Forging Strength: Exploring the Dynamic Interplay between Institutions and State Capacity

IMF Working Papers, June 13, 2025

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Canonical URL: Forging Strength: Exploring the Dynamic Interplay between Institutions and State Capacity

Paper examines the distinct and interactive effects of state capacity (SC) and institutional quality (IN) on real GDP per capita growth.
Sample: up to 130 countries over the period 1970–2022.
Main result: SC and IN shocks yield positive and persistent growth effects, particularly in emerging and developing economies where governance gaps are most binding.
Institutional reforms generate the strongest gains; SC shocks are weaker on average but highly effective when implemented alongside institutional improvements (strong complementarity).

Novel identification strategy isolates large, exogenous governance shocks via both residual-based and percentile-based approaches.
Dynamic responses estimated using local projections.
Endogeneity concerns addressed using a two-stage least squares (2SLS) approach.
Instruments used in IV analysis: income-group-based democratization waves and natural disasters.
IV estimates closely track the baseline, except for government effectiveness (GEE) shocks where the IV point estimate is significantly larger.

SC and IN shocks both produce positive and persistent effects on real GDP per capita growth.
Institutional quality (IN) shocks generate the strongest gains on growth.
State capacity (SC) shocks show weaker average effects but are highly effective in combination with institutional improvements, indicating complementarity between SC and IN.
Effects are most pronounced in emerging and developing economies.
Robustness: results hold across alternative shock definitions and when addressing endogeneity via IV; IV confirms shock validity.

Targeted institutional reforms should be prioritized to deliver substantial economic dividends.
Strengthening capable state structures enhances the effectiveness of institutional reforms; coordinated reforms in both IN and SC yield larger growth benefits.
Policy sequencing and complementarity matter: institutional improvements increase the payoff to investments in state capacity.

Results robust to alternative shock definitions and endogeneity checks.
2SLS IV strategy using democratization waves and natural disasters supports baseline findings.
Notable exception: IV point estimate for government effectiveness (GEE) shocks is significantly larger than the baseline, indicating heterogeneity across governance dimensions.
IMF Working Papers are research in progress and aim to elicit comments and encourage debate.