Now nearly everyone accepts the fact that institutions matter. However, institutions matter in more than one way. While sound institutions may help to reduce uncertainty and create order in human interactions, flawed institutions may produce results that go contrary to their designers' wishes, no matter what these wishes are. Defects in institutional arrangements may provide “wrong” opportunities, place “wrong” constraints, create “wrong” incentives, reward “wrong” behaviors and above all, structure human interactions in “wrong” ways. This article investigates what makes institutions defective and why defective institutions may cause ineffectiveness. It first identifies the fundamental underpinnings of effective institutions and probes their importance in generating efficiency. It then tries to explain why, in the absence of some of these key elements, defective institutions cannot deliver what effective institutions can. The case of fiscal relations in China is used to highlight the key propositions of the article.

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