Investor Protection, Optimal Incentives, and Economic Growth

Does investor protection foster economic growth? To assess the widely-held affirmative view, we introduce investor protection in a standard overlapping generations model of capital accumulation. Better investor protection implies better risk-sharing. Because of entrepreneurs ’ risk-aversion, this results in a larger demand for capital. This is the demand effect. A second effect (the supply effect) follows from general equilibrium restrictions. Better protection (i.e. higher demand) increases the interest rate and lowers the income of entrepreneurs, decreasing current savings and next period’s supply of capital. The supply effect is stronger the tighter are the restrictions on capital flows. Our model thus predicts that the (positive) effect of investor protection on growth is stronger for countries with lower restrictions. Cross-country data provides support for this prediction, as does the detailed examination of the growth experiences of South Korea and India. We are grateful to the editor, Alberto Alesina, two anonymous referees, Neil Wallace, Andrew Abel,