How institutions shape the economic returns to investment in European regions?

Most studies of institutional quality and regional growth assume uniform effects across territories. However, this may mask crucial regional heterogeneity, with direct policy implications. We use a latent class framework applied to 230 EU regions over 2009–2017 to identify institution-driven regional parameter groups, and to examine both average effects and catching-up effects associated with changes in the institutional environment. We demonstrate that institutional quality generates highly variable returns to investment in physical capital and innovation. Nordic and Central European regions show highest returns to physical capital and R&D investment, whereas less-developed regions benefit most from education spending. Crucially, we find that improving government quality not only raises average returns but also promotes territorial cohesion. By contrast, regional autonomy shows limited impact on returns. Our findings challenge the one-size-fits-all approach to cohesion policy and indicate that cohesion policy should explicitly promote institutional improvements in addition to capital deployment. • We assess investment returns in EU regions with institutional heterogeneity. • Latent Class methods uncover institution-driven regional parameter groups. • Strong governance raises capital and innovation returns. • Better institutions speed up regional convergence and reduce returns' dispersion. • EU cohesion policy should link funding to institutional upgrades.