Explanatory Notes and Data Sources

Explanation of Component Ratings and Sources of Data

I-A The rating for this component is equal to: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. The Vi is the country's actual government consumption as a proportion of total consumption, while the Vmax and Vmin represent the maximum and minimum values for this component during the 1990 base year for the countries included in our analysis. Countries with a larger proportion of government expenditures received lower ratings. If the ratio of a country's government consumption to total consumption is close to the minimum value of this ratio during the 1990 base year, the country's rating will be close to 10. In contrast, if this ratio is close to the highest value during the base year, the rating will be close to zero.

Sources World Bank, 1997 World Development Indicators CD-ROM and International Monetary Fund, International Financial Statistics (various issues). The 1997 figures were primarily from the latter publication.

I-B The rating for this component is equal to: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. The Vi is the country's ratio of transfers and subsidies to GDP, while the Vmax and Vmin represent the maximum and minimum values of this component during the 1990 base year. The formula will generate lower ratings for countries with larger transfer sectors. When the size of a country's transfer sector approaches that of the country with the largest transfer sector during the base year, the rating of the country will approach zero.

Sources World Bank, 1997 World Development Indicators CD-ROM; International Monetary Fund, International Financial Statistics (various issues); International Monetary Fund, Government Finance Statistics Yearbook (various years); and Inter-American Development Bank, Economic and Social Progress in Latin America, 1994.

II-A Data on the number, composition, and share of output supplied by State-Operated Enterprises (SOEs) and government investment as a share of total investment were used to construct the zero-to-10 ratings. Countries with more government enterprise and government investment received lower ratings. When there were few SOEs and government investment was generally less than 15 percent of total investment, countries were given a rating of 10. When there were few SOEs other than those involved in industries where economies of scale reduced the effectiveness of competition (e.g., power generation) and government investment was between 15 and 20 percent of the total, countries received a rating of eight. When there were, again, few SOEs other than those involved in energy and other such industries and government investment was between about 20 and 25 percent of the total, countries were rated at seven. When SOEs were present in the energy, transportation, and communication sectors of the economy and government investment was between about 25 and 30 percent of the total, countries were assigned a rating of six. When a substantial number of SOEs operated in many sectors, including manufacturing, and government investment was generally between 30 and 40 percent of the total, countries received a rating of four. When numerous SOEs operated in many sectors, including retail sales, and government investment was between about 40 and 50 percent of the total, countries were rated at two. A zero rating was assigned when the economy was dominated by SOEs and government investment exceeded 50 percent of the total.

Sources World Bank Policy Research Report, Bureaucrats in Business (1995); Rexford A. Ahene and Bernard S. Katz, eds., Privatization and Investment in Sub-Saharan Africa (1992); Manuel Sanchez and Rossana Corona, eds., Privatization in Latin America (1993); Iliya Harik and Denis J. Sullivan, eds., Privatization and Liberalization in the Middle East (1992); OECD, Economic Surveys (various issues); and L. Bouten and M. Sumlinski, Trends in Private Investment in Developing Countries: Statistics for 1970-1995.

II-B The more widespread the use of price controls, the lower the rating. The survey data of the International Institute for Management Development (IMD), World Competitiveness Report, 1990 and 1997, were used to rate the 46 countries (mostly developed economies) covered by this report. For other countries, the Price Waterhouse Doing Business in . . . series and other sources were used to categorize countries. Countries were given a rating of 10 if no price controls or marketing boards were present. When price controls were limited to industries where economies of scale may reduce the effectiveness of competition (e.g., power generation), a country was given a rating of eight. When price controls were applied in only a few other industries, such as agriculture, a country was given a rating of six. When price controls were levied on energy, agriculture, and many other stable products that are widely purchased by households, a rating of four was given. When price controls applied to a significant number of products in both agriculture and manufacturing, the rating was two. A rating of zero was given when there was widespread use of price controls throughout various sectors of the economy.

Sources IMD, World Competitiveness Report (various issues); Price Waterhouse, Doing Business in . . . publication series; World Bank, Adjustment in Africa: Reforms, Results, and the Road Ahead (1994); and U.S. State Department, Country Reports on Economic Policy and Trade Practices (various years).

II-C Data on the top marginal tax rates and the income thresholds at which they take effect were used to construct a rating grid. Countries with higher marginal tax rates that take effect at lower income thresholds received lower ratings. The income threshold data were converted from local currency to 1982-84 U.S. dollars (using beginning-of-year exchange rates and the U.S. Consumer Price Index). See Economic Freedom of the World: 1997 Report, page 265, for the precise relationship between a country's rating and its top marginal tax and income threshold.

Source Price Waterhouse, Individual Taxes: A Worldwide Summary (various issues).

II-D Data on the use and duration of military conscription were used to construct rating intervals. Countries with longer conscription periods received lower ratings. A rating of 10 was assigned to countries without military conscription. When the length of conscription was six months or less, countries were given a rating of five. When the length of conscription was more than six months but not more than twelve months, countries were rated at three. When length of conscription was more than twelve months but not more than eighteen months, countries were assigned a rating of one. When conscription periods exceeded eighteen months, countries were rated zero.

Source International Institute for Strategic Studies, The Military Balance (various issues).

III-A The M1 money supply figures were used to measure the growth rate of the money supply. The rating is equal to: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the average annual growth rate of the money supply during the last five years adjusted for the growth of real GDP during the previous 10 years. The values for Vmin and Vmax were set at zero and 50 percent, respectively. Therefore, if the adjusted growth rate of the money supply during the last five years was zero, indicating that money growth was equal to the long-term growth of real output, the formula generates a rating of 10. Ratings decline as the adjusted money supply growth differs from zero. When the adjusted annual money growth is equal to (or greater than) 50 percent, a rating of zero results.

Sources World Bank, 1997 World Development Indicators CD-ROM, with updates from International Monetary Fund, International Financial Statistics (various issues).

III-B The GDP deflator was used as the measure of inflation. When these data were unavailable, the Consumer Price Index was used. The following formula was used to determine the zero-to-10 scale rating for each country: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the country's standard deviation of the annual rate of inflation during the last five years. The values for Vmin and Vmax were set at zero and 25 percent, respectively. This procedure will allocate the highest ratings to the countries with least variation in the annual rate of inflation. A perfect 10 results when there is no variation in the rate of inflation over the five-year period. Ratings will decline toward zero as the standard deviation of the inflation rate approaches 25 percent annually.

Sources World Bank, 1997 World Development Indicators CD-ROM, with updates from International Monetary Fund, International Financial Statistics (various issues) .

III-C The zero-to-10 country ratings were derived by the following formula: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the rate of inflation during the most recent year. The values for Vmin and Vmax were set at zero and 50 percent, respectively. The lower the rate of inflation, the higher the rating. Countries that achieve perfect price stability earn a perfect 10 rating. As the inflation rate moves toward a 50 percent annual rate, the rating for this component moves toward zero. A zero rating is assigned to all countries with an inflation rate of 50 percent or more.

Sources World Bank, 1997 World Development Indicators CD-ROM, with updates from International Monetary Fund, International Financial Statistics (various issues) .

IV-A; IV-B When foreign currency bank accounts were permissible without restrictions, the rating was 10; when these accounts were restricted, the rating was zero.

Sources Currency Data and Intelligence, Inc., World Currency Yearbook (various issues) and International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions (various issues).

IV-C A 10 rating indicates that citizens are allowed to conduct both current and capital account foreign exchange transactions without having to obtain special permission from the monetary authorities. A zero indicates that there are restrictions on the convertibility of the domestic currency. The most common restrictions on this freedom are repatriation and surrender requirements. Repatriation requirements refer to the obligation of exporters to bring into the country export proceeds either by selling them in the foreign exchange market or depositing them in authorized accounts. Surrender requirements refer to regulations requiring the recipient of export proceeds to sell any foreign exchange proceeds (sometimes at a specified exchange rate) to the central bank or exchange dealers authorized for this purpose.

Source International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions (various issues).

V-A Countries with less risk of confiscation received higher ratings.

Source PRS Group, International Country Risk Guide (various issues).

V-B Countries with less risk of contract repudiation by the government received higher ratings.

Source PRS Group, International Country Risk Guide (various issues).

V-C Countries with legal institutions that were more supportive of the principles of rule of law received higher ratings. The original data were converted to fit a zero-to-10 scale.

Source PRS Group, International Country Risk Guide (various issues).

VI-A (i) The following formula was used to derive the ratings for this component: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the revenue derived from taxes on international trade as a share of the trade sector. The values for Vmin and Vmax were set at zero and 15 percent, respectively. This formula leads to lower ratings as the average tax rate on international trade increases. Countries with no specific taxes on international trade earn a perfect 10. As the revenues from these taxes rise toward 15 percent of international trade, ratings decline toward zero. (Note: except for two or three extreme observations, the revenues from taxes on international trade as a share of the trade sector are within the zero to 15 percent range.)

Sources International Monetary Fund, Government Finance Statistics Yearbook (various issues) and International Monetary Fund, International Financial Statistics (various issues).

VI-A (ii) The formula used to calculate the zero-to-10 rating for each country was: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the country's mean tariff rate. The values for Vmin and Vmax were set at zero and 50 percent, respectively. This formula will allocate a rating of 10 to countries that do not impose tariffs, As the mean tariff rate increases, countries are assigned lower ratings. The rating will decline toward zero as the mean tariff rate approaches 50 percent. (Note: except for two or three extreme observations, all countries have mean tariff rates within this zero to 50 percent range.)

Sources OECD, Indicators of Tariff and Non-tariff Trade Barriers (1996); World Bank, 1997 World Development Indicators CD-ROM ; J. Michael Finger, Merlinda D. Ingco, and Ulrich Reincke, Statistics on Tariff Concessions Given and Received (1996); Judith M. Dean, Seema Desai, and James Riedel, Trade Policy Reform in Developing Countries Since 1985: A Review of the Evidence (1994); GATT, The Tokyo Round of Multilateral Trade Negotiations, Vol. II: Supplementary Report (1979); UNCTAD, Revitalizing Development, Growth and International Trade: Assessment and Policy Options (1987); R. Erzan and K. Kuwahara, "The Profile of Protection in Developing Countries," UNCTAD Review 1: 1 (1989): 29-49; and Inter-American Development Bank (data supplied to the authors).

VI-A (iii) Compared to a uniform tariff, wide variation in tariff rates exerts a more restrictive impact on trade, and therefore on economic freedom. Thus, countries with greater variation in their tariff rates should be given lower ratings. The formula used to calculate the zero-to-10 ratings for this component was: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi represents the standard deviation of the country's tariff rates. The values for Vmin and Vmax were set at zero and 25 percent, respectively. This formula will allocate a rating of 10 to countries that impose a uniform tariff. As the standard deviation of tariff rates increases toward 25 percent, ratings decline toward zero. (Note: except a few very extreme observations, the standard deviations of the tariff rates for the countries in our study fall within this zero to 25 percent range.)

Sources OECD, Indicators of Tariff and Non-tariff Trade Barriers (1996); World Bank, 1997 World Development Indicators CD-ROM ; Jang-Wha Lee and Phillip Swagel, "Trade Barriers and Trade Flows Across Countries and Industries," NBER Working Paper Series, No. 4799 (1994); and Inter-American Development Bank (data supplied to the authors).

VI-B (i) The formula used to calculate the ratings for this component was: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi indicates the share of the trade sector covered by non-tariff restrictions. During the 1990 base year, this figure ranged from a low of zero to a high of 100 percent. Thus, the values for Vmin and Vmax were set at zero and 100 percent, respectively. This formula will allocate a rating of 10 to countries that do not impose non-tariff trade barriers. Ratings will decline toward zero as the share of the trade sector covered by restrictions increases toward 100 percent. Thus, countries with larger percentages of trade subject to non-tariff restraints receive lower ratings.

Sources UNCTAD, Directory of Import Regimes-Part 1 (1994); World Bank, 1997 World Development Indicators CD-ROM ; Sam Laird and Alexander Yeats, Quantitative Methods for Trade Barrier Analysis (1990); OECD, Indicators of Tariff and Non-tariff Trade Barriers (1996); and World Bank, Adjustment in Africa: Reforms, Results, and the Road Ahead (1994).

VI-B (ii) Regression analysis was used to derive an expected size of the trade sector based on the country's population, geographic size, and location. The actual size of the trade sector was then compared with the expected size for the country. If the actual size of the trade sector is greater than expected, this figure will be positive. If it is less than expected, the number will be negative. The percent change of the negative numbers was adjusted to make it symmetrical with the percent change of the positive numbers. The following formula was used to place the figures on a zero-to-10 scale: (Vi - Vmin) / (Vmax - Vmin) multiplied by 10. Vi is the country's actual value for the component. Vmax and Vmin were set at 100 percent and minus 50 percent, respectively. (Note: minus 50 percent is symmetrical with positive 100 percent.) This procedure allocates higher ratings to countries with large trade sectors compared to what would be expected, given their population, geographic size, and location. On the other hand, countries with small trade sectors relative to the expected size receive lower ratings.

Sources World Bank, 1997 World Development Indicators CD-ROM ; International Monetary Fund, International Financial Statistics (various issues); and Central Intelligence Agency, 1997 World Factbook.

VI-C The formula used to calculate the zero-to-10 ratings for this component was: (Vmax - Vi) / (Vmax - Vmin) multiplied by 10. Vi is the country's black market exchange rate premium. The values for Vmin and Vmax were set at zero and 50 percent, respectively. This formula will allocate a rating of 10 to countries without a black market exchange rate, i.e., those with a domestic currency that is fully convertible without restrictions. When exchange rate controls are present and a black market exists, the ratings will decline toward zero as the black market premium increases toward 50 percent. A zero rating is given when the black market premium is equal to or greater than 50 percent.

Sources Currency Data and Intelligence, Inc., World Currency Yearbook (various issues of the yearbook and the monthly report supplement) and International Monetary Fund, International Financial Statistics (various issues).

VII-A Data on the percentage of bank deposits held in privately owned banks were used to construct rating intervals. Countries with larger shares of privately held deposits received higher ratings. When privately held deposits totalled between 95 and 100 percent, countries were given a rating of 10. When private deposits constituted between 75 and 95 percent of the total, a rating of eight was assigned. When private deposits were between 40 and 75 percent of the total, the rating was five. When private deposits totalled between 10 and 40 percent, countries received a rating of two. A zero rating was assigned when private deposits were 10 percent or less of the total.

Sources Euromoney Publications, The Telrate Bank Register (various editions); World Bank, Adjustment in Africa: Reforms, Results, and the Road Ahead (1994); Price Waterhouse, Doing Business in . . . publication series; H.T. Patrick and Y.C. Park, eds., The Financial Development of Japan, Korea, and Taiwan: Growth, Repression, and Liberalization (1994); D.C. Cole and B.F. Slade, Building a Modern Financial System: The Indonesian Experience (1996); and information supplied by member institutes of the Economic Freedom Network.

VII-B For this component, higher values are indicative of greater economic freedom. Thus, the formula used to derive the country ratings for this component was: (Vi - Vmin) / (Vmax - Vmin) multiplied by 10. Vi is the share of the country's total domestic credit allocated to the private sector. Vmax is the maximum value and Vmin the minimum value for the figure during the 1990 base year. Respectively, these figures were 99.9 percent and 10.0 percent. The formula allocates higher ratings as the share of credit extended to the private sector increases. A country's rating will be close to 10 when the private sector's share of domestic credit is near the base-year maximum (99.9 percent). A rating near zero results when the private sector share of credit is close to the base-year minimum (10.0 percent).

Sources International Monetary Fund, International Financial Statistics (the 1997 yearbook and June 1998 monthly supplement) and Statistical Yearbook of the Republic of China (1996).

VII-C Data on credit market controls and regulations were used to construct rating intervals. Countries with market-determined interest rates, stable monetary policy, and positive real deposit and lending rates received higher ratings. When interest rates were determined primarily by market forces and the real rates were positive, countries were given a rating of 10. When interest rates were primarily market-determined but the real rates were sometimes slightly negative (less than 5 percent) or the differential between the deposit and lending rates was large (8 percent or more), countries received a rating of eight. When the real deposit or lending rate was persistently negative by a single-digit amount or the differential between them was regulated by the government, countries were rated at six. When the deposit and lending rates were fixed by the government and the real rates were often negative by single-digit amounts, countries were assigned a rating of four. When the real deposit or lending rate was persistently negative by a double-digit amount, countries received a rating of two. A zero rating was assigned when the deposit and lending rates were fixed by the government and real rates were persistently negative by double-digit amounts or hyperinflation had virtually eliminated the credit market.

Source International Monetary Fund, International Financial Statistics Yearbook (various issues, as well as the monthly supplements).

VII-D Descriptive data on capital market arrangements were used to place countries into rating categories. Countries with more restrictions on foreign capital transactions received lower ratings. When domestic investments by foreigners and foreign investments by citizens were unrestricted, countries were given a rating of 10. When these investments were restricted only in a few industries (e.g., banking, defence, and telecommunications), countries were assigned a rating of eight. When these investments were permitted but regulatory restrictions slowed the mobility of capital, countries were rated at five. When either domestic investments by foreigners or foreign investments by citizens required approval from government authorities, countries received a rating of two. A zero rating was assigned when both domestic investments by foreigners and foreign investments by citizens required government approval.

Sources International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions (various issues) and Price Waterhouse, Doing Business in º publication series.

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