Economic Freedom of the World

1975 - 1995


by

James Gwartney, Robert Lawson and Walter Block

The Fraser Institute, Vancouver, British Columbia, Canada



Copyright (c) 1996 by The Fraser Institute. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage or retrieval system, without permission in writing from the authors.

The authors of this book have worked independently and opinions expresed by them, therefore, are their own, and do not necessarily reflect the opinions of the members or the trustees of The Fraser Institute.


Forward

Freedom is a big word, and economic freedom not much smaller. To talk about economic freedom is easy; to measure it, to make fine distinctions, assign numbers to its attributes, and combine them into one overall magnitude-that is a very different and much more difficult task, as we found out when we started on this quest some thirteen years ago (see Michael Walker's introduction).

James Gwartney, Robert Lawson, and Walter Block deserve great credit for having brought this quest to so satisfactory a temporary conclusion-I say temporary because this study of economic freedom for more than 100 countries provides a cornucopia for students of the relation between economic freedom, political freedom, and civil freedom, and for further explorations of the relation between economic freedom and the level and rate of economic growth. The resulting studies will surely make revised editions necessary, both to bring the indexes of economic freedom up to date and to incorporate the additional understanding that will be generated.

For many of us, freedom-economic, political, civil-is an end in itself not a means to other ends-it is what makes life worthwhile. We would prefer to live in a free country even if it did not provide us and our fellow citizens with a higher standard of life than an alternative regime. But I am firmly persuaded that a free society could never survive under such circumstances. A free society is a delicate balance, constantly under attack, even by many who profess to be its partisans. I believe that free societies have arisen and persisted only because economic freedom is so much more productive economically than other methods of controlling economic activity.

It did not require the construction of an index of economic freedom for it to be widely believed that there is a close relation between economic freedom and the level and rate of economic growth. Theoretical considerations gave reason to expect such a relation, and little more than casual observation sufficed to show that what theory suggested, experience documented. We have not in a sense learned any big thing from this book that we did not know before. What we have done is to acquire a set of data that can be used to explore just how the relation works, and what are the essential connections, and that will enable skeptics to test their views objectively.

To achieve these advantages, it was essential that the measure of economic freedom not beg any questions by depending on outcomes; it was essential that it depend only on objective characteristics of an economy. This may seem obvious but I assure you that it is not. After all, the rate of economic growth or the level of living may be an excellent proxy for economic freedom, just as an auto's maximum speed may be an excellent proxy for the power of its motor. But any such connections must be demonstrated not assumed or taken for granted. There is nothing in the way the indexes are calculated that would prevent them from having no correlation whatsoever with such completely independent numbers as per capita GDP and the rate of growth of GDP. Yet the actual correlation between the indexes and the level and rate of economic growth documented in some of the extraordinarily informative graphs in the book (e.g., Exhibit S-2) is most impressive. No qualitative verbal description can match the power of that graph.

Milton Friedman
The Hoover Institution
Stanford University


Executive Summary

1.The central elements of economic freedom are personal choice, protection of private property, and freedom of exchange. The goal of this study is to construct an index that is (a) a good indicator of economic freedom across countries and (b) based on objective components that can be updated regularly and used to track future changes in economic freedom.

2.An index containing 17 components was designed to provide an empirical measure for economic freedom. The components were grouped into four major areas: I. Money and Inflation, II. Government Operations and Regulations, III. Takings and Discriminatory Taxation, and IV. Restrictions on International Exchange. Exhibit 1-1 provides a description of the specific components of the index. Data were assembled and procedures adopted to rate countries on a zero to ten scale for each of the components. Chapter 1 indicates the data sources used and explains how the each of the component ratings were derived. See Appendix II for the tables containing the underlying data and the ratings for each of the 17 components.

3.Since there is not a single "best way" to weight the components into an aggregate summary rating, three alternative summary indexes were derived. See Exhibit 1-2 for the component weights used to derive each of the three indexes.

4.Exhibit 2-1 presents the 1993-1995 ratings for each of the 17 components in our index, as well as area ratings, and the three alternative summary indexes (and the average of the three). With the exception of the high-income industrial countries, the three alternative summary ratings yield similar results. In the case of the industrial countries, the summary index that allocates only a very small weight to the size of government consumption expenditures and transfers and subsidies as a share of the economy yielded ratings that were approximately one unit higher than the two other summary ratings.

5.In terms of economic freedom, Hong Kong is the highest rated country in the world. Since Hong Kong's average for the three alternative ratings in 1993-1995 was significantly higher than any other country, it was given a letter grade of A+. New Zealand, Singapore, and United States earned a grade of A. The following ten countries were assigned a grade of B: Switzerland, United Kingdom, Canada, Australia, Ireland, Japan, Netherlands, Germany, Belgium, and Malaysia. Exhibit S-1A (Graphic Summary) indicates the average of the three indexes for each country and their ranking. Exhibit S-1B provides the same information for the Is1 index.

6.At the other end of the spectrum, the following 27 countries earned a grade of F-: Brazil, Haiti, Nicaragua, Venezuela, Hungary, Iran, Romania, Syria, Nepal, Algeria, Benin, Burundi, Central African Republic, Congo, Cote d'Ivoire, Madagascar, Morocco, Niger, Nigeria, Rwanda, Sierra Leone, Tanzania, Togo, Uganda, Zaire, Zambia, and Zimbabwe. The policies and institutional arrangements of these countries were inconsistent with economic freedom in almost every area.

7.In addition to the mid-1990s ratings, indexes were also derived for 1975, 1980, 1985, and 1990. Exhibit 2-2 presents the summary rating Is1 for the Top 15, Bottom 15, and selected middle-rated countries for these years as well as for 1995. Some of the top-rated countries were able to maintain their high rating throughout the 1975-1995 period, but there was also a great deal of both upward and downward mobility. Several top-ranked countries in 1975 and 1985 fell well down the rankings in later years (for example, Honduras and Venezuela). Correspondingly, several economies with low ratings in 1975, 1980, or 1985 substantially improved their scores in recent years (for example, New Zealand, Thailand, South Korea, and Costa Rica).

8.The five countries that improved their economic freedom rating the most during the 1975-1990 period were: Chile, Jamaica, Iceland, Malaysia, and Pakistan. See Exhibit 3-1 for more a complete list of countries that improved substantially during the 1975-1990 period. The five countries for which the economic freedom rating declined the most during the 1975-1990 period were: Nicaragua, Somalia, Iran, Honduras, and Venezuela. See Exhibit 3-2 for a more complete list of these countries.

9. The summary indexes indicate that there was little change in the average economic freedom rating for the more than 100 countries of our study during the 1975-1985 period. However, since 1985 there is evidence of an increase in economic freedom. The average summary ratings of both industrial and less developed countries rose during the last decade. The primary factors contributing to this improvement were: greater price level stability, greater freedom to maintain foreign currency bank deposits, improved credit market policies, lower top marginal tax rates, reductions in taxes (tariffs) on international trade, liberalization of exchange rate controls, and relaxation of restrictions on the movements of capital. See Exhibits 3-6 and 3-7 for details. Also see Exhibit S-7 in the Graphic Summary.

10.Economic theory indicates that economic freedom will enhance the gains from trade and entrepreneurship. Therefore, if economic freedom is measured properly, a positive impact on economic growth is the expected result. The data are consistent with this view. As Exhibit 4-1A shows, the 14 countries that earned a summary rating grade of either A or B in 1993-1995, achieved an average annual growth rate in per capita real GDP of 2.4% during 1980-1994 and 2.6% during 1985-1994. In contrast, the average annual growth of per capita real GDP for the 27 countries with a summary rating of F- in 1993-1995 was minus 1.3 percent during 1980-1994 and minus 1.6 percent for the 1985-1994 period. Twenty-one of the 27 experienced declines in real per capita GDP during 1980-1994. See Exhibits 4-1B for additional details. Also see Exhibit S-2 in the Graphic Summary for evidence that differences in economic freedom (and the accompanying grade level) exert a positive impact on both income levels and growth rates.

11.Since increases in economic freedom and maintenance of a high level of freedom will positively influence growth, countries that achieve and sustain high levels of economic freedom over a lengthy time period will tend to be high-income countries. The six countries (Hong Kong, Switzerland, Singapore, United States, Canada, and Germany) with persistently high ratings throughout the 1975-1995 period were all in the Top Ten in terms of 1994 per capita GDP. No country with a persistently high economic freedom rating during the two decades failed to achieve a high level of income. In contrast, no country with a persistently low rating was able to achieve even middle income status. See Exhibit 4-2 and Exhibit S-3 in the Graphic Summary for additional details.

12.The countries with the largest increases in economic freedom during the period, achieved impressive growth rates. As Exhibit 4-3 shows, the 15 countries (actually there are 17 because of a tie) with the most improvement in the index of economic freedom during the 1975-1990 period experienced an average growth rate in per capita GDP of 2.7 percent during 1980-1990 (and 3.1% during 1985- 1994). All 17 of the countries in the most improved category experienced positive growth rates. In contrast, the average real per capita GDP declined at an annual rate of 0.6% in the 15 countries (there were also 16 in this group due to a tie) for which the index of economic freedom fell the most during the same period. Eleven of the 16 countries with the largest declines in economic freedom experienced declines in real per capita GDP during 1980-1994. See Exhibit 4-4 and Graphic Exhibit S-5 for additional details.

13.Countries that achieved a one unit increase in the Is1 economic freedom rating between 1975 and 1985 and maintained that increase during the next decade grew at a average rate of 3.5% during 1985-1994. Mauritius, Pakistan, Japan, Chile, Jamaica, Singapore, Portugal, United Kingdom and Turkey comprised this category. In contrast, the growth rates of the countries where economic freedom declined during 1975-1985 were persistently negative. The pattern was similar for the countries that achieved and sustained increases in economic freedom between 1980 and 1990 compared to those experiencing declines in freedom. See Exhibits 4-5 and 4-6 for additional details. Also see Exhibits S-4C and S-4D in the Graphics Summary section.

14.Chapter 5 presents detailed data for both economic freedom ratings and recent indicators of economic performance for many of the countries included in our study.


Graphic Summary of Major Findings

Click here to display the Average of the Three 1993-95 Summary Index Ratings of Economic Freedom.

Click here to display the Average of the 1993-95 Summary Index (ls1) of Economic Freedom.

Click here to display the 1995 Economic Freedom, Grade Level per Capita GDP, and Growth.

Click here to display the Income Levels and Growth Rates of Persistently High and Persistently Low Countries.

Click here to display the Economic Freedom Ratings (ls1) during 1975-1995 and Growth Rate for High-Rated Non-Industrial Economics.

Click here to display the Economic Freedom Ratings (ls1) during 1975-1995 and Growth Rate for Low-Rated Non-Industrial Economics.

Click here to display the Economic Freedom Ratings (ls1) during 1975-1995 and Growth Rate of Less-Developed Economies that became more free during 1975-1995.

Click here to display the Economic Freedom Ratings (ls1) during 1975-1995 and Growth Rate of Less-Developed Economies that become less free during 1975-1995.

Click here to display the Growth Rates during 1980-1994 of the Ten Countries with the Largest Increases and Largest Declines in Economic Freedom during 1975-1990.

Click here to display the Growth of per Capita GDP during 1980-1990 for the Countries that had a One Unit Increase in the ls1 Economic Freedom Rating between 1975 and 1985 (and maintained that Increase into the 1990's) compared to the Growth of Countries with a One Unit decline during 1980-1990..

Click here to display the Changes in the Average Country Rating for the Summary Indexes and the Components: 1975-1995. Average Summary Rating of Countries, 1975-1995.

Click here to display the Changes in the Average Country Rating for the Summary Indexes and the Components: 1975-1995. Average Component Rating of Countries.


Introduction: The Historical Development of the Economic Freedom Index

by Michael A. Walker

The current volume is the culmination of a process which began at the 1984 meetings of the Mont Pelerin Society in Cambridge, England. In the course of a comment on a paper by Paul Johnson, I made reference to the famous passage in Capitalism and Freedom written by Milton Friedman and Rose Friedman, in which the authors note that, "Historical evidence speaks with a single voice on the relation between political freedom and a free market. I know of no example in time or place of a society that has been marked by a large measure of political freedom, and that has not also used something comparable to a free market to organize the bulk of economic activity."

There then ensued a discussion about the relationship between economic and political freedom led by the late Max Thurn, a long time member of the Society. It became clear during the course of this discussion that while Milton and Rose Friedman's comment had been extant for three decades there had been no serious attempt to explore the relationship between economic and political freedoms in a scholarly way. At the meeting I approached Milton and Rose Friedman to invite them to co-host a symposium to investigate these relationships. They agreed and subsequently Dr. Neil McLeod, President of the Liberty Fund, Inc. of Indianapolis agreed to provide the funding to bring a group of distinguished economists from all over the world to the Napa Valley, California in 1986.

The proceedings of this first symposium were published in a book which I edited entitled, Freedom, Democracy and Economic Welfare, published by the Fraser Institute in 1988. Meanwhile, Alvin Rabushka, Milton Friedman's colleague at the Hoover Institution who had been concerned about these issues for nearly a decade because of his direct involvement in the study and documentation of the economic development of Hong Kong, held a series of Liberty Fund conferences. One, on "Taxation and Liberty" was held in Santa Fe, New Mexico in 1985 and another on "Taxation, Democracy, and Threats to Liberty" in Savannah, Georgia in 1987. Alvin Rabushka was also a participant in the 1986 Napa Valley Conference and he was to play a central role in developing the symposium series.

Milton Friedman had suggested to me that I should invite to the first meeting in the Napa Valley a representative from Freedom House because they had expanded their 1982 Annual Report on political and civil liberties around the world to include, on an experimental basis, ratings for economic freedom. Raymond Gastil, then the President of Freedom House and Lindsay Wright, a young economist working for the organization, came and presented a paper on their findings on economic freedom at the first conference.

As Gastil and Wright shared their views on economic liberty, it was obvious that they differed significantly from those of most conference participants. The Gastil-Wright approach reflected the Freedom House perspective that democratic political procedures and civil liberties were the most important aspects of freedom. According to this philosophy, highly progressive taxation and large income transfers are entirely consistent with individual liberty, if policies in these areas are approved by democratic majorities of legislative bodies. For the presentation of this view, see Lindsey M. Wright, "A Comparative Survey of Economic Freedoms" in Freedom in the World: Political Rights and Civil Liberties, 1982, ed. Raymond D. Gastil (Westport and London: Greenwood Press, 1982), pp. 51-90 and Raymond D. Gastil and Lindsey M. Wright, "The State of the World: Political and Economic Freedom," in Freedom, Democracy and Economic Welfare, ed. Michael Walker (Vancouver: The Fraser Institute, 1988), pp. 85-119. For a detailed criticism of this view, see Alvin Rabushka "Freedom House Survey of Economic Freedoms," in Economic Freedom: Toward a Theory of Measurement, ed. Walter Block (Vancouver: The Fraser Institute, 1991), pp.57-71.Note Several of the participants in this first conference, including myself, Walter Block, and Alvin Rabushka, believed that the Freedom House approach trivialized and distorted economic freedom, making it dependent on the political process. We came away even more convinced that development of a sound measure of economic freedom was a vitally important project.

My colleague Walter Block and Alvin Rabushka had a subsequent meeting in which they decided to suggest that a series of follow up symposia be held in order to explore the weaknesses of the Freedom House approach and to develop an index of economic freedom that was consistent with the history and proper meaning of economic liberty. The long term objective would be to develop a measure of economic freedom that would be published on a regular basis just like the Freedom House's annual survey of political and civil liberties.

It was then left for me to persuade Milton and Rose Friedman to co-host a series of symposia to properly elucidate the subject and to persuade the Liberty Fund to provide the financing. The new President of Liberty Fund, Inc., Mr. W. W. Hill was quite excited by the project, could see its implications, and happily agreed to fund a further five meetings in which international experts would build up an intellectual base from which the index might be formed.

The second conference of the series was held in Vancouver in July of 1988 and centred on a paper presented by Alvin Rabushka on how economic freedom should be defined. For those interested in the papers and a summary of the discussion from the entire Fraser Institute/Liberty Fund series, see Michael A. Walker, ed., Freedom, Democracy, and Economic Welfare, (Vancouver: Fraser Institute, 1988); Walter Block, ed., Economic Freedom: Toward and Theory of Measurement, (Vancouver: Fraser Institute, 1991); and Stephen T. Easton and Michael A. Walker, eds., Rating Global Economic Freedom, (Vancouver: Fraser Institute, 1992).Note Building on the work of John Locke, Adam Smith, Milton Friedman, Murray Rothbard, and his own extensive empirical and theoretical analysis, Rabushka examined the attributes of economic freedom and the nature of policies consistent with that freedom. He argued that private property and rule of law provided the foundation-the institutional basis-for economic freedom. Rabushka applied the concept of economic freedom to five basic areas-taxation, public spending, economic regulation of business and labour, money, and foreign trade-and outlined some ideas about how it might be measured in each of these areas. This work proved to be quite important in focusing subsequent discussion at the other symposia.

Also at the second meeting came the first attempt to provide empirical measures with a paper by Zane Spindler and Laurie Still. In their paper they added to the taxonomy suggested by Alvin Rabushka and provided a first-cut try at evaluating the Freedom House Index and adding to it a measure of freedom based on involuntary military service and freedom of foreign trade and investment. One of the consequences of the discussion of this paper was the suggestion that all of the participants produce a list of factors that they felt should go in to an index of economic freedom and there resulted a list of indicators which might be used for this purpose.

The third meeting was held in 1989 at Banff, Alberta and represented the first real attempt to construct both theoretical and empirical measures which were derived from the principles sketched out by Rabushka at the second session. Sectoral papers explored the construction of indices for labour markets, international trade and money markets. The discussions were mostly interesting for the direction they would provide for the papers presented at the fourth meeting held at Sea Ranch, California in 1990.

The fourth symposium saw the investigation proceed to a much higher level of understanding both empirically and theoretically. A theoretical paper by Ronald Jones and Alan C. Stockman built upon two papers by Stephen Easton to specifically consider freedom as part of the standard economic model. Their analysis put to rest a confusion which often attends such discussions and that is the difference between wealth and freedom. They showed that there could simultaneously be a reduction in freedom and an increase in wealth.

Also at the fourth symposium there was the beginning of the index which is presented in this book. James Gwartney worked with Walter Block and Robert Lawson to produce the first comprehensive index which ranked 79 countries in the sectors which Rabushka had outlined and which were further discussed at the third symposium. The fourth symposium also involved, in a paper by Zane Spindler and Joanna Miyake, the consideration of the list of indices of freedom which had been devised during the second symposium.

One of the most interesting aspects of the fourth symposium was a survey of economic freedom conducted by Milton and Rose Friedman. Each of the symposium participants was asked to rank 11 countries which would be familiar to all participants. Milton and Rose then analyzed the ranking during the evening and presented it the following day. This simple survey and analysis of it proved to be quite helpful in discovering the dispersion of estimates of the freedom of countries that were neither very free nor very unfree but somewhere in between. The classic problem of distinguishing amongst things that are similar was also seen to plague the task of measuring freedom.

One of the conclusions that emerged from the Sea Ranch meeting was that there are two ways in which to construct an index of freedom. The "low tech," judgmental way in which a number of individuals are asked to provide their subjective ranking of a group of countries and the "high tech" way in which a large number of criteria, based on a series of measurable quantities, are applied to produce the rating.

By way of testing further the low tech approach, it was decided to have a future meeting consider a group of countries and to have individuals who were familiar with the countries rank them on a freedom scale. The fifth symposium held in 1991 at Monterey California focused on a series of papers which had been constructed in this way. Essentially, groups of respondents in Asia, Latin America, Africa, Europe and North America were asked to rank countries in their region as well as countries outside their region which were common to all of the lists. In this way it was hoped that an integrated picture might emerge of the economic freedom rankings of all countries considered.

While this exercise produced some interesting insights, in general it was found that respondents did not possess enough information about the countries they were asked to rank and it was quite difficult to find people in a given region who were knowledgeable about more than one or two countries. While there were many interesting insights generated from the various regions, it did not prove possible to derive a coherent index from the components.

In a separate survey conducted by Stephen Easton and myself, members of the Mont Pelerin Society were also asked to rank countries in their region and this survey did prove to be coherent. However, it was in general felt that more success might be achieved by reverting to the "high tech" method and the use of many index series for each country which Gwartney, Block and Lawson had begun in the fourth session. This objectification of the measurement process would overcome the problems of subjectivity and the difficulty of finding knowledgeable people to do the rating.

However, a serious problem remained. Namely, to find the weights that should be attached to the various data series in the Gwartney, Block and Lawson index. In partial response to the recognition of this problem, Easton and I undertook another survey of the Mont Pelerin Society membership in which we asked the respondents to rank each country's performance in a number of general areas such as international trade, monetary freedom, etc. The sixth symposium focused entirely on the revised Gwartney, Block and Lawson paper and the second paper which Easton and I had constructed.

The sixth symposium was held in Sonoma California in 1993 and the focus of discussion was a greatly revised Gwartney, Block and Lawson paper and the paper Easton and I had written to report the results of our second survey. Many suggestions for improvement were advanced and a number of approaches to the problem of weighting the components of the index were discussed. The Index of Freedom which is presented in this volume reflects the valuable contributions of the participants toward resolving the difficulties which were identified.

All told, 61 people have contributed to the Rating Economic Freedom program of the Fraser Institute. We feel that it would be appropriate to acknowledge their contribution to the process and they are therefore named at the end of this introduction. However, it goes without saying that they are not responsible for the resulting index nor do they necessarily endorse it or its implications.

Recently, the Heritage Foundation of Washington, D.C., has published an index of Economic Freedom. There is some question, therefore, as to why we should produce another, seemingly competing index. The answer is simple.

First of all, as The Heritage Foundation was careful to note in their publication, the research which has been produced by the Rating Economic Freedom Project of the Fraser Institute is of a fundamental kind and attempts to deal with the key methodological issues involved in the creation of such an index. The Heritage Foundation index reflects some of this research but is not as complete or as comprehensive as the index published here. It is hope that the Heritage Foundation will incorporate the advances in the state of research which are reflected in this index.

Secondly, this index provides a historical measurement of economic freedom. It is possible therefore using this index to undertake analysis of the relationship between economic freedom and other variables through time. This is a very important consideration.

Finally, we believe that this index represents the "state of the art" in the measurement of economic freedom and that it establishes both a new bench mark for economic freedom and a new starting point for research that will improve our understanding of this vital aspect of the human condition.


Chapter 1: Construction of the Economic Freedom Index

Measurement is the making of distinction; precise measurement is making sharp distinctions.
-Enrico Fermi As quoted by Milton Friedman in Walter Block (ed.), Economic Freedom: Toward a Theory of Measurement (Vancouver: Fraser Institute, 1991), p. 11.Note

Most people prefer to choose for themselves. This indicates that freedom, including economic freedom, has intrinsic value. Adam Smith noted that human beings have a natural inclination to "truck and barter." Restrictions on the freedom to choose and engage in voluntary exchange deny human beings something they value-something that is an integral part of their humanity. In addition, economic theory indicates that economic freedom affects incentives, productive effort, and the effectiveness of resource use. Since the time of Smith, economists have argued that the freedom to choose, supply resources, compete in business, and trade with others is a central ingredient-perhaps the fundamental element-of economic progress.

If economic freedom is this important, why have we invested so little time attempting to measure it? The obvious answer is that economic freedom is multi-dimensional and therefore its measurement is a difficult-some would say impossible-task. These same arguments were presented prior to the development of the national income accounts used to measure gross domestic product. Of course, there is a parallel here. Since most thought measurement of output with any degree of accuracy was an impossible task, it was 150 years after Smith's Wealth of Nations before a comprehensive measure was developed.

If we are unable to measure economic freedom, we are in a poor position to judge its significance as a source of progress. Clearly, the degree of economic freedom present is influenced by numerous factors. No single statistic will be able to fully capture all of them and their interrelations. However, we believe that it is possible to devise measures and develop indicators that will capture the most important elements of economic freedom and provide a reasonably good measure of differences in economic freedom across countries and time periods. Other researchers have also sought to quantify economic freedom across countries. See Zane Spindler and Laurie Still, "Economic Freedom Ratings," in Walter Block (ed.), Economic Freedom: Toward a Theory of Measurement (Vancouver: The Fraser Institute, 1991); Gerald W. Scully and Daniel J. Slottje, "Ranking Economic Liberty Across Countries," Public Choice (69: 121-152, 1991); and Bryan T. Johnson and Thomas P. Sheehy, The Index of Economic Freedom, (Washington, D. C. : Heritage Foundation, 1995).Note As the quotation of Professor Fermi indicates, measurement involves making distinctions. When something is difficult to measure precisely, the distinctions may not be as refined as we would like. This is the case with economic freedom. The measures developed in this study might best be viewed as approximations rather than precise measures. Therefore, small differences between countries and across time periods should not be taken very seriously.

This chapter addresses three topics. We begin with a discussion of the concept of economic freedom. The second section describes the various components of our indexes and indicates how the economic freedom ratings for each of the components are derived. The final section considers the problems that arise when the components are aggregated into a summary index and explains how the three summary indexes of economic freedom are derived.

THE CONCEPT OF ECONOMIC FREEDOM

The central elements of economic freedom are personal choice, protection of private property, and freedom of exchange. Individuals have economic freedom when (a) property they acquire without the use of force, fraud, or theft is protected from physical invasions by others and (b) they are free to use, exchange, or give their property to another as long as their actions do not violate the identical rights of others. Of course, the most basic property right of individuals is the property right to their person. The protection of individuals from "invasions" by others is the central element of criminal law. Since cross-country data on the safety of individuals from physical attacks on their person differ substantially and their reliability is generally questioned, our study does not attempt to deal with this factor.Note Thus, an index of economic freedom should measure the extent to which rightly acquired property is protected and individuals are free to engage in voluntary transactions. In an economically free society, the fundamental function of government is the protection of private property and the enforcement of contracts. When a government fails to protect private property, takes property itself without full compensation, or establishes restrictions that limit voluntary exchange, it violates the economic freedom of its citizens. See Ronald W. Jones and Alan C. Stockman. "On the Concept of Economic Freedom" in Stephen T. Easton and Michael A. Walker (ed.), Rating Global Economic Freedom, (Vancouver: The Fraser Institute, 1992) for an excellent discussion of the concept of economic freedom and an analysis of how it might be measured.Note

An index of economic freedom should measure the extent to which rightly acquired property is protected and individuals are free to engage in voluntary transactions.

This concept of economic freedom reflects the prior work of others. Alvin Rabushka, a pioneer researcher and leading scholar in this area, highlighted the relationship between private property and economic freedom in the following manner:

Private property is the common denominator that underpins every liberal philosophical treatment of individual economic freedom. John Locke regarded the existence of private property as the proper condition of man in a state of nature; the primary function of civil society, to which man granted the rights he enjoyed in the state of nature, was to protect and preserve private property. Most important, the state has no right to take any part of a man's property without his consent Alvin Rabushka, "Preliminary Definition of Economic Freedom," in Economic Freedom: Toward a Theory of Measurement, ed. Walter Block, (Vancouver: The Fraser Institute, 1991), pp. 87-108. This article provides an excellent foundation for the development of an empirical measure of economic freedom.Note.

Lindsey Wright of the Freedom House has also stressed the central role of private property. In the 1982 Freedom House annual report, she stated:

The freedom to have property and control its use is fundamental to the ability of individuals and groups to make economic choices independent of arbitrary intervention by others. Lindsey M. Wright, "A Comparative Survey of Economic Freedom," in Freedom in the World: Political Rights and Civil Liberties 1982, ed. Raymond D. Gastil, (Westport and London: Greenwood Press, 1982), p. 55.Note

Freedom of exchange and the autonomy of the individual are also integral elements of economic freedom. As Alvin Rabushka put it:

The free and voluntary exchange of property titles goes hand in hand with the rights of private property. Unless each individual controls the use of his property, including his right to transfer it to another party in exchange for some consideration, the notion of private ownership and use has little meaning. Thus, freedom of contract is inherent in private property.... A free society affords every individual freedom of contract in contrast with, say, an aristocratic society in which only the nobility can enter into contracts to exchange titles Rabushka (1991), p. 89.Note.

Intrusive rights such as a "right" to food, clothing, medical services, housing, or a minimal income level impose "forced labor" requirements on others. Alleged "rights" of this type are simply disguised demands for the forced transfers of income and wealth.

It is useful to view economic freedom within the framework of protective rights and intrusive rights. Philosophers generally refer to protective rights as negative rights and intrusive rights as positive rights. See Roger Pilon, "Property Rights, Takings, and a Free Society," in Public Choice and Constitutional Economics, James Gwartney and Richard Wagner (ed.), (Greenwich, CT: JAI Press, 1988) and Walter Block, The U.S. Bishops and Their Critics: An Economic and Ethical Perspective, (Vancouver: The Fraser Institute, 1986) for an analysis of this topic and its importance for a free society.Note Protective rights provide individuals with a shield against others who would invade and/or take what does not belong to them. Since they are nonaggression rights, all citizens can simultaneously possess them. In order to maintain protective rights, preventing people from initiating aggression against others is all that is required. In contrast, intrusive rights (or "positive rights" as they are sometimes called), such as a "right" to food, clothing, medical services, housing, or a minimal income level impose "forced labor" requirements on others. If A has a right to housing, for example, this logically implies that he has a right to force B to provide the housing. But A has no right to the labor of B or any other individual. Thus, A cannot possibly have a right to housing and other things that can only be supplied if they are provided by other people. Intrusive rights therefore conflict with economic freedom because such "rights" imply that some have a right to the labor and possessions of others. In reality, alleged "rights" of this type are simply disguised demands for the forced transfers of income and wealth.

It is important to distinguish economic freedom from political and civil liberties. Political freedom has to do with the procedures that are used to elect government officials and decide political issues. Political liberty is present when all adult citizens are free to participate in the political process (vote, lobby, and choose among candidates), elections are fair and competitive, and alternative parties are allowed to participate freely. Civil liberty encompasses the freedom of the press and the rights of individuals to assemble, hold alternative religious views, receive a fair trial, and express their views without fear of physical retaliation. A country may have a substantial amount of both political and civil liberty-it may be highly democratic and the major civil liberties may be protected-and still adopt policies that conflict with economic freedom. Countries like Israel, Sweden, and India illustrate this point. Political and civil liberties are present in such countries, but nonetheless, their policies-for example, the levels of taxation, government spending, and regulations-are often in conflict with economic freedom.

THE COMPONENTS OF OUR INDEX OF ECONOMIC FREEDOM

Our goal is to construct an index that is (a) a good indicator of economic freedom across countries and (b) based on objective components that can be updated regularly.

Our goal is to construct an index that is (a) a good indicator of economic freedom across a large number of countries and (b) based on objective components that can be updated regularly. To the extent possible, we want to avoid having to make "judgment calls" when rating the policies, legal structures, and institutions of a country.

As Exhibit 1-1 indicates, our index has 17 components that are allocated to four major areas: (1) money and inflation, (2) government operations and regulations, (3) takings and discriminatory taxation, and (4) international exchange. However, the data for three components-price controls, freedom of entry into business, and equality under the law-are unavailable for the years 1975, 1980, and 1985. The latter two variables are also unavailable for 1990. Thus, our index has 14 components for the years 1975, 1980, and 1985; 15 in 1990; and 17 in 1993-95.Note Since we want the ratings to be easily comparable across countries and time periods, a zero to ten rating scale was used for each component in the index. A ten represents the highest possible rating and a zero the lowest.

Because the structure of the underlying data used to derive the ratings was not always the same, three alternative methods were used to derive them. A continuous variable provided the underlying data for seven of the components. When this was the case, the data for 1985-our base year-were arrayed from the highest to the lowest values and divided into eleven groups containing an equal number of countries. Nations in those 11 groups were then assigned ratings ranging from ten to zero. For example, if there were 99 countries (for which the required data were available), then the nine countries that rated best in this category in 1985 would receive a rating of ten, the next nine would receive a rating of nine, and so on. Often the total number of countries for which the data were available was not evenly divisible by eleven. When this was the case, the odd number of ratings was spread as evenly as possible among high and low ratings categories.Note The cutoff points between groups in the 1985 data were then used to rate each country in the other years (1975, 1980, 1990 and 1995). To determine the interval cutoff points between, say, a ten and a nine rating, we calculated the midpoint in the 1985 data between the country with the lowest ten rating and the country with the highest nine rating.

The advantage of using only the base year 1985 to derive the conversion table is that this approach allows the ratings of countries to either improve or worsen in the other years. Thus, while the rating system judges countries relative to one another during the 1985 base year, the rating of a country can move up or down in the other years. If most countries improve (or regress) relative to the base year, this system allows their ratings to reflect this improvement.

A binary variable provided the underlying data for three of the components. This would be the case, for example, when a restriction was either present or absent (or when an act was either legal or illegal). If the condition consistent with economic freedom was present, the country was assigned a rating of ten. Alternatively, if the condition was absent, the country was assigned a zero.

Finally, in some cases a classification-rating system was developed and underlying data used to classify and rate each country. This method was employed when the underlying data were multi-dimensional. For example, both the top marginal tax rate and the income level at which the rate took affect were used to rate tax structures. The various countries were placed into rating categories reflecting both of these variables. When this method was used, the zero to ten rating range was still retained.

Exhibit 1-1: Components of the Index of Economic Freedom

I.Money and Inflation (Protection of money as a store of value and medium of exchange)
A.Average Annual Growth Rate of the Money Supply During the Last Five Years Minus the Potential Growth Rate of Real GDP
B.Standard Deviation of the Annual Inflation Rate During the Last Five Years
C.Freedom of Citizens to Own a Foreign Currency Bank Account Domestically
D.Freedom of Citizens to Maintain a Bank Account Abroad

II.Government Operations and Regulations (Freedom to decide what is produced and consumed)
A.Government General Consumption Expenditures as a Percent of GDP
B.The Role and Presence of Government-Operated Enterprises
C.Price Controls-the Extent that Businesses are Free to Set Their Own Prices (This variable is included in only the 1990 and 1995 Indexes.)
D.Freedom of Private Businesses and Cooperatives to Compete in Markets (This variable is included only in the 1995 Index.)
E.Equality of Citizens Under The Law and Access of Citizens to a Nondiscriminatory Judiciary (This variable is included only in the 1995 Index.)
F.Freedom from Government Regulations and Policies that Cause Negative Real Interest Rates

III.Takings and Discriminatory Taxation (Freedom to keep what you earn)
A.Transfers and Subsidies as a Percent of GDP
B.Top Marginal Tax Rate (and income threshold at which it applies)
C.The Use of Conscripts to Obtain Military Personnel

IV.Restraints on International Exchange (Freedom of exchange with foreigners)
A.Taxes on International Trade as a Percent of Exports Plus Imports
B.Difference Between the Official Exchange Rate and the Black Market Rate
C.Actual Size of Trade Sector Compared to the Expected Size
D.Restrictions on the Freedom of Citizens to Engage in Capital Transactions with Foreigners

The underlying data and the country ratings for each of the 17 components are presented in the tables of Appendix II. (Note: the labeling of the tables for each of the components presented in Appendix II matches the labels of Exhibit 1-1.) We now turn to a discussion of the components in each of the four major areas of our index and the explanation of precisely how the country ratings for each of the 17 components were derived. We will begin with the money and inflation area.

I. Money and Inflation

Since money plays such a central role in the exchange process, monetary institutions and arrangements exert an important impact on the security of property and freedom of exchange. Money makes it possible for people to engage in complex exchanges involving the receipt of income or payment of a purchase price across lengthy time periods. It also provides a means of storing purchasing power into the future.

Money makes it possible for people to engage in complex exchanges involving the receipt of income or payment of a purchase price across lengthy time periods.

The relationship between monetary arrangements and policies and economic freedom is a matter of some controversy. Some would argue that any government action whatsoever in this area necessarily conflicts with economic freedom.


For details on this view, see Murray Rothbard, The Mystery of Banking, (New York: Richard and Snyder, 1983) and What Has Government Done to Our Money, 3rd ed. (San Rafael, CA: Libertarian Publishers, 1985).11 Proponents of this view argue that if coinage of money and the business of banking were left completely to the private sector, firms would tie the value of money they issue to precious metals (like gold and silver) and follow strategies designed to maintain purchasing power stability in order to protect their reputation (brand name) and the future demand for their product. According to this perspective, the competitive process would lead to monetary stability because people would be reluctant to use money issued by institutions that lacked credibility. In turn, the credibility of banking institutions would be dependent upon their ability to develop and maintain a monetary unit with stable, predictable purchasing power.

Others argue that provision of a stable monetary framework is a legitimate function of government and if the government provides a stable monetary unit with predictable value, its actions are consistent with economic freedom. See Milton Friedman, Capitalism and Freedom, (Chicago: University of Chicago Press, 1962), Chapter III and Money Mischief: Episodes in Monetary History (New York: Harcourt Brace Jovanovich, 1992).Note The proponents of this view often argue for constitutional provisions that would commit the monetary authorities to stable money and limit their ability to expand the supply of money.

There is some common ground between these two camps. First, both would agree that economic freedom is diminished when monetary disturbances and unexpected price changes alter the value of money and the terms of time-dimension agreements involving money. Such actions involve, in effect, the taking of property. In many such cases, wealth is taken from one private party and given to another. In other cases, it is taken from individuals and transferred to the government.

Second, there is also widespread agreement that government actions which deter the use of alternative currencies infringe on the freedom of contract and therefore economic freedom. The right of trading partners to conduct their business affairs in any currency- domestic or foreign; private or issued by a government-is an important right. Thus, laws conflict with economic freedom when they require trading partners to use a certain currency or prohibit the ownership and use of alternatives. In turn, the freedom to maintain and use alternative currencies limits the power of the national monetary authorities. When trading partners can easily shift to other means of exchange, they are better able to protect themselves against a central monetary authority that follows inflationary and unpredictable policies.

The general ingredients of economic freedom in the monetary area are: (1) slow monetary expansion that maintains and protects the value of money, (2) price level (or inflation rate) stability, and (3) the absence of restrictions limiting the use of alter- native currencies.

Today, almost every government in the world issues money and operates a central bank that conducts monetary policy. Therefore, if we want to establish gradations of economic freedom in this area, we must evaluate these policies. Our discussion highlights three general ingredients of economic freedom in the monetary area: (1) slow monetary expansion that maintains and protects the value of money, (2) price level (or inflation rate) stability, and (3) the absence of restrictions limiting the use of alternative currencies. We proceed to an explanation of how the four monetary components of our index were derived.

I-A: The Average Annual Growth Rate of the Money Supply during the last five years Minus the Annual Growth Rate of Potential GDP.

Authorities that issue money have an implicit responsibility to maintain the purchasing power of the outstanding units. When the supply of a currency is increased rapidly relative to the availability of goods and services, wealth is taken from the people holding money (and assets yielding a fixed nominal return). In essence, rapid growth in the money supply "waters down" the value of the outstanding monetary units and thereby erodes its value. This is wrongful seizure of property. Therefore, countries with high rates of monetary growth relative to real GDP are given low ratings.

Data Sources and Methodology. The compound average annual growth rate of the money supply (M1) during the 5-year period just prior to each rating year minus the average growth of real GDP during the last ten years was calculated. A country's real GDP growth rate during the last ten years was perceived to be a good estimator for the growth of potential GDP. The money supply and GDP data were from the World Bank, World Tables, 1994 and the International Monetary Fund, Monthly International Financial Statistics. The latter source was generally used to update the data series for the more recent years. The statistics for this measure of monetary growth are presented by country for each of the five periods in Table I-A of Appendix II.

When a country's monetary authorities expand the money supply slowly (rapidly) relative to potential GDP, this variable will be small (large) and the country will receive a high (low) rating. While they were extremely rare during the period of our study, monetary contractions can also change the terms of trade and undermine economic exchange. Therefore, our transformation table is symmetrical. The larger a negative change in the money supply minus potential GDP, the lower the rating of a country. Further, a sizeable monetary contraction might well cause a sharp reduction in real GDP. Under these circumstances, money growth minus the change in current-year real GDP would lead to a higher rating than is justified. This is why we used the change in real GDP during the last ten years rather than the change in GDP during the current year to adjust the money growth figures for cross-country differences in the growth of potential real output. We would like to thank Milton Friedman for calling this problem to our attention and suggesting the use of the ten-year average growth rate to minimize distortions arising from this source.Note The data for the 1985 base year period were arranged in ascending order and divided into eleven groups of equal size. Since the 1985 money supply data were available for 101 countries, the nine countries with the lowest rate of monetary expansion were given a rating of ten. The nine countries with the next lowest rate of monetary expansion were given a rating of nine, and so on. The midpoints between intervals were then used to derive the range for each of the zero-to-ten ratings for the 1985 base year. The transformation table containing these values is included in the source note accompanying Table I-A (Appendix II). These base- year rating intervals were then used to assign ratings for the other four periods. These ratings are presented along with the actual money growth data for each of the five periods in Table I-A (Appendix II).

I-B: The Standard Deviation of Annual Inflation Rate during the last five years.

The efficacy of money is directly related to the stability of its value. When the inflation rate is constantly changing in an unpredictable manner-when it is 10% in one year, 40% the next, and 20% the year after that, it is extremely difficult to plan for the future and undertake exchanges that involve a time dimension (e.g., payment for the purchase of an automobile or house over a period of years). Since unpredictable changes in the rate of inflation undermine the efficacy of money, countries with the most stable-and therefore most easily predictable-rates of inflation are given the highest ratings. Correspondingly, countries with the highest variability in their inflation rates are given the lowest ratings. Our thinking in this area was influenced by the rational expectations theory of Robert Lucas, Thomas Sargent, Robert Barro and others. For a review of this literature, see The Rational Expectations Revolution: Readings From The Front Line, edited by Preston J. Miller (Cambridge, MA: MIT Press, 1994).Note

The efficacy of money is directly related to the stability of its value.

Data Sources and Methodology. Data for the GDP Deflator from the World Bank, World Tables, 1994 supplemented with recent data from the International Monetary Fund, Monthly International Financial Statistics were used to calculate the inflation rate of each country by year. Then the standard deviation of the inflation rate was calculated for each 5-year period prior to the rating year. Following the procedures adopted for continuous variables, the base-year 1985 data were divided into eleven intervals of equal size and these intervals were then used to determine the country ratings for each period. Data for both the standard deviation of the inflation rate and the corresponding rating by country for each of the five periods of our study are presented in Table II-B of Appendix II. The conversion table derived from the base year data is also presented in the note at the end of this table.

I-C: Freedom of Residents to Own Foreign Money Domestically.

Money offered by other monetary authorities is a substitute for money issued by the government of a given country. When residents are allowed to maintain bank accounts in foreign currencies, it is easier for them to avoid the uncertainties accompanying an unstable domestic monetary regime. Thus, citizens have more economic freedom if they are allowed to maintain domestic bank accounts in other currencies.

Data Sources and Methodology. The World Currency Yearbook, which was published bi-annually throughout the 1975- 1990 period contains a "front matter" table which lists each country and indicates whether it is legal for the citizens of the country to own foreign currency bank accounts domestically. This information was used to rate each country for 1975, 1980, 1985, and 1990. An Annual Report, Exchange Arrangements and Exchange Restrictions, published by the International Monetary Fund, also provides information on the legality of foreign currency bank accounts for each country. The 1994 Report provided the source for this component during the most recent period (1993- 1995).

Since this is a binary variable-generalized holdings of foreign currency accounts are either legal or illegal-a country is given a rating of 10 if citizen ownership of a foreign currency bank account is legal. If such an account is illegal, the country is given a rating of zero.

I-D: Freedom of Residents to Maintain Bank Accounts Abroad.

Ownership of a bank account abroad provides another alternative method of storing purchasing power for future use. From a security standpoint, this option may be preferable to the domestic ownership of a foreign currency bank account because an account abroad is less vulnerable to confiscation by one's own government. When the monetary arrangements of a country have a history of instability, many citizens may prefer to deposit their funds with a bank elsewhere. Freedom to own a bank account abroad provides them with this option and thereby reduces their government's power to utilize monetary expansion as a method of extracting wealth from them. Thus, countries that permit their citizens to maintain bank accounts abroad are given a higher rating.

Data Sources and Methodology. As was the case for the previous component, the International Currency Yearbook and the Exchange Arrangements and Exchange Restrictions-Annual Report are the source of this variable. When it is legal for the citizens of a country to own a bank account abroad, the country is given a rating of 10. When ownership of these accounts is illegal, the country is given a rating of zero.

II. Government Operations and Regulations

Market exchange is based on a voluntary agreement among trading partners. Unless all parties agree, the transaction will not take place. No private business firm, regardless of its size, can force potential consumers to purchase its products. Government is fundamentally different. Unlike business firms, governments can take (tax) some of your wealth and transfer it to others or use it to operate government agencies or enterprises. Governments can also set prices, limit entry into markets and occupations, mandate provision of services by private parties (usually businesses), and impose numerous other regulations on individuals.

There are two broad functions of government that are consistent with economic freedom: (1) protection of individuals against invasions by intruders, both domestic and foreign, and (2) provision of a few select goods-what economists call public goods.

There are two broad functions of government that are consistent with economic freedom: (1) protection of individuals and their property against invasions by intruders, both domestic and foreign and (2) provision of a few select goods-what economists call public goods-which have characteristics that make them difficult for private business firms to produce and market. Nobel laureate James Buchanan refers to these functions as the protective and productive functions of government.

Government's protective function seeks to prevent individuals from physically harming the person or property of another and to maintain an infrastructure of rules within which people can interact peacefully. The crucial ingredients of this infrastructure include the enforcement of contracts and the avoidance of restrictions, regulations, and differential or excessive taxes that would restrain exchange.

The productive function of government involves the provision of public goods-goods that have two distinguishing characteristics: (1) supplying them to one individual simultaneously makes them available to others, and (2) it is difficult, if not impossible, to restrict their consumption to paying customers only. National defense, flood control projects, and mosquito abatement programs are examples of public goods. While the public goods justification for government action represents the mainstream position, there are dissenters. See Hans-Hermann Hoppe, "Fallacies of Public Goods Theory and the Production of Security," in The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, (Boston: Kluwer, 1993); Tyler Cowen, ed., The Theory of Market Failure: A Critical Examination, (Fairfax, VA: George Mason University Press, 1988); Walter Block, "Public Finance and Taxation," Canadian Public Administration, Fall 1993 and Walter Block, "Taxation in the Public Finance," Journal of Public Finance and Public Choice, Fall 1989.Note

When governments move beyond these protective and productive functions into the provision of private goods, they restrict consumer choice and economic freedom. Most modern states are heavily involved in directing production toward more of some goods and less of others, operation of enterprises, the protection of government firms from the discipline of competition, the imposition of price controls, and numerous other expenditures and regulatory activities that have nothing to do with either the protection of property rights or the provision of public goods.

Given the breadth and magnitude of government operations and regulations, precise measurement of these activities is an impossible task. However, our index includes six components that provide insight into the relationship between government activity and economic freedom in several important areas. While these components are far from inclusive, they provide an indication of the degree to which governmental operations conflict with economic freedom.

II-A: Government General Consumption Expenditures as a Share of GDP.

When government consumption expenditures increase as a share of GDP, political decision-making is substituted for market choices and coordination. Ceteris paribus, more public sector spending means less spending by individuals and families.

As government expenditures increase, more and more of these expenditures tend to be channelled toward activities outside of the protective and productive functions of government. Big-spending governments generally tend to be more heavily involved in projects designed to benefit local constituents, organized special interests, and other favored groups-including government bureaucrats and officials. Therefore, as coercive political decision-making allocates more resources and non-coercive market decision-making allocates fewer, economic freedom shrinks.

Data Sources and Methodology. The World Bank, World Tables, provided the primary source of the data for this variable. In a few cases, data were obtained from the International Monetary Fund, Monthly International Financial Statistics, since current data were sometimes more readily available from this source. Both government consumption and GDP were measured in the domestic currency units of the respective countries. Government consumption expenditures include all spending on goods and services purchased by the government-things like national defense, road maintenance, wages and salaries, office space, and government-owned vehicles. Since it is obtained from the national income accounts, it includes all levels of government spending. Note, this variable does not include direct transfers and subsidies, since these do not enter into the national income accounts.Note Since government consumption as a share of GDP is a continuous variable, the general procedures that we previously outlined were utilized to derive the rating transformation in 1985. In turn, the 1985 intervals were used to rate the countries in the other years. The transformation table containing these intervals is presented in the note at the end of Table II-A of Appendix II. The country ratings for this variable are also presented in this table.

II-B: Government-Operated Enterprises as a Share of the Economy.

Government-operated enterprises also involve the substitution of political coercion for market decision-making. Government enterprises are fundamentally different from private businesses. Their start-up capital is coercively obtained from taxpayers, whereas the initial funds of private firms are voluntarily obtained from investors willing to risk their own wealth. Subsequent investment decisions of public sector firms are made by political officials playing with funds that belong to taxpayers, rather than entrepreneurs capable of attracting financial capital voluntarily from investors. Subsidies, favorable tax treatment, and regulations are often used to protect state-operated firms from private competitors. If the government project fails to generate enough revenue to cover its costs, there is no bankruptcy mechanism to bring it to a halt. Thus, public sector enterprises tend to stifle market forces and substitute political choices for market decision-making.

Data on government expenditures will substantially understate the intervention of government when state-operated enterprises are widespread.

Data on government expenditures will substantially understate the intervention of government when state-operated enterprises are widespread. To the extent the current operating expenditures of government enterprises are covered by sales revenue, they generally do not appear in the national budget. Only the subsidy (or revenue surplus) enters into the budgetary accounts. Inclusion of this variable helps to correct a major deficiency of general government consumption expenditures as a measure of the size and intrusiveness of the state.

Data Sources and Methodology. Ideally, it would be nice to have a continuous variable like the proportion of output (or employment) of government-operated enterprises as a share of the economy. To our knowledge, data of this sort are unavailable from a single source for a large number of countries. However, there has been a great deal of research on government-operated enterprises in recent years and empirical data are increasingly becoming available. The Organization for Economic Cooperation and Development (OECD) has done a number of studies of its members on this topic. The World Bank recently conducted a similar study of African countries. See particularly John R. Nellis, "Public Enterprises in Sub-Saharan Africa," World Bank Discussion Paper, no. 1 (Washington, DC: November, 1986); Rexford A. Ahene and Bernard S. Katz, eds., Privatization and Investment in Sub-Saharan Africa, (New York: Praeger, 1992); and OECD Economic Surveys, (Italy: Organization for Economic Cooperation and Development, January, 1994).Note Our research on the topic also turned up several country studies of government-operated enterprises and privatization during the last two decades. In addition, the International Monetary Fund, Government Finance Statistics Yearbook, provides a listing of the enterprises operated by the central governments of various countries. International Monetary Fund, Government Finance Statistics Yearbook (Washington, D.C.: IMF), annual.Note

We analyzed these various sources and used them to classify countries into six different categories that were assigned ratings ranging from zero to ten. Countries with very few government- operated enterprises that were estimated to produce less than 1 percent of the country's output were assigned a rating of ten. As the estimated size and breadth of the government enterprise sector increased, countries were assigned lower ratings. A rating of 8 was assigned when there were few government-operated enterprises except for power-generating or similar industries where economies of scale might reduce the effectiveness of competition. A rating of 6 was assigned when the government enterprises also spread into transportation, communications, and the development of energy sources, but private enterprises dominated other sectors of the economy. A rating of 4 was given when most of the large enterprises of the economy were operated by the government and these enterprises generally comprised between 10 and 20 percent of the total non-agricultural employment and output. The assigned rating declined to 2 when government enterprises were estimated to comprise between 20 and 30 percent of the total non-agricultural employment and output and to zero when the estimated share of the public sector businesses exceeded 30 percent of the economy. The source note at the end of Table II-B of Appendix II provides additional details on these rating categories as well as the country ratings for each of our rating years.

II-C: Price Controls-The Extent that Businesses Are Free to Set Their Own Prices.

The freedom of individuals to use their own property and engage in voluntary exchange can be substantially reduced by regulations that limit the scope of business activity and the use of privately-owned property. Price controls interfere with the freedom of buyers and sellers to undertake exchanges even though the terms of trade are mutually agreeable. Price controls also, in effect, take property from a private owner. For example, if price controls on rental housing cut the rate of return of a property in half, in essence, they take half of the property's value from the owner. Since price controls both constrain exchange and take property from owners, they are inconsistent with economic freedom.

Price controls interfere with the freedom of buyers and sellers to undertake exchanges even though the terms of trade are mutually agreeable.

Data Sources and Methodology. Two major data sources were utilized to rate countries in this area. First, the World Competitiveness Report published by The World Economic Forum contains survey data indicating the "extent to which companies can set their prices freely". This source provided data for 32 countries in 1989 and 41 countries in 1994. Since this was the most comprehensive empirical indicator on the breadth of price controls we could find, we used it to rate the countries covered by the World Economic Forum surveys. The list of countries rated from this source is supplied in the note accompanying Table II-C of Appendix II.

19. See The World Economic Forum, World Competitiveness Report, (Geneva: World Economic Forum, 1994). Also see various issues of this publication for earlier years.

In addition, Price Waterhouse's Doing Business in... publication series provides a verbal description of the imposition of price controls in various product categories for countries covered by the series. When available, this information was used to rate the countries not covered by the data from the World Competitiveness Report. In some instances, supplementary information from country sources was also used. These descriptive data were used to place countries into various categories indicating the coverage of price controls as a share of the economy. The more widespread the use of price controls throughout the economy, the lower the rating.

The country ratings for this variable and additional details concerning their derivation are provided in Table II-C of Appendix II. Since the source data for this variable were only available in 1990 and 1994, it was not included in the 1975, 1980, and 1985 indexes.

II-D: Freedom to Enter and Compete in Markets.

The freedom to enter and compete in product and labor markets is highly important. Governments often require licenses and/or impose other restraints that limit the entry of firms into various business activities and of individuals into various occupations.

Data Source and Methodology. The data source of this rating was the Freedom House, Freedom in the World: The Annual Survey of Political Rights and Civil Liberties, 1994-95. In recent years the Freedom House annual survey used to rate the political and civil liberties of countries has included a sub-category on the economic freedom of businesses and cooperatives to compete in the marketplace (Item 9 on the Freedom House checklist of 13 civil liberty categories). Each country was given a rating of 0 to 4 with a rating of 4 indicating the countries for which businesses and cooperatives were most free to compete. The actual ratings for the specific checklist items were unavailable in the Annual Survey publication. However, Joseph Ryan, a senior scholar at the Freedom House, graciously supplied them to us.Note We transformed the 0 to 4 rating of Freedom House to our 0 to 10 scale (0 = 0, 1 = 2.5, 2 = 5, 3 = 7.5 and 4 = 10). The ratings for each country are presented in Table II-D of Appendix II.

II-E: Equality of Citizens Under The Law and Access of Citizens to a Nondiscriminatory Judiciary.

A legal structure that clearly defines property rights, enforces contracts, and provides a mutually agreeable mechanism for the settlement of contractual and property right disputes provides the foundation for a market economy. To the extent countries provide such a legal system, they are given higher ratings.

Data Sources and Methodology. The rating data for this component are also found in the annual survey of political and civil liberties conducted by the Freedom House. (See Freedom House, Survey of Political Rights and Civil Liberties, 1994-95.) Item 5 of the 13 item civil liberties checklist is: "Are citizens equal under the law, do they have access to an independent, non-discriminatory judiciary, and are they respected by the security forces?" Countries were given ratings ranging from 0 to 4. The higher the rating, the greater the degree of equality under the law. As in the case of the previous component, we transformed the 0 to 4 ratings of the Freedom House to our 0 to 10 scale. Since this variable was unavailable prior to 1994, it was only included in our 1995 index.

II-F: Freedom from Government Regulations and Policies that Cause Negative Real Interest Rates.

This component seeks to measure the impact of credit market regulations, interest rate controls, and government operation of the banking system on the freedom of citizens to borrow and lend. Many government regulations restrict entry into various banking activities and increase the cost of transactions between borrowers and lenders. As a result, the differential between the borrowing and the lending (or deposit) rate is unnecessarily large and exchange between borrowers and lenders is retarded.

Probably the most damaging way that government regulations and controls restrict exchanges in the credit market is through the combination of an inflationary monetary policy and interest rate controls.

Probably the most damaging way that government regulations and controls restrict exchanges in the credit market is through the combination of an inflationary monetary policy and interest rate controls. When the inflation rate exceeds the fixed interest rate, negative real interest rates occur. With negative real interest rates, the purchasing power of the principal and interest of savers actually declines when wealth is held in the form of domestic savings deposits or bonds. Thus, there is little incentive to save and thereby supply funds to the domestic capital market. "Capital flight" will result as domestic residents seek positive returns abroad and foreigners shun the country. Such policies will both diminish economic freedom and undermine the operation of the capital market.

Data Sources and Methodology. Our objective is to develop a rating for this component that will reflect both regulations that drive a wedge between the borrowing and lending interest rates and policies that lead to destructive negative real interest rates. First, we obtained the inflation rate, deposit interest rate, and lending interest rate data for each country from the International Monetary Fund, International Financial Statistics Yearbook (or the monthly version of this publication). These data were used to estimate real interest rates. The differential between the nominal deposit and lending interest rates was used as the estimate of the respective real rates.

The data on the real deposit and lending rates (and the differential between the two) during the three years prior to a rating year were then used to classify credit markets. Countries were given rating of ten when their real interest rates were consistently low and positive and the differential between the borrowing and lending rates relatively small. A slightly lower rating (an 8) was given if the differential between the two rates was larger (8% or more), while the deposit and lending real rates remained persistently positive. Countries with persistently negative real deposit and lending interest rates were assigned still lower ratings. The larger the negative rate, the lower the rating. If either the deposit or lending real interest rate was persistently negative by a single-digit amount, a country was given a score of 6. If both were persistently negative by a single-digit amount, 4 was assigned. If either the deposit or lending real interest rate was persistently negative by a double-digit amount, the country was given a rating of 2. A zero was assigned if both the borrowing and lending real interest rates were persistently negative by double-digit amounts or if hyperinflation had virtually eliminated the operation of the credit market. Table II-F of Appendix II provides the country rating for this component. (See the note at the end of that table for additional details on the derivation of the ratings.)

III. Takings and Discriminatory Taxation

When a government plays favorites-when it takes from one group in order to make transfers to others or when it imposes the costs of public services disproportionately on various groups-the government becomes an agent of plunder. Such actions conflict with economic freedom. This is equally true whether the policies are undertaken by a dictatorial political leader or a legislative majority.

Much of what modern states do involves taking from some in order to make transfers to others (often with the intent of "buying" their votes).

Much of what modern states do involves taking from some in order to make transfers to others (often with the intent of "buying" their votes). This is true for both the budgetary and regulatory policies of government. We have identified three areas where discriminatory actions in the political sphere are particularly important and where measurement is possible. These three areas are (a) subsidies and income transfers, (b) marginal tax rates, and (c) conscription.

III-A: Transfers and Subsidies as a Percent of GDP.

Transfers and subsidies violate the freedom of individuals to keep the value of their productivity. When governments tax income from one person in order to transfer it to another, they are denying individuals the fruits of their labors. This is true whether funds are transferred from the rich to the poor (or as is often the case, from the poor to the rich), from one racial group to another, or from the politically disorganized to the politically powerful. The taking of property (including labor services) without fully compensating the rightful owner is a per se violation of economic freedom. See Terry L. Anderson and P.J. Hill, The Birth of the Transfer Society (Palo Alto: Hoover Institution Press, 1980) and Richard A. Epstein, Takings: Private Property and the Power of Eminent Domain (Cambridge: Harvard University Press, 1985) for additional analysis of income transfers, the taking of private property, and economic freedomNote The ratio of transfers and subsidies to GDP indicates the degree to which various countries use the budget to engage in taking and transfer activities. Thus, countries with large transfer sectors are given low ratings.

Data Sources and Methodology. Data on transfers and subsidies are supplied by the International Monetary Fund, Government Finance Statistics Yearbook, (various years). The GDP data are from the World Bank, World Tables, 1994. In addition, supplementary data on transfers and subsides from Inter- American Development Bank, Economic and Social Progress in Latin America, 1994 Report were also utilized. Special care was taken to ensure that the subsidies and transfers for all levels of government were counted, and that intergovernmental transfers were omitted in order to avoid double-counting.

Following the general procedures used for other continuous variables, the 1985 data on transfers and subsidies as a percent of GDP were arranged from highest to lowest and used to form a zero to ten conversion table. Countries with a small (large) transfer sector were rated high (low). The raw data, the ratings, and the conversion table showing the relationship between the size of the transfer sector and the rating for each year are presented in Table III-A (Appendix II).

III-B: Top Marginal Tax Rate (and Income Threshold at Which It Applies).

High marginal tax rates discriminate against productive citizens and deny them the fruits of their labor.

In essence, high marginal tax rates seize wealth from taxpayers without providing them an equivalent increase in service.

In essence, such rates seize wealth from taxpayers without providing them an equivalent increase in service. To the extent that they raise revenue, high marginal tax rates force some people to pay for services provided to others.

Generally, high marginal rates are a very inefficient form of raising government revenue, since people will often reduce their work effort and make other adjustments when a large proportion of their additional earnings is taxed away. Thus, high marginal tax rates impose an additional cost (and loss of freedom) over and above the revenues transferred to the government. Perhaps the following example will help illustrate this point. Suppose that the government threw everyone who earned more than $100,000 per year in jail for six months. In essence, this is a very high marginal tax rate. A tax scheme like this would substantially reduce economic freedom over and above the revenue it generated for the government. In fact, it probably would not raise much revenue. Nonetheless, the impact on economic freedom would be substantial. So it is with high marginal tax rates-they impose a discriminatory cost on people over and above the cost of the revenue they generate.

Data Sources and Methodology. Data on the top marginal taxes and the income threshold at which they apply were assembled from Price Waterhouse, Individual Taxes: A Worldwide Summary, (various issues). The exchange rate at beginning of the year was used to convert the income threshold data to U.S. dollars, and the U.S. Consumer Price Index was used to convert the threshold to real 1982-84 dollars. A conversion table was designed and used to assign each country a zero to ten rating based on the country's top marginal tax rate and the income threshold at which the rate took effect. Countries with low marginal tax rates and a high income threshold for the initial application of the top rate were given high scores (toward the ten end of the scale). Correspondingly, countries with high marginal tax rates and low income thresholds were assigned a low rating (toward the zero end of the scale). When there was a range of top marginal tax rates within a country, as was sometimes the case under federal systems of government, the midpoint of the top rates for the country was used to derive the rating for this variable.Note The data on the top marginal tax rates and their effective income thresholds, as well as the associated ratings for each country are presented in Table III-B of Appendix II. The conversion table used to derive the ratings from the tax rate and income threshold data is presented in the source note at the end of this table.

III-C: The Use of Conscripts to Obtain Military Personnel.

Conscription prevents individuals from selling their labor services to those who offer them the most attractive compensation package. In essence, military conscription denies draftees the property right to their labor services. While national defense is an acceptable activity for a "protective and productive" state, the cost of that protection should be imposed on all citizens. Singling out a specific group (for example, young men or young women) to pay for something that benefits all is a clear "taking" and a discriminatory form of taxation. The military draft falls into this category and, as such, is a violation of economic freedom. Some may argue that military conscription can sometimes promote economic freedom in the long run by helping to protect a country against an external threat imposed by an authoritarian aggressor. This may well be true, but we do not know how to measure the intensity of the potential future threat. Thus, we were unable to adjust for it.Note

Data Sources and Methodology. International Institute for Strategic Studies, The Military Balance, (various issues) indicate countries which use conscription to obtain military personal. This publication provided the source material for this component. There are only two possible values for this component- conscription is either present or absent. Nations that rely on wage payments rather than conscription to obtain military personnel are given a rating of 10. Those that utilize conscription earn a zero. Appendix II, Table III-C indicates whether countries utilize conscription and provides the ratings for each country.

IV. Restraints On International Exchange

Since the time of Adam Smith, economists of almost all persuasions have recognized the efficiency gains derived from free trade. Free trade makes it possible for the citizens of different countries to gain from division of labor, economies of scale, and specialization in areas where they have a comparative advantage. As a result, trading partners can produce a larger joint output and each can derive mutual gain. See Henry George, Protectionism or Free Trade 1886, reprinted edition, (New York: Robert Schalkenbach Foundation, 1980) for an excellent analysis of the economies of trade restrictions.Note

This standard economic argument, however, is not our major focus. We are interested in international trade because freedom of exchange is also a central tenet of economic freedom. It makes no difference if the potential trading partners live in different countries. Restrictions on exchange-both domestic and inter- national-are per se violations of economic freedom. See Stephen T. Easton, "Rating Economic Freedom: International Trade and Financial Arrangements," in Stephen T. Easton and Michael A. Walker (eds.), Rating Global Economic Freedom, (Vancouver: The Fraser Institute, 1992) for additional analysis on this topic.Note

It makes no difference if the potential trading partners live in different countries. Restrictions on exchange-both domestic and international-are a per se violation of
economic freedom.

Prodded by interest groups, governments use a variety of devices to restrain international trade. Tariffs, export duties, quotas, exchange rate controls, "buy-local" policies, marketing boards, restrictions on foreign ownership (or on the repatriation of the capital, interest, or dividends to owners), monopoly grants to domestic citizens, and discriminatory licensing or taxation that limits access to credit, foreign exchange, or other markets-all of these devices retard the ability of domestic citizens to engage in exchange activities with foreigners. Thus, they are a violation of economic freedom. Our task is to measure the extent to which various countries have imposed such restrictions. Toward this end, we will focus on four general types of restrictions: tariffs and other taxes on international trade, exchange rate controls, regulations that reduce the volume of trade, and regulations limiting capital market transactions.

IV-A: Taxes on International Trade as a Percent of Exports Plus Imports.

Taxes on international trade limit the freedom of domestic residents to trade with foreigners. Tariffs and taxes on exports drive a wedge between what the seller receives and what the buyer pays. Thus, they reduce the volume of international trade, lower consumer and producer surplus, and, most relevant to our concerns, retard economic freedom.

Data Sources and Methodology. Data on revenue derived from "taxes on international trade transactions" were obtained from the International Monetary Fund, Government Finance Statistics Yearbook, (various issues). These data along with the information on exports and imports (World Bank, World Tables, 1994) were used to derive an average tax rate on international trade. As this tax wedge increases, the freedom of domestics to trade with foreigners is retarded and therefore the country is given a lower rating. There is one significant deficiency with this approach as a measure of the loss of freedom due to the imposition of trade taxes-extremely high taxes on goods may limit trade so much that the duties will raise little revenue. A totally prohibitive marginal tax rate on a good would generate no revenue at all.Note As long as a nation's taxes on international trade are in the normal range-that is, in the range where higher tax rates lead to an increase in tax revenues-there will be a direct relationship between revenues from taxes imposed on international trade and the restrictive effects of the taxes on trade (and thus, economic freedom). However, if taxes on some goods are raised so high that they are in the prohibitive range-the range where higher taxes mean less revenues-then the revenues from trade taxes will understate the restrictive effects of the taxes and their adverse impact on economic freedom.

Taxes on international trade reduce the volume of trade, lower consumer and producer surplus, and, most relevant to our concerns, retard economic freedom.

Table IV-A of Appendix II presents tax revenues on international trade as a percent of exports plus imports for the years of our study. Following our usual procedures for continuous variables, the 1985 statistics were arrayed from lowest to highest and used to derive the conversion intervals for the base year (1985). These intervals were then used to rate each country in the other years. Of course, countries with the lowest average tax rates on international trade were given the highest ratings. See Table IV of Appendix II for the trade tax data and accompanying country ratings.

IV-B: Difference Between the Official Exchange Rate and the Black Market Rate.

If people in a country are going to trade with outsiders, they must be able to convert their domestic currency to foreign exchange (other currencies). Exchange rate controls often make it difficult for them to do so. Currency convertibility is no problem if a nation permits its domestic currency to be freely and legally converted to other currencies in the foreign exchange market. Many governments, however, fix the price of their currency and prohibit currency exchanges at other prices.

Fixed exchange rates need not interfere with the free convertibility of a currency if a country is willing to subject its monetary policy to maintenance of the fixed rates. Put another way, a country can either (1) follow an independent monetary policy and allow its exchange rate to fluctuate or (2) tie its monetary policy to the maintenance of the fixed exchange rate. It cannot, however, maintain convertibility if it is going to both fix the exchange rate value of its currency and follow an independent monetary policy. It must either give up its monetary independence or allow its exchange rate to fluctuate if its currency is going to be fully convertible with other currencies.

Some countries, particularly small ones, have chosen to forgo monetary independence and tie the exchange rate value of their domestic currency to a widely accepted currency like the U.S. dollar, the German mark, or the French franc. For example, Hong Kong has followed this strategy: its currency is tied to the U.S. dollar. Instead of a central bank that conducts monetary policy, Hong Kong has a currency board that issues HK dollars in exchange for U.S. dollars at a fixed rate of 7.7 Hong Kong dollars = $1 U.S. dollar. The HK dollars issued by the currency board are fully convertible and 100 percent backed with U.S. dollars and U.S. bonds dominated in dollars. If people want more Hong Kong dollars, they can obtain them by providing the currency board with U.S. dollars (at the fixed rate), which the board then invests in U.S. government bonds. Other countries have also followed this approach. Singapore has tied its currency to a bundle of foreign currencies. Several African countries, including Benin, Cameroon, Central African Republic, Chad, Congo Peoples Republic, Cote d'Ivoire, Gabon, Niger, Senegal and Togo, tie their currency to the French franc. Note Fixing the exchange rate value of one's currency works fine as long as the country is willing to forgo control over its monetary policy.

The black market exchange rate provides an indicator of the degree to which ex change rate controls limit trade with foreigners.

Problems arise, however, when a country attempts to both fix the exchange rate value of its currency and conduct an independent monetary policy, particularly if the latter is inflationary. When this happens, the fixed exchange rate value of the domestic currency will exceed the market level. Since the prices of foreign currencies are fixed below equilibrium, a shortage of foreign exchange will result and black markets will develop. The more a currency is out of line with the forces of supply and demand, the larger the black market premium and greater the adverse impact of the exchange rate controls on the volume of international trade. Thus, the black market exchange rate provides an indicator of the degree to which exchange rate controls limit trade with foreigners.

Data Sources and Methodology. International Currency Analysis, Inc. World Currency Yearbook (various issues), provided the information on the size of the black market exchange rate premium through 1990. More recently, the monthly newsletter of this organization was the source for the black market rate between various currencies and the U.S. dollar. In turn, this rate can be used to calculate the black market premium.

The larger the black market premium, the more restrictive the impact on international trade. Thus, countries with the highest black market premiums are given the lowest ratings. Since this is a continuous variable, the 1985 data were arrayed from the lowest to the highest and the intervals that allocated an equal number of countries to each of the 11 rating categories were derived. In turn, this transformation table was used to rate the countries for the other years. The information on the black market exchange rate premium, the associated ratings for each country and transformation table are all presented in Table IV-B of Appendix II.

IV-C: Actual Size of Trade Sector Compared to the Expected Size.

In addition to tariffs and exchange rate controls, many nations restrain trade through the use of quotas, monopoly grants, "buy local" schemes, and various other types of discriminatory regulations. Trade restrictions of this type are every bit as much a violation of economic freedom as tariffs, export duties, and exchange rate controls. Ignoring such restrictions would be a serious omission.

In addition to tariffs and exchange rate controls, many nations restrain trade through the use of quotas, monopoly grants, "buy local" schemes, and various other types of discriminatory regulations.

Data Sources and Methodology. Since these restrictions are numerous, complex, and heterogeneous, their direct measurement is an insurmountable task. Thus, we devised an indirect method designed to approximate their severity. Regression analysis was used to estimate the expected size of the trade sector for each country, given its geographic size, population, and location relative to potential trading partners.

We hypothesized that the expected size of a country's trade sector is a function of the following five variables: (1) geographic size, (2) population, (3) a dummy variable indicating that the country is land-locked and therefore restricted in its use of oceans for transport purposes, (4) a dummy variable indicating that the country has potential trading partners within 150 miles of its borders but less than 50 percent of its population resides within this distance from the potential trading partners, and (5) a dummy variable indicating that more than 50 percent of the country's population was located within 150 miles of a potential trading partner. The base for the last two variables is therefore countries that do not have a potential trading partner within 150 miles.

Since geographically large countries tend to have many producers and consumers located long distances from potential foreign trading partners, physical size tends to reduce the expected size of the trade sector. Similarly, a large population will facilitate the ability of domestic producers to sell (and domestic consumers buy) in the domestic market while fully realizing the potential economies associated with large scale production. Thus, a negative sign is expected for the geographic size and population variables. A negative sign is also expected for land-locked countries. Finally, a positive sign is expected for the last two variables since having closer trading partners will tend to enhance the size of the trade sector. Regression analysis confirms each of these relationships.

This model was then used to derive an "expected size of the trade sector" for each country which was then compared with the actual size of the country's trade sector. If the actual size of a country's trade sector as a share of GDP was significantly smaller than expected (given its geographic size, population, and locational characteristics), this is consistent with the view that its trade sector was reduced as the result of quotas and other regulatory restraints. Such countries were given low ratings. In contrast, if the actual size of a nation's trade sector as a share of GDP was large relative to the expected size, this indicates that regulatory restrictions were minimal. Therefore, countries in this category were given high ratings. The data for the various components of the regression equation and the actual size of the trade sector were from the World Bank, World Tables and World Development Report.

Table IV-C of Appendix II provides the data on the actual size of the trade sector, the expected size, and the percentage difference between the two. This latter figure was used to derive the rating transformation table in the usual manner for continuous variables. This transformation table along with the associated country ratings are also presented in Table IV-C of Appendix II.

IV-D: Restrictions on the Freedom of Citizens to Engage in Capital Transactions with Foreigners.

Limitations on domestic investments by foreigners and the freedom of citizens to invest abroad restrict economic freedom and often lead to side effects such as political favoritism, bribes, and other forms of corruption.

Many countries require foreigners to get permission from the government in order to make an investment or remit its earnings. Sometimes these regulations reflect the presence of an inflexible exchange rate regime. In other instance, they are designed to protect domestic industries and/or centrally plan the investment of the economy. Often there are side effects such as political favoritism, bribes and other forms of corruption. Clearly, such regulations of capital movements are inconsistent with economic freedom.

Many governments also limit the freedom of their citizens to make either real property or financial investments abroad, or both. In some cases there is an outright prohibition and in other instances, permission to undertake an investment must be obtained from government authorities. These restrictions also conflict with economic freedom.

Data Sources and Methodology. International Monetary Fund, Exchange Arrangements and Exchange Restrictions (various issues) provides excellent descriptive data on the presence of restrictions, if any, that apply to both foreigners who want to make investments within the country and citizens wishing to make investments abroad. This descriptive information was used to classify and rate each country. A country was given a rating of ten when foreigners were free to undertake domestic investments and nationals were free to undertake investments abroad. As more and more restrictions were placed on the freedom of nationals to invest abroad and foreigners to invest domestically, a country was given a lower and lower rating. The source note at the end of Table IV- D of Appendix II provides the details on the various categories of restrictions and the ratings accompanying them. This table also provides the ratings for each country for the various years of our study.


ATTACHING WEIGHTS TO THE COMPONENTS

We have identified 17 elements where institutional arrangements and/or public policies exert a substantial influence on economic freedom. How can we aggregate these 17 elements into a summary index? If we could accurately measure the costs of the actions that prohibit or retard voluntary exchanges and/or mandate involuntary "transactions", we could use these figures to attach weights to the various components. Of course, data limitations generally prevent us from making such calculations.

There are several alternative methods that might be used to aggregate components of economic freedom into a summary index. Unfortunately, all of them have problems. Therefore, we will develop and present the results for three alternative summary indexes.

There are several alternative methods that might be used to aggregate components of economic freedom into a summary index. Unfortunately, there are problems associated with each of them. Therefore, we will develop and present results for three alternative summary indexes, each of which attaches different weights to the components. We now proceed to a discussion of how these indexes were developed and the deficiencies that accompany each.

Equal Impact Index Ie. The simplest alternative would be to take the position that since we do know the weight that should be attached to the various components, each should exert an equal impact on the index. Only one adjustment is required to achieve this objective-each variable must be assigned a weight equal to the inverse of its standard deviation. This is precisely what the summary index that we will refer to as Ie does. (The "e" refers to equal impact.) Each component in the Ie index is assigned a weight equal to the inverse of its standard deviation. Thus, less weight is given to a component when it has a great deal of variability across countries. Under this procedure, each of the components will exert an equal impact on the index. Exhibit 1-2 indicates both the standard deviation of the ratings across countries and the weights attached to each component when the Ie index is An adjustment of this type is particularly important when the index includes both continuous and binary variables. Since our rating procedure for continuous variables assigns an equal number of countries to each of 11 intervals during the base year, the standard deviation of these components will be equal and they will all be assigned the same weight in the Ie index (see Exhibit 1-2.) Since the standard deviations of the three binary variables (I-C. I-D, and III-C) were greater, the weights attached to these components were smaller. Failure to make this adjustment would result in the dominance of the index by the variables with the most variability.constructed.Note

Exhibit 1-2: The Weights Attached to Each Component in the Alternative Indexes

Survey Index Is1. An alternative approach would be to ask knowledgeable people to provide their estimates for the importance of each component (the relative size of the loss in economic freedom imposed by the restrictions encompassed in the component) and to use this survey data as a basis for attaching weights. Our summary index Is1 follows this procedure (the Is1 refers to the Index derived from the Survey 1 method). We constructed a survey instrument which described the 17 components in our index and asked the participants of the past three conferences on Measurement of Economic Freedom jointly sponsored by the Liberty Fund and Fraser Institute to provide us with their views concerning the weights that should be attached to each of the components. Since all of these people attended at least one of the conferences, we were reasonably sure of their familiarity with the concept of economic freedom and the factors that influence it.

Eighteen of the 40 individuals who received the questionnaire responded. Exhibit 1-2 (the second column under Is1) presents the average weight for each of the seventeen components derived from this survey. The survey weights were also adjusted for differences in the standard deviations of the various components. See previous endnote.Note The respondents were instructed to assign weights summing to 100 and to insert a zero weight for any component that they did not believe contributed to economic freedom. Nonetheless, at least 17 of the 18 respondents assigned a positive weight for each of the components.

As a comparison of the weights accompanying the Ie and Is1 indexes reveals, the survey respondents attached an above average weight to transfers and subsidies (III-A) and high marginal tax rates (III-B). At the other end of the scale, the respondents attached the least weight to the deposits abroad (I-D), the credit market (II-F), and the size of the trade sector (IV-C). Except for these five cases, the weights attached by the respondents to the other 12 variables were similar (prior to the adjustment for the differences in the standard deviations.) This indicates that the respondents believed these twelve factors were of similar importance as an indicator of economic freedom.

While this procedure is both understandable and simple, it still has a few deficiencies. First, survey methods are generally not favorites of economists. The views of the respondents-even knowledgeable respondents-may not accurately reflect the "true" importance of the various factors as indicators of economic freedom. There is also a second problem-the weights (or importance of the components) will in some cases vary across countries. For example, one would expect that freedom of exchange with foreigners will be more important for residents of small countries than for large ones. This suggests that the appropriate weights should vary across countries. Therefore to a degree, the weights might be thought of as an average that would be most appropriate for a typical country. The use of uniform techniques to derive estimates that we know will have a bias under certain circumstances is not particularly unusual. For example, we recognize that our methods of deriving GDP will understate the output of less developed countries since non-market and therefore uncounted productive activities will be greater for such countries than for modern industrial economies. In a similar manner, our index Is1 will overestimate the economic freedom of small countries with numerous restraints on international trade and underestimate the economic freedom of large countries with numerous restraints on international trade.Note

Survey Index Is2. A third approach to the problem of weights would be to ask a large number of people who are familiar with specific countries to rate those countries' overall economic freedom on a common scale (for example, zero to 100) and then attempt to regress various objective indicators of economic freedom (e.g. the ratings of our 17 components) on these country ratings in order to derive the "implicit" weights underlying the subjective aggregate ratings for each of the countries. If the subjective ratings for the various countries were "correct" then the regression coefficients would provide estimates for the weights of the components. While this option is attractive, there is a major practical problem-the number of countries is not large enough to provide for reliable simultaneous estimates of a model with 17 components. Thus, we were unable to develop a summary index based on this method.

However, we did pursue a modified form of this approach. Stephen Easton and Michael Walker conducted a survey from which they were able to derive a subjective aggregate rating for 33 countries, 31 of which are included in our analysis. Stephen T. Easton and Michael A. Walker, "A Survey Approach to Indexes of Economic Freedom," a paper presented to the Sixth Liberty Fund-Fraser Institute Symposium on Rating Economic Freedom held November 18-21, 1993 in Sonoma, California.Note We calculated the simple correlation coefficient for each of the variables in our index and the subjective country ratings of the Easton-Walker survey. Each component was then weighted according to the relative size of its correlation coefficient. If the ratings of a component across the 31 countries were highly correlated with the Easton-Walker country ratings, then the component was given a large weight. In contrast, components that were poorly correlated with the Easton-Walker index were given proportionally smaller weights. The weights for the components derived by this method are presented in Exhibit 1-2, column 4. We refer to the summary index derived by this procedure as Is2-the Survey 2 approach.


When the component weights are derived by this method, the government enterprise (II-B) and price controls (II-C) components receive the largest weights, 10.4 percent and 9.7 percent respectively. In contrast, the government consumption (II-A) and transfers and subsidies (III-A) components receive very little weight, less than 1 percent.

Some Final Thoughts on Weights. Given that there is no ideal solution to the problem of weights for the components, we generally present each of the three summary indexes. If we had to choose among these three, our preference would be for Is1 because it reflects the views of a sample of people who have thought seriously about both economic freedom and the importance of various ingredients of that freedom. We recognize that others may have different views with regard to the importance of the components in our index. If one thinks that alternative component weights would be preferable for any country (or in aggregate), the index can be recalculated from the ratings for each component.

When a country has either low or high ratings for all, or almost all, of the components, the weights attached to the various components will not exert much impact on the summary index.

In conclusion, we would like to make two additional points with regard to the component weights and evaluation of the summary indexes. First, when a country has either low or high ratings for all, or almost all, of the components, the weights attached to the various components will not exert much impact on the summary index. Under these circumstances, almost any sensible set of weights will lead to a high rating when the ratings for most of the components are high (and a low rating when the ratings for most of the components are low.) As we will see, a substantial number of the countries fall into one or the other of these categories. Second, the ability of the summary indexes to explain differences in economic growth across countries also provides evidence as to their merit. Economic theory indicates that the gains from specialization, exchange, and productive efficiency associated with economic freedom will tend to generate higher income levels and growth rates. Therefore, if our measures of economic freedom are related to the level and growth of income, this will enhance our confidence in their accuracy. We will address this subject in Chapter 4.

LOOKING AHEAD

In this chapter we defined the various components of our indexes and explained how these components are weighted in the three alternative indexes of economic freedom that we derive. The following chapter will present the country ratings for the components and the summary indexes for the 1993-95 period.


Chapter 2 Rating the Economic Freedom of Countries in 1993-1995, 1990, 1985, 1980, and 1975

Having explained how the index of economic freedom is constructed, we are now ready to present the data for the 103 countries (102 prior to the separation of Czechoslovakia into the Czech Republic and Slovak Republic in 1993) for which we were able to obtain reasonably complete data. This chapter focuses on three topics. First, we will present the component ratings, area ratings, and summary indexes for the 1993-1995 period for each country. These data will allow us to identify the strengths and weaknesses of each country and make comparisons across countries. Second, we will also present the summary ratings for the Top 15, Bottom 15, and selected other countries for 1975, 1980, 1985, 1990 and 1995. These data will permit us to observe the changes in the composition of country rankings during the last two decades. Finally, we will identify two groups-the first comprised of countries with persistently high levels and the second with persistently low levels-of economic freedom throughout the entire period of our study.

COUNTRY RATINGS IN 1993-1995

Exhibit 2-1 presents the 1993-1995 ratings for each of the 17 components in our index, as well as area ratings, and the three alternative summary indexes. The area ratings and the summary indexes merely reflect the aggregation of the component ratings which range from zero to ten. The higher the rating, the greater the estimated degree of economic freedom.

Click here to display Exhibit 2.1: Component, Area, and Summary Index Ratings: 1993 - 95


Some Reflections on the Component Ratings

The country component ratings ranging from zero to ten for each of the 17 components are presented in Part 1 of Exhibit 2-1.

Since both the summary and area ratings are merely an aggregation of the component ratings, it is important for the reader to understand the meaning of the The underlying data used to derive the country ratings for each of the 17 components in our index are contained in the 17 tables of Appendix II. The Roman numeral and letter labels for these tables match the area and letter labels for the components of our index. The note at the end of each table in Appendix II provides a detailed explanation of how the ratings for the component were derived. Readers interested in the details of the relationship between the underlying data and the component ratings will want to review these tables carefully.latter.Note Let us look at the various component ratings for a few countries and consider their significance. France (and Sweden and Switzerland among several others) received a rating of ten for component I-A, monetary expansion adjusted for the estimated growth rate of potential output. Since the monetary expansion variable was continuous, the ten rating indicates that the rate of monetary expansion in France during the five years immediately prior to 1995 would have placed it in the top 1/11th of the countries during the base year (1985) in terms of the least monetary expansion adjusted for the potential growth of real output. Canada, Japan and Denmark (among others) received a rating of 9, indicating that the expansion in the money supply of these countries would have placed them in the second 1/11th of countries during the base year.

At the other end of the spectrum, Brazil received a rating of zero, indicating that the growth rate of its money supply during the five years immediately prior to 1995 would have placed it in the bottom 1/11th of countries-those with the highest growth rates of the money supply-during the base year. (Note: the annual growth rate of the money supply in Brazil was 1,233% during the five years immediately prior to the 1995 rating.) France, Sweden, Switzerland, Canada, Japan, Denmark and other countries with high ratings received them because they did not use monetary expansion to dilute the value of their monetary unit and thereby seize property from persons holding money during the 1990-94 period. On the other hand, Brazil, Argentina, Ecuador, Peru, Uruguay, and other countries with low ratings received them precisely because of their highly expansionary monetary policies.

The second component (I-B) in the index is the instability in the price level as measured by the standard deviation in the rate of inflation during the last five years. As previously discussed, fluctuations in the inflation rate increase uncertainty and retard time-dimension exchanges. When the rate of change in the price level is relatively constant, it will be more easily predictable; therefore it will exert less adverse impact on exchange. Thus, the countries with the lowest standard deviation (least variability) in the inflation rate are given the highest ratings. The ratings of ten of the United States, Canada, Australia and Japan, for example, indicate that the small variability in the inflation rate in each of these countries during 1990-1994 would have placed them in the top 1/11th of the countries with the least variability in the inflation rate during the base year period. The nine ratings for Finland, Ireland, and Italy indicate that while the 1990-1994 variability in the rate of inflation in these countries was low, it was slightly greater than for the countries receiving a rating of ten. At the other end of the spectrum, the zero ratings of Argentina, Brazil, and Nicaragua indicate that the fluctuations in the inflation rates of these countries during 1990-1994 would have placed them in the bottom 1/11th of all countries during the base year period.

The next two components, freedom to maintain a foreign currency bank account domestically (I-C) and freedom to maintain a bank account abroad (I-D) have only two possible outcomes-it is either legal or illegal to maintain these accounts. The ten ratings for the United States, Canada, Australia, and numerous other countries indicate that it was legal in the mid-1990s for the citizens of these countries to maintain accounts of this type. The zero ratings for Belize, Brazil, and Dominican Republic, for example, indicate that the citizens of these countries were not permitted to legally maintain these accounts in the mid-1990s.

A higher component rating indicates that the country's institutional arrangements and/or policy choices are more consistent with economic freedom in the specific category measured by the component.

Using the weights derived from our survey of experts (see Exhibit 1-2), the four components in the area of money and inflation (Area I) are aggregated into an Is1 area Of course, area ratings could also be derived by using the weights associated with the Ie and Is2 aggregated indexes. (See Exhibit 1-2 for the component weights associated with the alternative methods of aggregating the component ratings into area and summary ratings.) In most cases, the three alternative methods yield similar results. Thus, in the interest of