Institutions and the Sectoral Organization of Production

Do institutions, such as the Rule of Law, affect the way in which output is generated? This paper provides evidence suggesting that countries with better contract enforcement have disproportionately higher labor shares in sectors that interact more with other input-providing sectors; further, such countries also experience disproportionately higher sectoral value added in those sectors. The data are consistent with institutions affecting the productivity of technological use or adoption, thus acting as sectoral productivity shifters. However, labor (mis)allocation (and not direct productivity loss) is quantitatively the most important effect of poor institutional quality in reducing sectoral value added. These effects are statistically undetected once we rely on data aggregated across the subsectors of manufacturing. Yet, when sectoral data are used, a one standard deviation increment in the Rule of Law indicator results in an increase of the overall value added in the manufacturing sector of 36%. Our findings support the notion that sectoral transformation is grounded on good institutional quality.