Understanding Solow Residuals in Latin America

This paper presents a series of development accounting exercises for Latin America using novel databases and methods to investigate the robustness and policy implications of its results. While the residual – often interpreted as total factor productivity or aggregate efficiency –appears to be the most important driver of output per worker gaps in Latin America and the Caribbean using the traditional development accounting approach, this result depends on the functional forms, adjustments for the quality of human capital and alternative benchmarks. Two factors are important, in the sense that, if explicitly modeled, the fraction of Latin American output per worker differentials with respect to the US explained by the remaining residual falls from 52 to, respectively, 42 and 34 percentage points: first, differences in the quality of education, empirically modeled here as a function of standardized test scores; second, differences in the relevant production possibilities frontier. The paper also highlights the heterogeneity among countries in the region and discusses alternative ways to link macroeconomic benchmarking exercises to policies.