate
into additional annual income of $2,500 for the average American
family of four.
The President's new trade negotiating authority has already resulted
in the successful completion on the substance of free trade agreement
(FTA) negotiations with Singapore and Chile. These agreements cover a
wide range of issues, including, among others, the eventual
elimination of tariffs, increased openness to trade in
telecommunications and other services, transparency requirements,
protections for foreign investors, and provisions for enforcement of
labor and environmental standards. One study suggests that although
the net benefits to the United States from these two FTAs will be
relatively modest (0.05 percent and 0.18 percent of GDP,
respectively), the benefits to Chile and Singapore will be
proportionately greater (0.6 percent and 2.7 percent of GDP,
respectively).
TPA will provide an impetus to conclude a number of other trade
agreements currently under negotiation, most of which are with
developing countries. These negotiations include the ongoing
discussions with countries in the Western Hemisphere toward a Free
Trade Agreement of the Americas (FTAA) and the recently inaugurated
talks with Australia, Morocco, the countries of Central America
(Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua),
and the countries of the South African Customs Union (Botswana,
Lesotho, Namibia, South Africa, and Swaziland). The commitment of
the United States to conclude these talks under TPA reflects the
Administration's determination to advance pro-growth trade
liberalization, especially in the developing world.
The FTAA, in which 34 countries in North, Central, and South America
will participate, is the most complicated and far-reaching of the
regional trade agreements toward which the United States is currently
negotiating. One study suggests that, when the FTAA is in place, the
United States could experience a 0.6 percent increase in GDP, and
the combined GDPs of the Latin American participants (excluding
Mexico and Chile) could increase by 1.1 percent. The same study
suggests that Mexican and Chilean GDP would rise by 0.8 percent
and 2.5 percent of GDP, respectively, as a result of the FTAA.
As with the FTAs with Chile and Singapore, the benefits of these
bilateral and regional agreements are proportionately larger for
other countries than for the United States, although smaller in
absolute dollar terms. The reason for the asymmetric effects is
straightforward: the U.S. economy is so large relative to these
trading partners that the economic benefits of FTAs with them will
be small as a share of U.S. economic activity. In addition, U.S.
trade barriers are already low on average, so that the impact at
home of further trade liberalization will be modest. For example,
the U.S. economy in 2001 was 151 times larger than the Chilean
economy, and trade in goods with Chile (exports plus imports)
amounted to only 0.4 percent of total U.S. trade. U.S. tariffs in
2001 averaged 1.6 percent, compared with average Chilean tariffs
of 8 percent; thus the costs of current trade barriers fall more
heavily on Chile. However, U.S. exporters of goods and services
and U.S. investors will be able to operate more freely in a fully
liberalized Chilean market.
Despite their modest effects in relation to total U.S. output,
these agreements are important to the United States as part of the
broader U.S. effort toward multilateral reduction in trade barriers
under the auspices of the World Trade Organization (WTO). TPA will
be especially important for the United States and developing
countries by helping bring the current WTO negotiations to fruition.
The importance of further integrating developing countries into the
world trading system is reflected in the name given to these
negotiations: the Doha Development Agenda. (Doha, the capital city
of Qatar, is the site of the WTO ministers' meeting where the agenda
was launched.)
The United States has offered bold proposals in the Doha negotiations
for the reduction of trade barriers on agricultural and nonagricultural
goods. The agricultural initiative proposes to reduce agricultural
tariffs, limit governments' support of agriculture to 5 percent of
the domestic value of production, and eliminate agricultural export
subsidies. The Administration has also proposed that, by 2010, WTO
members eliminate all tariffs on nonagricultural goods that are
currently below 5 percent and sharply reduce the rest, including those
on textiles and apparel. Going further, the Administration has
proposed that all nonagricultural tariffs be eliminated in all WTO
member countries by 2015.
The reduction and eventual elimination of tariffs on goods is but one
aspect of the U.S. trade liberalization agenda in the WTO negotiations.
The United States has put forth over a dozen proposals to reduce
barriers to trade in an array of services industries. In addition, the
United States has advocated greater regulatory transparency, both
through general disciplines and through rules applicable to specific
industries, such as financial services. This initiative reflects the
assessment, discussed above, that regulatory quality is key to economic
outcomes.
These liberalization initiatives will bring important benefits to U.S.
firms, workers, consumers, and farmers, both from increased exports
and from lower priced imports. The U.S. agricultural and nonagricultural
market access proposals are of particular importance to developing
countries, since many expect to increase their exports of agricultural
goods as well as textiles and apparel to developed countries if
barriers are reduced. However, developing countries can also expect
important efficiency gains and faster growth as they remove their own
barriers.
The economic effects of the current WTO negotiations cannot be examined
in detail until the outlines of the final agreement become clearer.
One study provides some sense of the possible outcome, however, by
analyzing a hypothetical 33 percent reduction of trade barriers across
all sectors. In this scenario U.S. GDP rises by 2 percent, that of
Europe (the countries of the current European Union and the European
Free Trade Area combined) by 1.5 percent, and that of Japan by
1.9 percent. The same study also predicts large increases in GDP in
developing countries, including the Philippines (5.4 percent), South
Korea (2.5 percent), Mexico (1.8 percent), Chile (2.4 percent), the
rest of Latin America (1.4 percent), and the Middle Eastern and North
African countries (1.9 percent).
These estimated effects of trade liberalization take into account only
its static impacts, such as a reallocation of resources to more
efficient uses and the benefits accruing to consumers from lower
prices. The estimates do not capture the dynamic effects on growth,
such as those arising from greater economies of scale, productivity
gains, and access to improved technologies, that increased openness
would bring. Including these effects could substantially boost the
impact of trade liberalization. For example, the World Bank study
previously cited found that, by 2015, world income would increase
by another 134 percent, with 65 percent of that increase going to
developing countries, in response to the multilateral elimination of
all trade barriers. Thus, including dynamic effects increases the
impact of liberalization but also increases the potential benefits
accruing to developing countries.
The conventional estimates also typically fail to capture gains in
services trade, in large part because quantifying barriers to such
rade can be difficult. Nonetheless, services are becoming more
important to developing countries, with their average share in GDP
rising from an estimated 40 percent in 1965 to 50 percent in 1999.
Removing barriers to services leads to lower costs and greater
efficiency in such important sectors as telecommunications,
e-commerce, transport services, professional services, and financial
services. A World Bank study suggests that multilateral liberalization
in the services sector alone would increase combined developing-country
GDP by nearly $900 billion, a gain nearly five times greater than the
anticipated benefits of merchandise trade liberalization.
Of all the trade liberalization initiatives currently on the agenda,
the United States and its developing-country partners stand to gain
the most from completion of the WTO negotiations, but the bilateral
and regional agreements will also bring benefits. For example, a
33 percent cut in all global tariffs could lead to gains in U.S.
and Chilean GDP of $177 billion and $1.9 billion, respectively, and
an increase in world GDP of $612 billion. The U.S.-Chile FTA would
increase U.S. and Chilean GDP by $4.2 billion and $479 million,
respectively.
Some have argued that a focus on regional and bilateral trade
liberalization could undermine the broader process of multilateral
trade liberalization and the WTO as an institution. However, the
Administration sees these bilateral and regional agreements as part
of a strategy of ``competitive liberalization,'' that is, as
steppingstones to worldwide trade liberalization rather than as a
stumbling block.  In other words, the bilateral, regional, and
multilateral prongs of the Administration's strategy for trade
negotiations are intended to work in concert, to help achieve the
broadest possible degree of trade liberalization in the United States
itself and among the greatest possible number of its trading partners.
Trade agreements negotiated by the United States have had, and will
continue to have, other indirect benefits to economic performance.
The rules-based nature of modern trade agreements helps encourage
the development of institutions consistent with the pro-growth
principles enunciated in this chapter. In particular, transparency,
rule of law, contract enforcement, and property rights are all part
of recent U.S. rules-based trade agreements. The introduction of
bilateral and multilateral trade and investment commitments can
help transform economies in ways that foster these pro-growth
policies. For example, rules-based trade agreements enhance the
transparency of government actions. Trade commitments must be
cataloged, organized, and made public, not only to trading partners
but also, ultimately, to domestic constituencies. As citizens become
accustomed to public transparency and accountability in trade
policy, they may be more likely to demand similar transparency in
other aspects of their country's public policy. Such accountability
limits government's ability to make arbitrary decisions and thus
ultimately creates better conditions for strong growth. In some
respects, domestic reforms reinforced by the rules-based trading
system have already taken hold in China (Box 6-2).
Trade agreements also encourage the rule of law and the enforcement
of contracts. All such agreements require that governments write
down their rules governing trade, and in most agreements, governments
agree to submit trade disputes to external review by third-party
panels. Governments that know that their actions can be reviewed by
external and impartial dispute settlement bodies may be less likely
to enforce laws arbitrarily. Similarly, foreign firms can resort to
a dispute settlement panel if a trading partner fails to enforce
legally binding contracts. As domestic firms and individuals become
more familiar with the legal procedures available to foreigners
within the country, they may pressure their government for similar
nonarbitrary decisions and legal protections in internal matters.
Once again, the external commitment may help with internal reform.
A rules-based system also fosters the development of protection for
property rights, especially through agreements that cover FDI. Many
trade agreements, including the North American Free Trade Agreement
and the bilateral FTAs between the United States and Israel and
Jordan, and now Chile and Singapore, contain protections against
uncompensated expropriation by


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Box 6-2. China, the WTO, and the Rule of Law

The accession of the People's Republic of China to the World Trade
Organization in December 2001 should strengthen and accelerate the
economic reforms launched by the Chinese government over 20 years
ago. These reforms not only have increased trade and investment
dramatically but also have enhanced transparency and decreased state
control over the economy. The benefits of economic liberalization and
reform can be seen in the huge reduction in poverty and dramatically
increased income per capita in China since 1980.
China's integration into the world economy has been one of the most
dramatic events in the recent wave of globalization. In 1980 China's
total goods exports and imports amounted to only $37.8 billion.
Exports were tightly controlled by the various state bureaucracies.
Foreign direct investment was essentially nonexistent. Beginning in
the early 1980s, China began to move away from formal trade planning
and toward market-based trade incentives. Tariffs and nontariff
barriers replaced quantitative planning, foreign direct investment
was welcomed in many sectors, and encouraging exports became a prime
motivating factor in Chinese economic policies. Although China's
policies remained far from textbook free trade during the early years
of integration (China's average tariff rate in 1982 was 56 percent),
the dramatic shift in economic policy created far-reaching new
economic opportunities.
By 2001 these reforms had brought enormous changes to the Chinese
economy. Exports of goods had grown to $266 billion, a 14-fold increase
since 1980. Imports of goods expanded from less than $20 billion to
$244 billion over the same period. Average tariffs had fallen to
15 percent by the time of WTO accession. Annual foreign direct
investment flows had risen from $430 million in 1982 to over
$38 billion in 2000. Income per capita had risen from $167 in
1980 to $824 in 2000.
China's efforts to gain WTO membership led to external pressure for
extension of the rule of law and more transparent decisionmaking in
the country. For example, during the 1990s the United States informed
the Chinese government that failure to protect copyrighted materials
such as software, films, and other recordings would undercut U.S.
support for China's membership. China finally agreed to begin to
enforce intellectual property rights laws in 1996, but its enforcement
efforts still need to be strengthened.
China's formal accession to the WTO will lead to further reform. By
mid-2002 approximately 830 existing laws and regulations had been
repealed, 325 amended, and 118 new laws and legislation adopted in
order to bring China into conformity with WTO rules. With its new
WTO obligations, China has now made a formal external commitment to
a whole range of trade-related reforms. Failure to live up to these
commitments will put Chinese exports at risk in other WTO members'
markets, because members may enforce China's commitments through
WTO dispute settlement proceedings and may retaliate if China refuses
to cease its actions deemed WTO-inconsistent. For example, China is
adopting regulations for controlling injurious dumping of imports,
as WTO rules allow. Whereas in the past bureaucrats could restrict
imports arbitrarily, however, Chinese antidumping procedures
henceforth will be carefully scrutinized by other WTO members for
inconsistency with WTO rules.
China has undergone enormous changes in its economic orientation over
the last 20 years. Membership in the WTO brings with it an external
commitment to this process of reform and makes a return to a
centrally planned economy even more difficult.
---------------------------------------------------------------------

governments. As these commitments to
U.S. firms become widely known, domestic firms in those countries may
expect similar guarantees.
The United States also extends special benefits to certain
low-income countries through various programs including trade
capacity building assistance, the Generalized System of
Preferences, the Andean Trade Preference Act, and the African
Growth and Opportunity Act (AGOA).  AGOA, which was signed into
law in May 2000, reduces trade barriers for Sub-Saharan African
countries' products entering the United States below those required
under the multilateral trade commitments negotiated under the WTO.
However, countries in this region do not automatically qualify for
lower U.S. tariffs. To be eligible, a country must have a
market-based economy, and its government must be making efforts to
limit its interference in the economy and must protect property
rights. In addition, the government must undertake economic policies
that aim to reduce poverty, improve health, and promote private
enterprise. Finally, eligible countries must be taking steps to
combat official bribery and improve labor rights. In short, through
AGOA the United States offers lower trade barriers to poor countries
in Sub-Saharan Africa that are making efforts to pursue good policies
and promote good institutions. The principles behind AGOA are thus
very similar to those of the second major new Administration
initiative, the Millennium Challenge Account, which is discussed next.


The Millennium Challenge Account

In March 2002 the President proposed a new program designed to promote
growth in developing countries. Over the next 3 years, the Millennium
Challenge Account will increase annual U.S. bilateral development
assistance by $5 billion, a 50 percent increase over current levels.
MCA funds will be used to support activities that directly contribute
to economic growth and poverty alleviation. MCA programs will be
implemented by the private sector, nongovernmental organizations,
and public sector agencies. The MCA will strive to achieve within
recipient countries a broad coalition around development investments.
Because MCA aid will be in the form of grants, not loans, in
accordance with the policy set forth by the President at the Group
of Eight summit in 2001, this development assistance will not increase
the debt burden of recipient countries.
The MCA is based on the fact that development assistance is most
effective when funds flow to countries that have already adopted
policies and created institutions that promote growth. In other
words, only those countries that have taken concrete steps themselves
to improve their condition will be potential MCA recipients. The MCA
approach has the added advantage that, as countries strive to qualify
for U.S. grants, they will be implementing policies that also
encourage inflows of private capital and increased trade, the real
engines of sustained economic growth.
Countries receiving MCA assistance must be active partners in the
development programs funded by the MCA. Each country selected for
aid will negotiate and sign a contract with the MCA, which will specify
the following: a limited number of clear, quantifiable goals; concrete
benchmarks that specify the time needed to accomplish the tasks;
commitments to financial accountability; and conditions under which
the contract would be terminated. MCA resources are meant to complement
and enhance specific efforts and policies undertaken in the
participating countries; indeed, the MCA program will not impose a
development plan designed by others, but rather recognizes that the
countries themselves are in the best position to evaluate their own
needs. In short, MCA recipients must take responsibility for their
own development programs.
Monitoring and evaluation to ensure accountability for results will
be an integral part of every activity for which MCA funds are used.
Monitoring and evaluation will be conducted by the MCA administrative
structure or by third-party contractors, or both. To facilitate such
monitoring, all contracts will include baseline data against which
progress can be measured. The U.S. Government will provide technical
assistance to help countries establish these credible baseline data.
Every contract will specify regular benchmarks for evaluating
progress and provide for the corrective actions necessary to keep
the program on track. All evaluations and all terms of the contract
will be made public in the United States and in the host country.
MCA contracts will fund projects for a limited term and include
provisions for a midterm review. Programs will continue to receive
funding under the terms of the country's MCA contract unless the
country fails to meet the contract's conditions for performance.
Funding for all or part of a particular MCA contract may be scaled
back or ended for failure to meet financial standards or specific
benchmarks. In addition, a country's participation in the MCA may
be terminated for failure to adhere to the three  fundamental
principles laid out earlier in this chapter--economic freedom,
governing justly, and investing in people--as indicated by an
absolute decline in the policy environment. Participation may also
be terminated in the event of material change such as a military
coup.
Allocation of MCA resources will be based primarily on quantitative
benchmarks in order to ensure procedural accountability and
transparency. These criteria will focus on the three broad
principles just mentioned. Use of published, quantitative measures
will also help countries understand why they did or did not qualify
to receive MCA funds. This knowledge will enable countries to
identify where they need to improve their policies in order to
qualify for future grants. Table 6-2 lists the 16 specific indicators
(and the initial public sources for the data) for the three MCA
principles. These indicators were chosen because of their quality
and objectivity, country coverage, and public availability.



As described previously, economic freedom broadly encompasses the
freedom to start a business, hire workers, invest, and make other
business and personal decisions without undue government interference.
In the MCA process, economic freedom will be measured by six publicly
available criteria: country credit ratings, inflation rates, budget
deficits, measures of openness to trade, measures of regulatory
quality, and the number of days it takes to start a business. Country
credit ratings are included because they contain useful summary
evaluations by private sector sources of the country's macroeconomic
situation. Inflation rates and budget deficits are included to capture
those aspects of macroeconomic stability so important to growth.
Trade policies, including the degree to which imports are subject to
tariffs and nontariff barriers, as well as the extent of corruption
in the national customs service, will measure the extent to which a
country's policy environment allows it to take advantage of global
markets. Finally, regulatory quality and the time it takes to start
a new business provide quantitative measures of the environment for
entrepreneurial activity.
The second principle--governing justly--involves various facets of
good governance and good institutions that help sustain a pro-growth
environment. The inclusion of criteria that embody this principle
reflects the important complementary role of the quality of
institutions in improving economic performance. The criteria will
measure the extent to which citizens of a country are able to
participate in the selection of governments, the freedom to develop
views and institutions independent of the state, the role of elected
representatives in policy formation, the control of corruption,
and the rule of law. These are important indicators of whether there
is political accountability in the country.
Measures of governing justly will be based on surveys by the World
Bank and Freedom House, a nonprofit, nonpartisan organization.
Rankings will be based on the following criteria: civil liberties,
political rights, voice and accountability, government effectiveness,
rule of law, and control of corruption. Assessment of the rule of
law, which, as discussed above, is important to investor and
entrepreneurial confidence, will cover such factors as the
effectiveness of the judiciary and the enforceability of contracts.
Ratings of political rights and civil liberties will be determined
through a compilation of foreign and domestic news reports,
publications by nongovernmental organizations, policy center research,
and academic and professional analysis.
The third principle--investing in people--involves public commitment
to developing human capital through education and improved health.
Here the quantitative criteria include public spending on primary
education as a percentage of GDP, the share of children who have
completed primary school by the national graduation age, public
expenditure on health as a percentage of GDP, and immunization rates
of children under 12 months for DPT (diphtheria, pertussis, and
tetanus) and measles. The importance of education in maintaining
and improving worker productivity is reflected in the inclusion
of both a public education input (public spending on primary
education) and an education output (the share of children completing
primary school). As noted in the earlier discussion of pro-growth
principles, improved health care is also important to better economic
outcomes. Consequently, public expenditure on health care is included
as an MCA criterion, along with immunization rates for some of the
most common serious childhood diseases worldwide.
Countries must demonstrate commitment to and performance on all
three principles to be deemed a ``better performer'' and thereby
qualify for possible MCA assistance. Eligibility will be limited to
those countries that score above the median on at least half of the
indicators in each of the three areas. However, countries must score
above the median on the corruption indicator to be considered for
grants, regardless of their scores on other criteria. This
requirement reflects the importance that corruption plays in whether
or not development assistance achieves its aims. As noted above,
reducing corruption supports the benefits of other good policies
and of development assistance by building public trust in institutions,
encouraging investment, and helping ensure that aid is put to
pro-growth uses.
Candidate countries will be evaluated within one of two income
categories. Initially, only countries with gross national income per
capita below $1,435 (in 2001 dollars) will be eligible for grants.
This level was chosen because it is the historical income threshold
for assistance to the world's poorest countries from the International
Development Association (IDA), the World Bank affiliate that
specializes in assistance to the poorest countries. In subsequent
years, the income threshold for eligibility will be raised to
$2,975, the projected cutoff for the World Bank's designation for
lower-middle-income countries. However, the two income groups
(those with incomes per capita below $1,435 and those with incomes
between $1,435 and $2,975) will continue to be evaluated separately.
This separation is important because, as discussed above, higher
income is associated with better social and economic indicators.
Grouping the countries in this way will ensure that countries of
similar income and economic development compete with each other.
Countries prohibited by current statutory restrictions from receiving
U.S. assistance will not be eligible. Qualifying as a better performer
does not guarantee receipt of MCA funds. The MCA Board of Directors,
composed of Cabinet-level officials and chaired by the Secretary of
State, will make final recommendations to the President.
As already noted, the provision of grants rather than loans will
ensure that the MCA program will not add to countries' debt burdens.
The resources provided can then be allocated as intended, to development
rather than debt service. Aid in the form of loans causes many
heavily indebted poor countries to accrue even greater debt, which
can hinder their growth. One study of 93 developing countries from
1969 to 1998 found that, for a country with average indebtedness,
doubling the debt ratio (either the debt-to-exports ratio or the
debt-to-GDP ratio) reduces annual growth of GDP per capita by
between 0.5 and 1 percentage point.


Reforming the Multilateral Development Banks

The Administration believes that the World Bank and other
multilateral development banks will be more effective in helping
countries improve their living standards if, when distributing aid,
they place greater emphasis on factors that improve productivity.
The Administration's agenda for reform of the MDBs seeks progress
toward better measurement, monitoring, and management of development
assistance. The Administration also has pushed for an increase in
the proportion of MDB assistance to the poorest countries that is
delivered in the form of grants rather than loans.
MDBs will be more effective in reducing poverty if they address the
basic causes of slow growth, including poor business environments
and inadequate education and health care. This means that MDBs
should help countries reduce the impediments that constrain the
creation of high-productivity jobs in the private sector. To this
end, the United States has secured agreement on a change in
assistance strategies by the IDA. IDA funds will now include the
distribution of resources to private sector development, in addition
to the public sector uses that have been its traditional focus.
This agreement creates the basis for expanded collaboration between
the IDA and the International Finance Corporation, the World Bank
Group's private sector finance arm. Such collaboration will help
remove the obstacles to private sector-led growth in the world's
poorest countries.
The Administration also believes that a major priority for the MDBs
should be greater attention to measuring development results. Donor
and recipient countries both benefit from quantifying the outcomes
of assistance programs and understanding the reasons for success or
failure. The recent IDA replenishment agreement calls for a
fundamental shift of focus within the MDBs toward measurable
results. IDA will also establish a system that tracks specific results
in education, health, and private sector development. These innovations
will allow donors to link their contributions to IDA to observable
outcomes. This approach will help direct scarce donor dollars toward
those activities and projects that are demonstrably improving
people's lives. Furthermore, the Administration's position is that
MDBs should expand similar results-based operational plans into all
of its grant and loan programs.
Consistent with the MCA approach, U.S. leadership has resulted in a
significant expansion of MDB grants for the world's poorest countries.
In July 2001 the President called upon the World Bank and other MDBs
to increase the proportion of their assistance to the poorest
recipient countries that is provided as grants rather than loans. One
year later, the United States finalized an agreement with other
international donors on a substantial increase in grants. As a
result of this agreement, IDA grant assistance for programs targeting
education, HIV/AIDS, health, nutrition, potable water, and sanitation
will be increased. U.S. leadership was also crucial in obtaining
agreement on an increase in grants for the recently concluded
replenishment of the African Development Fund. These agreements
significantly advance the Administration's policy objective of
helping poor countries make productive investments without saddling
them with ever-larger debt burdens.
The Administration recognizes that countries may sometimes face
economic crises that can lead to sharp net outflows of capital.
Countries will be well served if these crises can be managed
effectively. Consequently, in parallel with MDB reform, the
Administration believes that clarifying the size of official
financing packages from the international financial institutions
is essential to increasing predictability in the market, curbing
excessive risk taking, and providing the right incentives for
countries to pursue good policies. The Administration has worked
to create a more orderly and predictable process for restructuring
sovereign debt, so that the long-term growth of developing
economies is not subverted by short-term crises. In particular,
the Administration has proposed the incorporation of collective
action clauses into sovereign debt contracts to facilitate a more
predictable and transparent resolution of sovereign debt defaults
when they do occur.


Conclusion

Economic growth has the potential to improve the lives of millions
of people around the globe, both through higher incomes and through
improvements in social indicators such as health outcomes. This chapter
has laid out three broad principles for promoting growth.
Economic freedom is a critical prerequisite for the harnessing of
entrepreneurial energy to improve productivity and increase growth.
Macroeconomic stability, including low inflation and small fiscal
deficits, helps create an economic environment in which people can
plan and invest. Governments should avoid burdensome regulation,
distortionary taxes, and nationalization of industries, because all
of these lead to inefficiency and slow growth. Openness to
international goods, services, and capital brings with it exposure
to world best practices and generates the competition that leads
domestic firms and workers to enhance their productivity.
Poor institutions, especially those that fail to enforce property
rights, promote the rule of law, and discourage corruption, can
subvert good economic policy decisions. Entrepreneurs will be less
willing to commit resources for the long term if they believe that
arbitrary decisions by governments may rob them of the anticipated
returns. Workers will be more reluctant to work hard if they believe
the fruits of their labor will be seized by corrupt officials or
criminals. Ultimately, promoting growth depends on appropriate
policies, aimed at both macroeconomic stability and creating a
supportive economic environment.
Investment in people, through improvements in both education and
health, will support a work force that can fully utilize the
opportunities created by sound policies and good institutions.
Well-trained workers will be better able to make productive use of
the capital available to them, both the existing capital stock and
new investment. This will lead to higher productivity and enhanced
growth. A healthy work force will be less prone to absenteeism,
allowing a higher rate of utilization of capital, and this, too,
will improve the country's economic prospects.
The Administration's initiatives--the promotion of openness to the
world economy through trade liberalization, and the new approaches
to bilateral and multilateral development assistance--are intended
to complement developing countries' own efforts to improve their
economic performance. TPA will help the United States reach agreements
that increase trade and thus foster growth in developing countries.
The MCA will provide both financial assistance to the least developed
countries and incentives for them to implement pro-growth policies.
Reform of the MDBs will complement the MCA initiative by focusing
these institutions' funds on pro-growth efforts, especially in the
private sector, and assisting the world's least developed countries
through grants in aid. Through all these programs, the United States
will stimulate worldwide economic development, raising incomes in
developing countries and spreading prosperity both at home and abroad.