A country’s institutional environment has long been considered a determining factor of competitiveness, and will remain largely unchanged in the updated GCI. In the context of the current GCI, institutions are defined by two characteristics that reflect core features put forward by economic literature.⁴ First, institutions set formal, legally binding constraints—such as rules, laws, and constitutions—along with their associated enforcement mechanisms.⁵ Second, institutions include informal constraints such as norms of behavior, conventions, and self-imposed codes of conduct such as business ethics, and can be thought to include norms of corporate governance as well. By shaping the ways in which individuals organize themselves and their economic transactions, institutions form the backbone of societies.⁶ The differences among institutions explain many of the underlying reasons for the differences in technology and in physical and human capital between countries, which in turn explain a large part of cross-country differences in income.⁷

Ample empirical evidence has shown the importance of institutions for productivity,⁸ suggesting that their fundamental role consists in setting the right incentives and lowering uncertainty so that citizens can be confident in engaging in economic activities.⁹ Economic agents will invest only if they believe that they will reap expected benefits and returns on their work or investment without needing to spend excessive amounts of time and money protecting their property and monitoring the fulfillment of others’ contractual obligations.¹⁰ This depends, informally, on adequate levels of trust in society;¹¹ it also depends, formally, on the existence of institutions capable of ensuring a basic level of security and enforcing property rights. This in turn relies on the institutions’ political set-up and power structure, characterized by (1) the incidence of transparency, (2) efficiency of the public sector, and (3) the existence of checks and balances.

Economic literature has documented the importance of enforceable property rights for the economy¹²—that is, the right of control over an asset and the returns it may generate provides incentives to invest (in physical or human capital or technology), create, innovate, trade, and maintain. If physical or financial property cannot be acquired and sold with confidence that the authorities will endorse the transaction over the long run, economic growth will be undermined. An absence of property rights also drives people out of formal markets into the informal sector. De Soto suggests that no nation can have a strong market economy without adequate participation in a framework that enforces legal ownership of property and records economic activity, because they are the prerequisites to obtaining credit, selling properties, and seeking legal remedies to conflicts in court.¹³ Ensuring the protection of property rights is therefore a key role of the state.

Another fundamental role of the state is guaranteeing the security of its citizens, which is a minimal requirement for incentivizing economic activity. Violence, racketeering, organized crime, and terrorism all constitute substantial disincentives to private investment and economic transactions. Empirical research provides evidence that homicides, robbery, extortion, and kidnapping can crowd out investment;¹⁴ and organized crime can generate misallocation of capital and labor and act as a barrier to enter a market.¹⁵

Although the two roles of the state provide a raison d’être for formal constraints, their implementation depends on the quality of institutions. Research shows that three characteristics of institutions determine their quality. The first is an absence of corruption and undue influence. Broadly understood as the misuse of public power for private gain, corruption interferes with the allocation of resources to their most efficient uses and undermines growth in five main ways: (1) it diminishes incentives to invest, because economic agents view corruption as a species of tax; (2) it leads to a misallocation of human capital, because talent is incentivized to engage in rent-seeking activities rather than productive work;¹⁶ (3) it results in loss of tax revenue; (4) it pushes inappropriate public spending, because government officials are tempted to allocate expenditures less on the basis of promoting public welfare than on the opportunity they provide for extorting bribes;¹⁷ and (5) it lowers the quality of infrastructure and public services through the misallocation of public procurement contracts.¹⁸

The second determinant of institutional quality is efficiency in the public sector, which has two aspects: efficient administrative services and a stable policy environment. Administrative efficiency implies a lack of unnecessary red tape in business processes such as the collection of taxes, compliance with regulations, obtaining permits, and the judicial system; there is empirical evidence that burdensome bureaucracy decreases investments and firms’ efficiency.¹⁹ Policy stability may affect productivity by reducing uncertainty about the future and consequently expanding the time horizon of society’s preferences; this may lead to better resource allocation, including more R&D investments and hence faster technological progress.²⁰

Finally, quality institutions are endogenous—that is, the rules governing human interactions are the result of choices made by those in power, selected on the basis of the rules they set. Separation of powers, and especially the independence of the judiciary,²¹ has long been recognized as pivotal to preventing those in power from arrogating absolute power or shaping economic institutions to benefit themselves at the expense of the rest of the society.²² Branches of governance represented by the separate powers should be able to hold each other reciprocally accountable for the discharge of the powers apportioned to them by law.²³ It is the extent to which this actually happens in practice—not merely that it is provided for in principle in a country’s constitution—that matters.²⁴

In addition to the quality of public institutions, corporate ethics and governance standards determine incentives for companies, investors, and society to engage in economic activities. Strong corporate governance standards contribute to productivity in two ways. First, they enable shareholders to exert control over firms, and shareholder value in turn is maximized by raising the firm’s productivity. Second, by aligning incentives of firms’ managers and owners, they limit risks to investors, incentivizing higher levels of investment and reducing costs of capital for the firm. Key to corporate governance is the transparent access of shareholders to timely and accurate information, accountability of management to strong and independent corporate boards, and auditor independence.²⁵ In addition to formal standards, informal behavioral norms also play a crucial role in the way businesses are run. High ethical standards among business leaders can contribute to building trust, thereby reducing the cost of capital and compliance.