Does institutional quality foster economic complexity? The fundamental drivers of productive capabilities

This study investigates the role of institutions in shaping international differences in economic complexity—a novel measure of productive capabilities. More specifically, economic complexity corresponds to an enhanced capacity to produce and export a diverse range of sophisticated (high-productivity) products. This paper hypothesizes that there exists a positive association between institutional quality and economic complexity. The underlying intuition is that well-functioning institutions fundamentally drive structural transformation towards productive activities via strengthening incentives for innovative entrepreneurship, fostering human capital accumulation, and deploying human resources in acquiring productive capabilities. Employing data for up to 115 countries, I consistently obtain precise estimates of the positive effect of institutional quality, measured by the Economic Freedom of the World Index, on economic complexity. The main findings advocate for establishing a pro-development institutional environment, which helps attenuating the persistence of underdevelopment by fostering economic complexity.