The Pillars of Shared Prosperity: Insights From Elite versus State Extraction And From a New Instrument

What are the origins of shared prosperity? By synthesizing the literature on development, institutions and state capacity, this paper develops a new instrumental variable (IV) approach to identify the pivotal mechanisms explaining cross-country income and inequality differences. Exploiting the interaction between climate zones (using latitude) and native state history faced by European colonizers as an IV, this research explains 70-80% of colonial settlements in 1900 and subsequent institutional and economic development. This novel IV strategy also addresses the flaws of previous attempts, suffering from measurement error, weak instrument bias, and narrow research frameworks. That is, to identify better the causality chains going from colonial institutions to current outcomes. The results support the neoinstitutionalists' thesis, stressing executive checks for development (by checking elite capture), but challenge the key role given to market over state institutions. Prosperity and equality appear chiefly driven by state capacity, rather than by market rules or property rights. Across Africa, Latin America, and Asia, despite convergence to more "pro-market" and "inclusive" economic systems in the 20th century, both underdevelopment and high elite extraction persist via a state capacity trap. In the Periphery, persistently limited executive checks have undermined forming the state's credible commitments to public probity necessary for building tax capacity. Then, this limits these nations' ability to (I) support markets and private sector development via an ample public goods provision, and (II) check elite extraction via progressive taxes and transfers ensuring significant redistribution. These stand out as the two pillars of shared prosperity.