Contracts Do Matter: Robust Evidence of an Optimal Level of Legal Formalism in Developing Countries

Abstract

Previous research on contracting institutions suggests that legal systems in developing countries are either too formal or unrelated to economic growth. This paper shows a strong quadratic effect of legal formalism on household wealth in a sample of over a million households in 64 developing countries, indicating that there is an optimal level of legal formalism. The estimated gains from moving towards the optimum are larger in magnitude than those from improving property rights or reducing corruption. Analyzing how institutions impact household wealth is intuitive: institutions impact micro behavior and regressions on micro outcomes lessen the endogeneity problem of country level analysis, contain broader controls and can consider multiple institutional variables. The results are robust to inclusion of controls for other institutions, geography, economic indicators, historical factors and democracy.

Keywords: Institutions, Property Rights, Contracts, Growth, Endogeneity

JEL Classification: O43, P48