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Economic Freedom


Rating Global Economic Freedom

Edited by

Stephen T. Easton and Michael A. Walker

The Fraser Institute, Vancouver, British Columbia, Canada

Copyright (c) 1992 by The Fraser Institute. All rights reserved. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews.

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


THIS VOLUME IS THE THIRD in a series of books reporting on a program of research and discussion in The Fraser Institute Rating Economic Freedom project. The project has emerged out of a series of symposia which are part of the program of the Liberty Fund Inc. and which are designed to explore the relationships among civil, economic and political freedom, and to devise methods of theoretically isolating these concepts and providing measurements of them.

Four such symposia have been held. The first held in the Napa Valley, California was prompted by Milton and Rose Friedman's comment in the book Capitalism and Freedom that "historical experience 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." One of the obvious questions that occupied the first colloquium was whether or not political freedom in the sense of freedom to elect one's political representatives is a necessary condition for maintenance of a competitive markets approach to economic organization. This became clearer in the first symposium and the ones that followed.

The idea of economic freedom is a difficult one to articulate. This is particularly the case as economists are wont to be precise, and there is as yet no unambiguous, clear conceptual definition of economic freedom to which most people are willing to subscribe. The Liberty Fund-Fraser Institute conferences on economic freedom have followed this issue along two distinct paths. The first is theoretical, and the second is empirical. Most of the authors have proposed one definition or another of economic liberty, or at least impediments to it. In designing empirical measures to correspond to their notions, they have frequently come face to face with both the limitations of their characterization of economic freedom, and the adequacy with which they could measure it.

But unlike other efforts of pure philosophy, our authors have made the effort to draw the relevant evidence to the theory wherever possible. It is worth reminding the reader that these papers have been drawn from two conferences hosted by the Liberty Fund and The Fraser Institute. The authors were working from relatively specific guidelines at both conferences, but these differed as the second built upon the contributions of the first. At the first conference, authors were asked to assess economic freedom in sectors of the economy for a number of different countries. At the second, some were asked to provide a candidate index for future research in comparing countries. In both cases there were many measures proposed and many issues developed that will serve as guides for future research.

The book has been divided into three sections corresponding to emphasis since most papers deal in some measure with both theory and empirics. The first section develops characterizations of economic freedom which range from philosophical to empirical. The four papers in this section share the general characteristic of delving into the problem of what kinds of restrictions should be measured as reducing economic freedom. The first paper, by Jones and Stockman, is primarily theoretical although it does sketch an agenda for empirical research. Easton's two papers rely on a definition of impediments to economic freedom that allows him to make measurements consistent with those made for consumer surplus. He calculates a number of indexes of economic freedom in the international sector, the first paper, and for a number of different countries in the second. Jack Carr considers an output based measure of impediments to economic freedom in his paper on capital markets. The second section stresses the development of indexes for a wide range of countries. Gwartney, Block and Lawson provide a consistent index for four different time periods for nearly eighty countries. Spindler and Miyake develop indexes consistent with suggestions made at previous conferences, while Scully and Slottje introduce factor analysis to collapse many variables into a few specific measures of economic freedom. Included, too, in this section is a survey or experiment conducted by Milton and Rose Friedman using the (Sea Ranch) participants as the sample. In their experiment, they tried to assess the ability of the group to rank eleven relatively well known countries according to their relative levels of economic freedom. The third section provides a look at particular problems. Denzau considers why particular prices are so politicized while DiLorenzo tackles the labour market and its distortions. Reynolds rounds out this section by reporting on particular expenditure and tax distortions in several Latin American countries.

Section I

Ronald W. Jones and Alan C. Stockman explore the consequences of defining the loss of economic freedom as the consumer and producer losses associated with third party constraints on transactions. Constraints include both prohibited and mandated behaviour. Their illustrations include the appropriate calculation of the losses associated with transfers, taxes, minimum consumption requirements, and both quantity and price coercion. Their framework is broad and exciting. They introduce the notion of "bundling" to pose the question of whether government restrictions on freedom should be treated individually and their costs computed, or whether the whole package of restrictions should be treated as one bundle. Such a distinction is important if we think of Peter being required to transfer one dollar to Paul and then Paul being forced to transfer one dollar back to Peter. If these are lump-sum transactions so that there is no distortion, on a bundled basis neither is worse off. On a transaction by transaction basis, both are worse off. In addition to providing a formal proof of the freedom reducing character of an "optimal" tariff, they raise a host of important conceptual problems with what we think we mean when we discuss economic freedom. Their framework, however, allows for the calculation of many of the costs of impediments to freedom and is an extension in both the theoretical and empirical literature on economic freedom.

Stephen Easton in exploring economic freedom in the international markets develops a quantitative measure of the loss in economic freedom as an extension to consumer surplus related measures. In particular he asserts that any distortion that impedes free exchange is a loss in freedom. Thus the value of the loss in freedom is the value of the distortion. Unlike the consumer surplus triangle, however, the direct loss in freedom includes both the rectangle (the tax revenue, for example) plus the triangle. In the case of international trade taxes the loss in freedom is complicated by the domestic production of importable goods. The imposition of a trade tax reallocates rent to domestic producers, and Easton includes this as an indirect loss in economic freedom. He shows that even though an "optimal tariff" will raise income, it will result in a loss in economic freedom.

In his second paper in this volume, Easton develops his measures of economic freedom for a variety of different countries. To this end he uses two gross indexes-the ratio of government expenditure to national income and the number of government employees relative to population. The former is a measure of direct government intervention by way of the tax "rectangle" distortion while the latter is an attempt to measure the impediments to freedom posed by government regulation. Each government worker is (heroically) assumed to impede economic freedom by the same amount. Easton aggregates the two measures by estimating the relative price in terms of income of each government employee and then summing the two measures. This he does through an immigration function. The level of immigration from country A to country B is written as a function of government expenditure and government employees per head and per capita income. The amount of income it would take to induce an additional person to immigrate (per change in the number of government employees) provides the implicit price of the regulatory environment. Thus his approach allows for an explicit pricing of the implied cost of regulation although his measure only considers immigration to the United States or Canada.

In examining capital markets, Jack Carr takes the stance that economic freedom is not an end in itself, and thus does not include it as a separate argument in the utility function. Anything that impedes free exchange will impinge on economic freedom, and this, he suggests reduces economic welfare. The notion of a definition of economic freedom, he argues, is like the definition of money. It is not independent of the uses to which it will be put. He proposes a measure that would be one of many factors of production in the aggregate output function. Economic freedom is seen as being the index that best helps predict aggregate output. His paper finds that deregulation of financial markets has increased freedom over the past twenty years in several of the more developed countries. To measure economic freedom in this sector he considers such features as the regulation of the central bank, the regulation of commercial banks, the regulation of capital flows and the regulation of the stock market. Among the group of six countries considered, West Germany was the least impeded, followed by Canada, the United Kingdom and the United States, while France was the most impeded of the group.

Section II

The second section explores a number of empirical measures of economic freedom typically involving a wide range of countries and the consideration of many possible contributors to an index. The first by Gwartney, Block and Lawson rates 79 countries along dimensions such as price stability, the size of government, discriminatory taxes, and restraint of international trade. Their index is devised for four periods, 1975, 1980, 1985 and 1988. It shows Hong Kong as the economically most free and permits an extensive ranking of the rest of the countries in the sample. Further analysis suggests that countries with high indexes of economic freedom tend to have grown more rapidly than those with poorer levels of economic freedom. Their extensive data set has been reproduced in the Appendix to the paper and is also available on diskette.

Gerald W. Scully and Daniel J. Slottje used 15 attributes (from foreign exchange regimes and freedom to travel, to the rule of law and conscription) combined into indexes weighted by the ranks of the attributes, the principle components of the attributes and a hedonic representation of the attributes. Based on these indexes Scully and Slottje provide an overall index that combines the component rankings into a final assessment.

Zane Spindler and Joanna Miyake provide a number of rankings for different countries by integrating several measures of economic freedom that were suggested at a previous conference. (Hence their use of the title the "homework" measures.)

Milton and Rose Friedman took the opportunity to survey the assembled group. Their point was that while we have different indexes available, we need some mechanism to test whether they conform to our own notions of usefulness. In particular, they argued, we must be sure that whatever ratified combination of objective factors we observe, they conform in some measure to our general sense of which countries are more economically free than others. By surveying the audience, they found considerable consistency of view (over the dozen countries they listed), but were not convinced that the other indexes which had been constructed reflected the general consensus too well.

Section III

Arthur Denzau argues that a critical feature of the restriction to economic freedom derives from the state's politicization of prices. Rather than being free to buy and sell, firms must first meet various political tests before they are allowed to buy and sell. Such added costs to the pricing mechanism reduced economic efficiency, but also formed the basis for the argument that the microenvironment is the critical location from which we should measure impediments to economic freedom. Detailed questionnaires form the basis for current research into the kinds of impediments present in the Peruvian economy.

Labour market freedom was assessed by Tom DiLorenzo for four major countries: the U.S., Canada, England, and Japan on the basis of some thirty categories. These categories included whether there was compulsory collective bargaining, agency shop, taxes on immigration, and temporary work permits to mention a few. Rather than construct a weighted index, Di Lorenzo ranks each of the thirty categories from zero to ten and sums them for each country. Although he finds England the most free and Japan the least in this small group, a number of categories could not be assessed, and he is reluctant to view these rankings as final.

Alan Reynolds considers the tax and expenditure policies of a number of countries. His paper reports in some detail on tax rates in a small group of Latin American countries in which the taxes (income tax, sales tax, social security tax, wealth tax and investor tax) are used to construct an overall rating of different tax regimes. In the final analysis, Bolivia scores relatively well (even when measures of the deficit are included) followed by El Salvador and Brazil, then Mexico and Argentina.

Concluding Remarks

These papers have devised many measures of economic freedom. Progress has taken place over the past several years. The ideas we have now of economic freedom are substantially advanced over those that we explored at the first conference. Although there is anything but universal agreement about which measures are the most appropriate, we have identified a number of useful ways in which to think about economic freedom conceptually, and a number of good candidates for indexes to correspond to those conceptualizations. To drive home the point that the ideas and measures are still in development, we have included a synopsis of some of the main features of the discussion that followed each paper. Although many of the remarks may at times appear pointed, they serve the purpose of sharpening the issues that need to be further discussed. In this context, however, it is worth recalling that the papers were presented at two conferences (the first taking place at Banff, Alberta and the second at Sea Ranch, California) and are incorporated in the current volume as a function of their content, not their chronological development. As a result some of the issues may appear slightly redundant in light of papers developed "earlier" in the volume, some of the papers have been revised to reflect particular comments, and some commentators are conspicuous by their absence in some of the commentaries - they may have only attended the "other" conference. But on the whole we believe that the wide-ranging discussion serves to enliven, enlighten and elaborate the text.


These Notes have no corresponding reference in the text

1From the first conference the selected papers are by Carr, Di Lorenzo, Easton, Reynolds, Scully and Slottje, and from the second, Denzau, Easton, Gwartney, Block and Lawson; Jones and Stockman.

2The earlier conferences are chronicled in Michael Walker, ed. Freedom, Democracy and Economic Welfare, Vancouver: The Fraser Institute, 1988, and Walter Block, ed., Economic Freedom: Toward a Theory of Measurement, Vancouver: The Fraser Institute, 1991.

3The Table of Contents identifies at which conference the paper was given. The Banff conference was held a year before the Sea Ranch conference.

Milton and Rose Friedman's Experiment

[Editor's note: At the end of the first day of the Sea Ranch Conference (the second in the series reported in this volume), Milton and Rose Friedman proposed the following experiment. This is reported in a slightly different fashion since it was not a written document as a formal part of the series. We have tried to capture the sense of the presentation as well as the occasion without actually transcribing the proceedings.]

IN REVIEWING THE PAPERS, ROSE and I have had difficulty making sense of the different measures in the large number of countries. We have taken eleven countries about which we feel we know something and would ask you [the conference participants] to rank these countries from the most free to least free. We will tabulate the results tomorrow. One conclusion we have reached is that we are studying too many countries.

[One Day Later]

In the handout there is a tabulation which summarizes the results of the survey. In the results for the eleven countries which we know relatively well, we have provided an average, a standard deviation, the range and the maximum and minimum values of the rankings made by the 23 people at the conference. In each case 1 equals the greatest economic freedom and 11 the least. Every country was ranked by each person. In addition we have provided the rankings where possible by the indexes from Gwartney, Block and Lawson, by Easton's measures, and by Spindler and Miyake's HMF ranks. It is fascinating that there is both a great deal of agreement and considerable disagreement. The greatest agreement was on Hong Kong which everyone but one person ranked as 1 and that person ranked as 2. The United States had one 1, and three 3's and all the others ranked it as 2. Beyond that there is roughly the same amount of dispersion which is fairly moderate. The greatest dispersion is for Chile which is understandable given recent history. But if you look at the standard deviations and means, except for Hong Kong and the United States as the most economically free, and India, Israel, and Sweden as the least free, there is little to distinguish the intermediate countries.

If you look at the Gwartney ranking of his number 1, the ranking is not that different. Chile and India were a bit out of line. The right way to do this is to send surveys to people who know something about these countries, people who live there-almost everyone here is from the United States or Canada (and we should have put Canada in this). Looking at the

Easton list, F1 seems way out of line as India ranks so high. The key thing to know in the cardinal approach is that what you call economic freedom or utility or whatever, is the numerical measure however you choose to construct it. You use a set of specified steps. The useful thing in the Jones-Stockman paper is the steps that they set out to define economic freedom. Many people object to the results of this kind of methodology. Indeed, as Stockman has suggested, the use of government expenditures as a fraction of income is an application of their kind of methodology, and we find that it doesn't give very good results. It is fine for the developed countries, but none of us here will accept the fact that by that measure all underdeveloped countries will be freer than developed countries. The test of whether we have a good measure is that it "works" and gives you results that you like. As I heard Fermi once say, the concept of length may be a good measure on earth, but it may be useless on the surface of the sun. The results that appear in F1 are very important from that point of view since they expose a defect. Easton's F2 is much better from this perspective. It has Japan as 1 and France as 2 and the U.S. as 3, and Sweden comes in last. Looking at the "HMF-homework" averages, the main thing that comes out is that these measures give you no discrimination. That doesn't mean that there are not some good ones among them, but as an average they are not very helpful.

On the Concept of Economic Freedom

This section is missing

Rating Economic Freedom: International Trade and Financial Arrangements

Stephen T. Easton, Simon Fraser University


THIS IS A CHARACTERIZATION OF economic freedom in a number of countries with respect to their international exchanges. The measures developed are relentlessly additive. This means that in comparison with earlier work, the characterization of economic freedom may appear Spindler and Still (1991) discuss previous efforts to characterize economic freedom and provide a number of dimensions along which it may be measured.narrow. The advantage to this strategy is that additional research may always add (literally) to what is extant without any reweighting or complex indexing. Tables in the text illustrate the measures developed, and a summary table at the end highlights the dollar values of the reduction in economic freedoms as I see it.

Two issues have arisen in conjunction with the development of my measures. First, identifying economic freedom sector by sector is awkward as the measures in one sector may overlap with those of another sector and lead to double counting. I.e., suppose a study of the domestic economy uses taxation as a measure of freedom's reduction. Since one of my measures of freedom's reduction in the international sector is related to expenditure, unrequited official transfers, we may not wish to count both revenue and expenditure as distinct reductions in economic freedom. Reconciliation of the national freedom accounts will have to take place.

Second, by choosing to focus on an additive characterization of economic freedom, the indexes devised have emphasized the trade accounts which are relatively easy to measure, to the virtual exclusion of the loss in freedom associated with the flows of factors, which are comparatively difficult to measure. Even though, as I will argue below, the conceptual measures of freedom are the same, more extensive research is required to continue with the same systematic characterization of economic freedom as has been accomplished for the trade accounts.

A Working Definition of Freedom

As we can see from the discussions at the two previous conferences related to rating economic freedom (Walker, 1988; Block, 1991), a conception of economic freedom is difficult to define in a clear and unambiguous fashion. In the absence of consensus, perhaps the measure that serves best is the most simple. Economic freedom is the voluntary allocation of resources. Now in the extreme such a definition may not serve. "Your money or your life!" presents an opportunity for "voluntary" exchange which most of us would agree is not appropriate.

One would like a definition that says that economic freedom is the voluntary allocation of resources subject to as few constraints as possible - other than those imposed by nature, and those imposed by voluntary, non-coercive associations of others. But as a definition, this is a quagmire. There will be divergent views on what is voluntary, what is the state of "nature," and what is "non-coercive." Rather than attempt a definitive statement, or even one that caters successfully to most peoples' views, the task at this point emphasizes identifying, enumerating and elaborating what I take to be the relevant constraints. Other conceptions of freedom may involve additional or even very different sets of constraints on voluntary exchange.

In the context of international trade and finance, the relevant dimensions are comparatively simple. Individuals of different countries are more free if they have the opportunity to allocate their own resources. For these purposes, the government is not just another individual. It is instead a direct impediment, through its powers of taxation and reallocation, to the exercise of economic freedom. We need to be careful here. This does not imply that there is no role for government. It does suggest, however, that the rule of law, and the provision of all the other goods and services government provides, should be seen as trading-off with individual freedom and viewed with healthy suspicion in consequence.

Freedom in the Context of International Exchange

From the international trade perspective, the ability to allocate one's own resources takes several forms. If you, in your own country cannot trade at the prices available to individuals in another country (net of "natural" costs such as transportation, insurance, and the like), then some distortion exists. I will take it as obvious that by far the most significant distortions in this regard are those created by government fiat. Impediments to both goods and factor trade abound. Tariffs and non-tariff barriers, prohibitions on immigration and emigration are rife. Exchange controls and controlled exchanges are far more common than genuinely flexible exchange rates. In all of these cases, the ability to engage in free exchange is compromised.

How we identify and quantify this diminution in our freedom is the task of this paper. It is a search along one dimension. As a result, some of the issues which are characterized as diminishing our freedom may nonetheless lead to a higher level of national income. In this respect we part company with traditional economic analysis which tends to take income maximization as the objective function. In contrast, our analysis pays little heed to the consequences of government spending - for "good" or "ill" - but characterizes the act of taxation as freedom reducing as it stands between the individual's resources and the individual's allocation of those resources.

Appropriate Categorizations

Once we decide upon constraints that need to be measured, there are several ways in which we may classify aspects of economic freedom. We may choose categorical, ordinal, or cardinal measures.

Categorical measures are those that can be answered with a "yes" or a "no," a "present" or "absent," etc. For example, we might ask, "Does a country require a permit to emigrate or immigrate?" or "Is the exchange rate freely floating?" The most information that can be gleaned from these measures is whether they exist, or have they changed from previous observations. Categories are useful, but are of limited value in the long run. Although categorization requires less information (than ordinal or cardinal measures) at some level of abstraction, they require strong criteria for deciding whether the variable is "on" or "off" which may obscure important nuances. Categorization does not readily permit consistent aggregation over sub categories. This means that sub categories are unlikely to be very useful in terms of constructing broad indexes reflecting economic freedom. Since the information requirements necessitated by such measures are less stringent than for ordinal or cardinal measures, categories of economic freedom are likely to be with us for some time. Spindler and Still (1991) have provided an extensive list of categories identifying dimensions of economic freedom.

There are two kinds of ordinal rankings which are usefully distinguished. The first is of the kind, "Is what I am measuring significantly different than in some previous (base) period?" This is the kind of question familiar to economists who are interested in inflation, and indexes in general. In this case, price comparisons can be made between periods even though the value of the index itself is entirely arbitrary. It would make no sense to compare a price index in one country with the level of some price index in another country. But comparisons of rates of change of these price indexes, the rates of inflation, across countries is often revealing.

A second ordinal measure asks simply whether something is greater or less than something else. For example, "Are trade taxes greater in one country than another?" In this case we have a comparison that is without reference to some base period - the measures are intrinsically Strictly speaking we could interpret one set of taxes as the base period with which to compare the other, but the point is that we do not have to have comparisons only between changes in taxes in one country with changes in taxes in another country. We can compare the level of taxation at home with the level of taxation abroad.meaningful.

For our purposes, a cardinal measure means that measurements are additive. For example, taxes are additive: tax A gathers $10 and tax B gathers $25 so that the total tax burden is $35. A cardinal measure is most useful as it can do at least what the other rankings can accomplish. In the present context it is particularly fruitful because it is both easily interpretable and open-ended. These are virtues insofar as it will undoubtedly take many iterations to establish a satisfactory or consensus set of dimensions for measuring freedom. If the total value of freedom's loss is $100 using the measures available today, additional research may provide an additional measure that suggests the loss is another $25. Rather than create a new, improved index that embodies some relatively arbitrary reweighting of old and new categories which makes the index difficult to compare with past efforts, the new costs may be added to the old. An additive index which gives the opportunity to cumulate is particularly well suited for the ongoing development of characterizations of economic freedom. Of course additive measures also impose the most stringent information requirements. Our discussion of economic freedom develops almost exclusively cardinal, additive measures of freedom.

The Measure of Freedom

The notion of economic freedom I will use is based on the idea that the individual has the "right" to allocate the resources that he or she owns without impediment. In the context of international trade this means that tariffs, quotas, voluntary export restraints (VERs), and other nontariff barriers (NTBs), which diminish the individual's ability to trade at international prices reduce freedom. Similarly, interference with factor flows which reduces the opportunity for the equalization of factor returns also diminish freedom.

As a working hypothesis, I will assume that the measure of economic freedom (in a negative sense) is the dollar value of the impediments to free exchange and allocation. This is not the same as saying that the measure of economic freedom is the dollar cost of the impediment.

To illustrate this difference consider the case of an idealized excise tax. The usual definition of the cost is the "welfare cost" associated with the tariff. Figure 1 is drawn for linear demand, DD', and constant marginal cost which, in the absence of tariffs or other impediments, is equal to the domestic price, p0. The usual "welfare cost" associated with the tax, T, is the triangle, ABC. This represents the loss in value of the quantities Q0Q1 foregone due to the tax. The revenue from the tax, area P0P1AB is usually assumed to be returned to the domestic consumer in some lump-sum, non-distorting, fashion.

Click here to view Figure 1: An Excise Tax

My (first) measure of the loss in freedom is exactly this revenue rectangle. This is the value of resources over which the individual has lost control. They may be returned or they may not be returned, but the essential feature for our purposes is that the individual consumer does not have the freedom to allocate these Although attributable to the tax, the triangle losses are of a "second order" of small in comparison with the "first order" rectangle losses. It is the latter that are stressed here for practical reasons. To calculate the welfare losses we need to know more information about the underlying demand and supply schedules-the relevant elasticities of demand and supply. As a matter of theory, the welfare losses are generally an order of magnitude smaller than the first order redistribution effects which are relevant to our discussion of freedom, but in principle there is no reason why they would not qualify as yet another component of freedom lost.resources.

Economic Freedom and Income Maximization

The issue in the context of international trade is a little more subtle. This characterization of freedom may actually put real income maximization at odds with what we described as a more free society. That is, income maximization may lead to a loss of freedom!

To illustrate this point recall that an import tariff distorts domestic choice and thereby reduces freedom by raising the domestic price above the international price. The effect of the distortion on domestic income is related to the volume of goods affected, the change in the quantity of imports induced by the tariff, and the effect on the terms of trade. A tariff may raise the level of domestic income if the home country is able to affect world prices. A tariff may reduce domestic demand, and if the home country is "large," lower the world price sufficiently so as to leave the domestic economy better-off once tariff revenues are returned to the populace. This is the traditional argument for an "optimal The appropriate calculation is that the change in income, dy, equals the level of imports, M, times the (negative of) change in world prices for domestic importables, dp*, plus the difference between the distorted value of domestic goods, p, and the world price, p*, all multiplied by the change in domestic goods, p, and the world price, p*, all multiplied by the change in domestic imports induced by the tariff: dy = -Mdp* + (p-p*)dM. The traditional optimal tariff is one that balances the gain in the terms of trade induced by the tariff, a fall in p*, with the loss in income associated with the fall in imports.

If the home country is small in world markets, then a tariff induces no change in world prices, dp*=0, and the domestic country loses in proportion to the distortion, (p-p*), which is positive as one tariff imposes a wedge between domestic and world prices, and the change in the quantity of imorts, dM, which is negative, as higher prices serve to reduce domestic imports. The effect is to reduce domestic income.tariff."

But any suggestion that because (an optimal) tariff raises domestic income, it enhances economic freedom should be rejected for several reasons. First, although it is not the focus of this paper, it is worth remarking that even though domestic income rises by the imposition of (an optimal) tariff, world income, the sum of domestic and foreign incomes is reduced since world trade is distorted. Second, domestic residents are denied the opportunity to trade at world prices. Third, domestic residents are now dependent upon the government to redistribute the tariff revenue in some fashion across the general populace. And fourth, the government has redistributed income throughout the economy as a result of changing relative prices.

Direct and Indirect Measures of Economic Freedom's Loss

It is these last three characteristics that I will use as a foundation for measuring the loss of freedom for each country. The revenue from the tariff is the direct measure of the loss of command over resources suffered by the populace, and the change in economic rents induced by the tariff are the indirect losses associated with the distorted prices. Were we to use a measure of price distortion alone, i.e. the difference between world and domestic prices, we would have to weight each distortion by its importance unless we were satisfied with a mere catalogue of goods taxed. The revenue raised by the tax aptly describes the command over resources lost to the private sector.

But using tariff revenue as a characterization of freedom's loss is not The tariff will stand for general tax distortions in the following discussion. This is to simplify the exposition and retain the international flavour of the analysis.sufficient. A tariff may be sufficiently high so as to be prohibitive, and we do not want to allow this state of affairs to be confused with no diminution in freedom which would be the case if the tariff were zero. Indeed as tariff rates rise, at some point revenue must be Since tariff revenue starts at zero tariff rate and ends at zero with a prohibitive tariff, there will be a region in which increases in the tariff rate increases tariff revenue, some point of maximum revenue, and a region in which increases in the tariff rate decreases tariff revenue-ultimately to zero. In the macroeconomic setting this is familiar to the popular press as the "Laffer Curve."reduced.

To avoid this problem and capture the distortion taking place in resource allocation, two dimensions of our characterization of economic freedom can be distinguished: direct and indirect diminutions in economic freedom. The direct effects are those reallocations of resources that are spent by the government. The indirect effects are those reallocations that are caused by government policy but spent by private individuals.

Figure 2 is a traditional, partial equilibrium representation of the effect of a tariff in a small country. The (linear) demand curve for the importable good is DD'and the (linear) domestic supply schedule is SS'. The world price is p*, and without tariffs the home country imports MM'. With the imposition of a tariff, T, the domestic price rises to p=p*+T, and the quantity of imports falls to M"M"'. The area, A, is the tariff revenue, as it is the tariff rate times the quantity of imports. This I have called the direct effect of the tariff in reducing economic freedom. Tariff revenue is both taken away from the private sector and spent in ways that differ from the private owner's allocation.

Click here to view Figure 2: Direct and Indirect Costs

The second effect is the indirect effect a tariff has in reducing economic freedom. It is represented as (trapezoid) B in Figure 2. The indirect effect of the tariff arises from the reallocation of resources in the domestic industry that produces the importable good. Output of the importable good rises as the price received by the producer at home increases in proportion to the tariff. The increase in price draws additional resources into the industry and provides an increase in economic rents to (fixed) factors already employed in the Economic theories of rent-seeking focus on the gains, B, as the source of political pressure by interest groups, the producers of the importable who own some of the "fixed" factors, which lead to tariff creation.industry. This is a reduction in economic freedom because it represents an effect of government policy that stands between the producer and the undistorted value of the resources that are owned. I term it indirect because even though the government policy has changed the allocation of resources to particular individuals, the resources are not spent by the government directly, but by private In passing it is important to remember that we are reversing the importance economists usually assign to the distortions induced by tariffs. Typically tariff revenue is assumed to be redistributed to the general population in a "lump-sum" or (at the margin) nondistorting redistribution of the tariff revenue. This is more an analytical convenience than a serious statement about the behaviour of governments. The usual notions of a tariff's distortion lies in the two shaded triangles of Figure 2. They represent the resource loss to society induced by the tariff. This is an important but very different issue than the one we are addressing here. A more detailed analysis would include both triangles as they indicate losses. As explained above, however, including them requires much more information about the details of the economy and the loss in an order of magnitude smaller than those already detailed.citizens. Which of these measures is most important? Obviously if there is no domestic production, the indirect losses are nonexistent. Just as obviously the indirect costs are likely to be vastly greater than the direct costs if domestic production is large relative to excess demand - imports.

How does this measure deal with the problems of a prohibitive By analogy any other tax that chokes-off exchange.tariff? If the tariff is prohibitive, then the (indirect) loss is the value of domestic production, which is the same as domestic consumption, times the tariff rate - again, ignoring the second order welfare costs, the shaded areas under both the demand and supply Where the measure fails to allow simple application is the case in which there is a prohibitive tariff and no domestic production. Without insight into the demand curve, there is little we can say other than to report the nominal tariff schedule.schedules.

Extending the Measure to Non-tariff Barriers

The effect of non-tariff barriers can be assessed in the same framework. A quota has a tariff equivalent, voluntary export restrictions, VERs, have effects similar to a quota, variable import levies, VILs, have effects similar to those of tariffs, non-automatic import authorizations, NAIAs, may be thought of as a form of quota, and even government purchasing can be seen as a device reallocating domestic rents.

Calculating the Loss of Freedom

Distortions in the international sector are divided into those affecting trade in goods and services and distortions affecting the flows of factors of production - labour and capital. Among the activities we can catalogue which lead to a decrease in freedom in the goods component of the international sector are tariffs and NTBs: quotas, VERs, and various specific arrangements.


As we have discussed, there are several elements of tariffs that can reduce the ability to allocate resources without distortion. First there is the tariff rate itself. As a first approximation, a 10% ad valorem tariff adds 10% to the private individual's cost of the We will assume that the countries under consideration are small: they do not have the ability to affect the world price. Although no doubt an oversimplification in some situations, a great deal more information at every level of generalization-e.g. the elasticities of excess demand-is required to go much further.good. The direct effect of the tariff is to raise revenue for the government. This constitutes resources no longer available to be allocated by private individuals. The indirect effects are those that arise from the increase in price as rents on factors already employed in the industry are created and new resources are brought into production. To measure the rents created requires knowledge of the amount of domestic production. For example, if the tariff is 10% and domestic production before the tariff is imposed amounts to 100 units each of which is worth $1 on the international market, then roughly $10 of indirect rent reallocation is created by the tariff (for the factors already More precisely the rent created depends on the elasticity of supply, e, and comes to $10+(1/2)t2Q0e in the linear case, where Q0 is the level of domestic production prior to the imposition of the tariff. Should foregone benefits be taken into account on the demand side, we would add another triangle proportional to the square of the tariff rate, the level of domestic consumption, and the elasticity of demand.

A more complete conception of economic freedom which requires even more information would take account of the repercussions in other domestic markets. These markets may be distorted. This leads to additional revenue gathered through other taxes, and rents redistributed because of the relative price changes. Although a theoretically attractive stance, it is not a practical alternative for the present paper.employed).

Our description of the tariff is based on the direct and indirect costs to freedom. In particular we can observe the revenue generated by the outstanding tariff structures around the world. Table 1 provides such a listing for twenty-seven countries. Each country is described by the level of trade taxes in column 3, the value of imports in column 4, and gross domestic product in column 5. All are measured in domestic currency. Columns 6 and 7 suggest a basis for comparing the loss of freedom induced by such taxes. In column 6 we have the percentage of imports that the taxes reflect, and in column 7 the taxes are expressed as a percentage of gross domestic product.

Click here to view Table 1: Revenue Generating Taxes Associated with International Transactions

In terms of our categories, all countries obtain some revenue from tariffs, but the figures in the last two columns enable us to rank countries in terms of the relative amounts trade is distorted by taxation (scaled for convenience by imports), and the fraction of total income affected by these taxes. Yugoslavia is the least free in this regard, and the less developed countries are generally more actively involved in the reallocation of resources as a share of their national incomes than the developed countries. Italy, for reasons that are unclear, and Luxembourg appear to be the least distorted by tariffs.

These categorical and ordinal measures of freer trade are the most traditional of the measures that we can construct. They are based on a comparison of countries each of which is considered an entity in its own right whose trade is obstructed relative to others. Can we say that a country is twice as free (in this dimension) as another? Probably we can, although deflating taxation by domestic product which includes government expenditures evaluated at cost must be at best a second best deflator.

The relative measures do not permit us to aggregate across categories of trade taxes. If we are to generate a ranking with quotas, it is surely possible that a country will rank first in terms of one measure and last in terms of the other. Further the ranking generated in Table 1 does not emphasize the distinction between the direct loss of freedom and the indirect measure. These points are developed more fully in Table 2.

Click here to view Table 2: International Transaction Taxes Compared

The Direct and Indirect Costs of Tariffs

In Table 2 the "cost" of the tariff reflects more than the direct trade costs -the tariff revenue. In constructing column 5, we assume that prices of all traded goods increase by the (trade) tax rate. The penetration ratio, the ratio of imports to total domestic consumption, is used to obtain the fraction of traded goods produced for each Where possible the import penetration ratio is issued as reported in Pearson and Ellyne (1985, p. 404-405). Where it is not available, the world average is employed-0.33 of GDP. This is then multiplied by two under the assumption that trade is roughly balanced to obtain the direct effects on traded Added to the direct costs of the tariff, the tariff revenue, this yields an approximation to the total cost-direct and indirect of the outstanding taxes on trade. Column 6 expresses the total U.S. dollar cost on a per capita basis for each country. A per capita valuation seems appropriate as it emphasizes the loss in freedom per An alternative such as costs relative to per capita domestic product would scale each individual's loss by the average level of domestic income. But the implicit assumption of such a scaling is to say that a dollar's loss in freedom in one country is different than a dollar's loss in another country.individual.

In Table 2 it is clear that Icelanders suffer the greatest loss in freedom to acquire goods at world prices and that their government is most deeply involved in reallocating resources with costs amounting to over $1,000 a head. Switzerland, Australia, Portugal, Malta, Canada and New Zealand comprise the next most affected countries with freedom diminished by $300-$400 per capita. There is a gap until roughly $150 per head. And the costs diminish steadily thereafter.

Non-tariff Barriers

But unlike tariffs which are relatively easy to quantify, the cost of non-tariff barriers is difficult to measure. Further, unlike tariffs which have been diminished in significance through past rounds of the GATT negotiations, the formation of freer trade areas in both Europe and North America, and the antipodes, NTBs have been increasing in importance over the years. Table 3 provides a rough idea of the "coverage" of imported goods that are subject to quota in a number of developed Coverage refers to the share (in value) of products restricted relative to total imports. Restricted products include "core" NTBs: variable import levies, quotas, non-automatic import authorizations (voluntary export restraints, restrictive import licensing, and trade covered by the Multifiber Arrangement).countries. Columns 2 and 3 report the non-tariff coverage ratios in 1981 and 1986. From column 4, which reports the difference between the two years, it is clear that more goods are covered by quotas now than in 1981. This is an issue that is likely to be of increasing importance.

Click here to view Table 3: Non Tariff Barriers

Table 4 indicates the kinds of NTBs that are present in the countries of the OECD in Australia, Canada, and Sweden were exluded because of problems associated with obtaining adequate measures of the NTBs (Coughlin and Wood, p. 35).1986. The second column indicates the share of imports facing quotas, the third, the share facing voluntary export restraints, the forth, restrictions under the Multifibre Arrangement; the fifth, non-automatic import authorizations; and the sixth, variable import levies. From Table 4 it would seem that quotas, voluntary export restrictions and non-automatic import authorizations are the most extensive devices to limit freedom, while both the Multifiber Arrangements and variable import levies are of less This is in terms of their significance to developed countries. Their effects on exporting, poorer, less developed countries is not assessed here.significance.

Click here to view Table 4: Types of Non-Tariff Barriers: 1986 Shares of Imports Facing Each Type of Non-Tariff Barrier

It is striking how much certain countries favour one device over another. New Zealand and Japan prefer quotas and NAIA, while the U.S. chooses VERs, notably autos, and the Multifiber Arrangement. Italy, which appears to have very low tariff revenue, does a more thorough job with quotas and other restrictions. In broad terms it appears that quotas, NAIAs, and VERs have become roughly equal participants in the barriers affecting world trade.

To get a handle on measuring the effects on resource allocation of a quota, in principle it can be treated as a tariff at a particular level. However, unlike the tariff, the quota generates no revenue directly. Rents are created since the domestic price will rise as supply from abroad is restricted. Most analysis of quotas is spent identifying the magnitude of the the welfare losses generated and who benefits from the rents generated - although this is not our task here. In contrast we are concerned with the magnitude of the rents created as it is they that are a measure of the indirect loss of freedom in the nomenclature devised above. They are losses as they change the allocation of resources, and they are indirect as they are spent by private individuals rather than by governments directly.

But obtaining the tariff equivalent is easier said than done. Wood and Coughlin (1989) note that there is no tariff equivalent available for the aggregates they have Their study is drawn from an unpublished manuscript by Laird and Yeats, Quantitative Analysis for Trade Barrier Analysis (Macmillan, forthcoming) which appears to be the last word on the subject. In an aerlier study Roningen and Yeats conclude that there is no relation between simple coverage of a sort and relative price differences. They attribute this phenomenon to a masking of the effect of the coverage by other domestic government interferences (Vernon Roningen and Alexander Yeats, "Non-tariff Distortions of International trade: Some Preliminary Empirical Evidence," in Hans Singer, Neelamber Hatti, and Rameshwar Tandon, New Protectionism and Restructuring (New Delhi: Ashish Publishing House): 317-332.generated. But can we assume that a coverage rate of 12% means a greater loss of freedom than a coverage rate of 6%? Certainly that is possible, but until a detailed study of each country identifies the prices available for each product, we have little recourse but to approximate.

One approximation strategy is to use the information we have on one country in which we know the details of both the coverage ratio and the price effects of the quota. In the case of the United States while the effect of the quotas is to have the effect of increasing prices by 1.7% as opposed to the 2.8% identified as the effect of tariffs (Department of Finance, 1988 pp. 58-60), the "coverage ratio" of Table 3 is Note that this is the quota rate in the U.S. but the coverage rate refers to the core NTBs.some 17%. If this rough ratio of 10% were to be true in the rest of the world as well, a truly heroic assumption, then the effects of the non-tariffs barriers can be calculated in the manner of Table 2. Table 5 gives the results.

Click here to view Table 5: Tariff and Non-Tariff Barriers

In Table 5, column 2 gives the tariff induced price changes, column 3 the calculated induced price changes and column 4 the total effect on relative prices. The inclusion of the quota/non-tariff barriers in many cases more than doubles the effects on prices induced by tariffs. This means that the values associated with the "full cost" calculations would also more than double. The implied full cost per capita caused by the NTBs - the rent reallocation-is included as column 5 in the table.

International Factor Flows

There are many dimensions along which restrictions can be measured. In principle, the problem is the same as before. We plot the demand or marginal product of capital or labour, then the loss of freedom associated with the international immobility or interference with free exchange is the economic rent created by the discrepancy between real wage rates (or real rates or return on capital) measured in each country compared with the "world" wage or rate of return net of appropriate transportation costs. The impediments to factor mobility create a wedge between the world opportunity cost and the rewards at home. What we have called freedom is ability to move owned factors to their desired location at world prices.

Labour Mobility and Freedom

None of the countries in the above tables have a prohibition against emigration, and all have some restrictions on immigration. The actual restrictions are difficult to identify. In particular, a survey of documents depicting the restrictions on labour migration around the world is not presently available. This, as I was told by both U.S. and Canadian research divisions of the respective immigration authorities, would be an extremely useful but academic study which they themselves would like to read but would be reluctant to commission as it would be of no particular consequence to domestic policy.

In principle, the way to assess the impact of factor mobility is to estimate a demand for labour schedule and then assess the wage paid now relative to the equilibrium world wage, i.e. the wage that would be paid to labour if it were free to flow to the location of greatest remuneration. Some adjustment has to be made for differences in accumulated human capital, and each country has a different demand for various types of labour, but in principle the task could be done. The stock of labour in any country is likely to be quantity constrained, so differences in wages times the amount of labour indicates the distortion imposed by an immigration policy. Although there are many issues related to immigration and national advantage, from the perspective of economic freedom, the lack of mobility is reflected in wage differentials on comparable labour in different countries.

Capital Mobility and Freedom

The difference between labour and capital is primarily that capital is far more mobile internationally than labour. In the jargon of economics, capital is in perfectly elastic supply at a world real rate of return. A country can impose restrictions on capital that will generally speaking reduce the quantity of capital at home, but not the real rate of return that is available to foreigners, and hence domestic residents. The cost, therefore, of restrictions on the flow of capital are borne by domestic residents, not through different rates of return at the margin, but through a lower stock of capital than would otherwise exist.

Thus unlike the case of labour, it is unlikely that a careful study of restrictions on capital flows will identify a differential between the returns in one country relative to another in a systematic fashion. In terms of defining economic freedom, the shift in the marginal product of capital schedule needed to identify the consequences of capital restrictions are particularly difficult to characterize in the absence of a returns differential.

But there are some issues related to capital and financial issues that can be identified. Table 6 indicates that not all exchange rates are free to As before our definition of freedom may conflict with income maximization. A country may not be an optimum currency area and may choose to fix its exchange rate with another country. This may increase income. But from the point of view of individual freedom within a country, it seems more reasonable to insist that an individual be free to exchange whatever currency he or she is paid for whatever other currencies are available without interference by the national authority. This begs the question, however, of competitive currency creation since it assumes the current extant units of exchange as the only alternatives.float. As categorical variables, it is not immediately useful in quantifying the degree of distortion that the different policies create.

Click here to view Table 6: Categories of Exchange Rate Freedom

In contrast, Table 7 points to international exchange reserve accumulation as one source of the diminution of economic freedom. Recall that our definition is that an individual has the right to allocate his or her own resources. If a national government accumulates international reserves, then that act potentially separates the exchange rate from the decisions of the private sector. Decumulation has the effect of reducing demand for foreign exchange on international markets and accumulation has the effect of increasing the demand for foreign exchange. The price of one currency vis-a-vis another is different when there are reserve accumulations and Here we ignore the issue of the loss in freedom from the initial state of reserve accumulations and look only at the implications of the changes in the stock.decumulations.

Click here to view Table 7: Foreign Exchange Rates, Reserves and Accumulation: 1987-88

In Table 7, column 7 identifies the U.S. dollar value of the reserve accumulation net of currency This is a bit ticklish. If the foreign currency depreciates against the U.S. dollar by 10%, I treat foreign holdings of a constant stock of U.S. dollars as no changes in accumulation.revaluation. Column 8 reports the change in exchange rates. There is clear evidence that the major currencies are managed as depreciations in local currencies. Positive values of the percentage change in exchange rates, are associated with decreases in foreign reserve holdings as central banks try to "lean against the wind" and slow the adjustment to market demands and supplies. Table 8 identifies these costs on a per capita basis at the national leThere are obviously more dimensions to international financial arrangements than those described here. The security of assets in Switzerland and Luxembourg is not captured by these measures, nor are the effects of multiple exchange rates in, for example, Belgium and South Africa, let alone Yugoslavia. v el.

Click here to view Table 8: The Value of Foreign Exchange Accumulation or Decumulation (1987)

But there are more international costs to government activity than those associated with the exchange rate. Table 9 points to transfers made at the international level from one government to another. The amount of official development assistance is a clear example of resources extracted from one country to give to another. There is little question that this reduces freedom at home as there is no quid pro quo at the margin, nor any hint that private transfers would take place in such orders of magnitude. Column 4 reports the transfers on a per capita basis.

Click here to view Table 9: Sources of International Official Development Aid: 1985

There are also transfers made by governments measured by the balance of payments. In some sense this is a less revealing measure than the direct government to government transfer for assistance explored in Table 9, as it nets out many transfers that are into a country as well as from a country. These transfers are reported in Table 10.

Click here to view Table 10: Official Unrequited Transfers, 1988

Summing Up

Table 11 provides a summary of the impingements on individual freedom from the international perspective. It is incomplete as I have been at pains to indicate, but it is useful as a starting point that can be extended by future analysis. To the extent that further research is additive, we can add a column to the table and apply the calculations directly.

Click here to view Table 11: Economic Freedom Rating Per Capita Costs

What emerges from the table is that a group of countries (of those that are complete in the table) for which the diminution in freedom amounts to $600-700 per capita with tariffs and foreign exchange transactions playing a dominant role, and then the United States, Japan and Britain which have costs of freedom at a distinctly lower level of roughly $200 per capita. Part of the reason for this is that the United States and Japan are relatively large economies in which international distortions play less of a role than in smaller economies. It is also true that the levels of distortion are lower.


Block, Walter, ed., Economic Freedom: Toward a Theory of Measurement (Vancouver, B.C.: The Fraser Institute, 1991).

Coughlin, C.C. and G.E. Wood, "An Introduction to Non-Tariff Barriers, to Trade" Review the Federal Reserve Bank of St. Louis, Vol. 71, No.1: 31-46.

Department of Finance Fiscal Policy and Economic Assessment Branch, The Canada-U.S. Free Trade Agreement: An Economic Assessment (Ottawa: Canadian Government Publishing Centre, 1988)

International Monetary Fund, International Financial Statistics (Washington, D.C., 1989)

Pearson, C. and M. Ellyne, "Surges of Imports: Perceptions versus Evidence," The World Economy (1985) reprinted in H. Singer, N. Hatti and R. Tandon. New Protectionism and Restructuring (New Delhi: Ashish Publishing House, 1988):, 397-420.

Spindler, Z. and L. Still, "Economic Freedom Ratings," in Walter Block, ed., Economic Freedom: Toward a Theory of Measurement (Vancouver, B.C.: The Fraser Institute, 1991).

Walker, Michael A., ed., Freedom, Democracy and Economic Welfare: Proceedings of an International Symposium (Vancouver, B.C.: The Fraser Institute, 1988)

World Bank, World Development Report (New York: Oxford University Press, 1986) 218-219.


Milton Friedman liked the general approach to valuing economic freedom with a dollar measure as it goes beyond the internal calculus. The problem with this approach arises from the presence of transactions costs. There are tradeoffs to be made: national defense and tariffs, for example. A tax may be the least costly way to preserve economic freedom by preventing long-run domination by a foreign power.

Richard McKenzie remarked that what is here is an index of government impediments. But with the advent of new technologies, fewer governmental institutions are needed. Thus we are freer regardless of the state of tariffs. A well-known New York insurance company ships data (for entry into a company data base) to Ireland and then ships it back to New York each day. Newer technologies may lead to more economic freedom in and of themselves.

Tom DiLorenzo made two points. First, the costly, rent-seeking behaviour of lobby groups is manifestly obvious as one sees the many companies springing-up around Washington. Second, foreign aid has two costs. The first is the cost in economic freedom to the country giving the aid (as resources are allocated by the government), and the second is the cost to the people in the foreign country as the aid attempts to prop-up governments that reduce economic freedom.

Clifford Lewis suggested that nominal restrictions and actual restrictions on economic freedom were not always the same. In many LDC's there are prohibitive tariffs, but everything is smuggled and available. AID conducted some price surveys of certain computer products and found that they were cheaper (than in the United States) in some countries that nominally prohibited their entry. The reason is that the added cost to smuggled goods is a function of weight, and software does not weigh very much.

Jack Carr suggested that more thought be given to the points raised in the paper that tax revenue falls with the higher tax rate beyond some point, and amplified the issue that once some government is taken as needed, we must have some tax revenue. Thus to evaluate economic freedom, one needs the whole picture of a society.

James Gwartney remarked that trade taxes understate the degree of loss in economic freedom to the extent that customs inspectors have discretion about what rates to charge. The bribes to bring merchandise into a country "tax-free" should be counted against economic freedom as they add to the excess burden.

Easton replied that his measure is not a measure of excess losses but a measure of first-order losses. In particular, it measures extant price distortions that diminish economic freedom through rent reallocation as well as, in principle, the second order losses. The whole picture is not at issue, he argued, as this measure of the loss in economic freedom is a measure along a single dimension-the economic freedom dimension, not an effort to measure the highest level of income, or even contingent freedom in the future. Thus economic freedom can be traded-off against alternatives, but this is a different issue than that of measurement and quantification.

Alvin Rabushka argued that identifying fixed exchange rates with losses in freedom is wrong. For example, Hong Kong benefitted enormously from fixed rates. Flexible rates are not intrinsic to the notion of freedom. Protection of the standard of value is what needs to be protected. Easton replied that freedom and income do not necessarily coincide, and to the extent that the foreign exchange authority is involved, resources are allocated by someone other than the individual who earned the money. Walter Block suggested that the gold standard period was one of free exchange. Milton Friedman responded that this was not the case as governments were intimately involved in the gold standard from the beginning. It was a pegged price for gold. If the market had chosen, it probably would have chosen silver. Further there was a confusion between pegged exchange rates and a unified currency. Hong Kong went to a unified currency with the United States dollar and did not prohibit the use of other currencies. The right indicator is whether there is a central bank, and in Hong Kong's case, there was no central bank. It would not improve economic freedom if California started to issue California dollars.

Walter Block argued that there was a contradiction in Easton's measure. Easton says that a government can increase income through an optimal tariff, but then tries to use income as a measure of economic freedom. How can this be if they go in opposite directions? Easton replied that we can distinguish full income and measured income. Economic freedom is part of full income. We need a marginal valuation of economic freedom to aggregate it with measured income. One possible way would be to use immigration among countries with measured economic circumstances as similar as possible. We could then "price" a measure of economic freedom in terms of immigration flows.

Milton Friedman was concerned with the use of the exchange rate to add-up losses in economic freedom across countries. He felt that some kind of purchasing power exchange rate should be used to compare countries. Is a dollar in the U.S. as relevant as a dollar in Italy? The issue is that the income used should be potential, not actual, income. If a country loses $5, then it is more serious if the potential income in that country is $50 rather than $500. India has a potential income far greater than current income. We do not get a good measure of the scale of the economy by using current income. Easton replied than an ideal measure would be with "one world." Friedman agreed saying that the utopian level of income would be the levels of national incomes associated with freely flowing factors of production as well.

Alan Reynolds suggested that some revenue needed to be raised through tariffs. Milton Friedman responded that we use the difference between the tariff and domestic excise taxation to measure protection. Walter Block argued we need to count all current restrictions regardless of the reasons. He didn't care why there was a draft, just that it exists. Friedman replied that you may need a short-run loss in freedom to protect economic freedom in the long-run. The draft is a good example. It may be necessary in Israel or even Switzerland. In the short-run it may be impossible to satisfy the need for soldiers without some kind of forced service. It is certainly a restriction on economic freedom.

James Gwartney was concerned with Easton's measure of economic freedom that did not normalize for the size of the country. It would lead to a situation that a large country would have larger losses in freedom just because it was large. Easton replied that a dollar loss was a dollar loss and that the issue went back to that raised earlier about the purchasing power prices and potential income versus measured income.

Measures of Economic Freedom

Stephen T. Easton, Simon Fraser University


DURING THE LAST RATING OF Freedom Conference I proposed a measure of economic freedom that seemed to offer some hope that a cardinal measure of economic freedom could be devised. In this paper I propose to elaborate that measure and suggest some ways in which it can be implemented.

Conceptual Measures of Economic Freedom

Although there is no generally accepted definition of economic freedom, I will define it as the allocation of one's own resources at one's own Finding a definition with which we may all agree is not an easy matter in any discipline. Bertrand Russell (1956) points out that "The question `What is a number?' is one which has been often asked, but has only been correctly answered in our own time." In Easton (previous chapter, this volume) I identify what I take to be some of the limitations of this definition of economic freedom.behest. Two possible approaches to measuring economic freedom might be characterized as the "constructive" approach and the "impediments" approach. At first blush, the constructive approach is the most natural to an economist. Economic freedom is conceived of as a separate argument of the utility function. An increase in "F" has exactly the same impact on utility as an increase in consumption of any other good or service. What remains to be decided is what constitutes the measure of "F." The second notion of freedom is based on impediments. The essence of this conception is that economic freedom is associated with the ability to trade at prices set by individual agents without impediment. Any artificial wedge between the price demanded and received reduces the freedom of individual economic agents. The most relevant ingredient of the artificial wedge is the application of governmental authority through taxation and regulation. The reduction in economic freedom is identified as the value of the We are characterizing one dimension of choice, economic freedom. We may choose to impose a tax or other distortion, but this tradeoff among economic freedom and other "goods" is a separate issue.impediments.

What should a definition or a measure of freedom do? A definition should correspond to a common understanding of what economic freedom means. But whose understanding? I will take those who share the view that the (market) economy functions best with a minimum of government interference, the philosophy of economic liberalism, as the appropriate audience at least Clearly someone with a philosophy that there is something intrinsically good about a government allocating resources rather than the individual allocating resources will be dissatisfied by my characterization of economic freedom.initially.

A definition should pass some test of usefulness. It should be possible to use the definition to develop frameworks that answer questions we wish to pose. In this case we wish to rank countries as to the amount of economic freedom they permit. I see two competing approaches to the definition of economic freedom which are characterized in the next two sections.

The Constructive Approach

If we define freedom constructively, we need a characteristic or good or service that can be identified with economic freedom. It may be associated with a variant of a particular set of economic activities. For example, our notion of economic freedom may be that higher income yields command over more resources and makes people "freer." Alternatively, more choice or a more equal distribution of income may be what we wish to use as a definition of more freedom. In this way we can produce an index of any number of "goods" to represent economic freedom. Regardless of what is chosen, however, the constructive definition allows economic freedom to be "traded-off" against other arguments of the utility function and will imply that there is a demand for economic freedom to which the usual economic calculus applies.

Although these are congenial terms to economists, the difficulty with this conception is that no single construction has emerged to claim the mantle of "freedom." Until such a "good" is identified, the constructivist approach is empty. To date the most promising approaches have identified many categories of activities which contribute to economic freedom (Spindler and Still (1991), Scully and Slottje (this volume) and Spindler and Miyake (this volume)). A review of past Symposia, however, provides little grounds for complacency that "something will turn up" as a common core of goods and services to identify as the set of activites constituting economic freedom.

The Impediments Approach

Unlike the constructive approach, the impediments approach to a definition of economic freedom stresses interference with free exchange as reducing freedom. This approach flows from the assumption that the demand price reflects the individual's marginal benefit from consumption and the supply price reflects the marginal value of resources brought into production. Since both are the result of an "individual" optimization, any interference reduces utility. But this is awkward. As pointed out in Easton (this volume, previous chapter), an optimal tariff raises income (and, if you will, utility) of those imposing the tax. Yet, I think we are in general agreement that the tariff reduces economic freedom, i.e., if we think of economic freedom as reflecting the individual's right to the fruits of his or her own labor (or, more generally, one's own resources), then the interference in the pricing of a transaction reallocates economic rents, and that reallocation is a reduction in economic freedom-the right to allocate one's own Here is where a (constructive) definition of freedom as an argument of the utility function becomes most attractive. There would be no paradox in saying that the commonly calculated "optimal" tariff raises income and yet reduces utility. In the traditional calculation only income matters for reaching the "optimum." Once "F" is in the utility function directly, it is part of full income and consequently a full partner in the optimization calculus.
product. If the amount of one's own economic reward allocated freely could be measured directly, and valued explicitly, perhaps we would have an ideal measure. But failing this, the impediments viewpoint focusses on measuring the amount of economic rent being reallocated by government In a different context Harberger (1964) has referred to "the economics of the nth best." As a practical matter, rather than search for some kind of global optimum, we are constrained to consider the effects of relatively small changes in various impediments.action.

To see what is being defined as a loss in freedom, consider Figure 1 in which equilibrium is initially at point A, the intersection of the downward sloping demand schedule, P*D, and the (horizontal) supply schedule, PS, for some good. Equilibrium prices and quantitites are at P and Q. Now imagine the imposition of a tax that increases price to P+T, from P. As is well-known, the value of the consumption foregone is approximated by the "triangle" losses in region W in Figure 1. There are a number of theoretical reasons why this definition of changes in economic welfare is less than fully satisfactory (Silverberg, 1978) although for our purposes, the approach is adequate.Note The loss in economic freedom, however, is something more. All transactions that were taking place at point A have been impeded. The impediment to these transactions is in two parts. The losses associated with foregone consumption in region W, plus the impediment to every transaction that is made-the rate of tax times the volume of transactions, i.e., the value of the tax, region R.

Click here to view Figure 1: Economic Freedom and Economic Welfare Measurement

Notice what is being defined in this characterization of economic freedom. We are not defining a loss in economic freedom as the loss in economic welfare associated with a distortion. We are, instead, defining the loss of economic freedom as the (marginal) value of the distortion weighted by the number of transactions both undertaken and foregone. The triangle loss is part of the loss in freedom, but only insofar as it reflects the weight of foregone transactions rather than realized transactions. We could approximate the loss in freedom as the quantity that would have transacted without the tax, Q, times the distortion, in which case the rectangle, R+W+V, would provide one measure of the loss in freedom. The transaction weight with which we choose to aggregate the distortion is unimportant for small changes, but it becomes of crucial importance if we are considering distortions that are prohibitive in a market. The greater the number of foregone transactions, the more important the distinction. If we have enough information about a particular market, then we can calculate the loss in freedom as the area between the demand and supply schedules foregone.

Some Complications

This conception of economic freedom deals with rent reallocation, but there are a number of complications. In the (first) case of the simple tax described in Figure 1, the appropriate measure is the value of the tax itself, R, plus the triangle, W. In the (second) case of a prohibitive tax, then rent reallocation is approximated either at the price at which the demand schedule hits the axis, P*, times the number of foregone equilibrium transactions, Q, or with sufficient information, the triangle loss itself-P*AP. It would be grossly inappropriate to use the actual (zero) transaction weights. In the (third) case of traded goods there are two possible measures of the loss of economic These are explored in Easton (previous chapter, this volume).freedom. These are displayed in Figure 2. We have the losses associated with the tariff revenue, R, and the triangle welfare losses, W and W*, and in addition we include the reallocation of rent that takes place as a result of the higher prices. Area Z is being reallocated from consumer to producer and as a result, economic freedom is being reduced. In Easton (previous chapter) I referred to the latter as an indirect loss. This led to the observation that the loss in economic freedom in a traded-goods setting is (approximately) proportional to the volume of consumption times the value of the tariff rather than merely the value of tariff revenue plus the triangles of welfare loss.

Click here to view Figure 2: Economic Freedom and Traded Goods

If rent reallocation is our characterization of a reduction in economic freedom, then we need to establish some principles by which we can measure the various countries of the world. The first principle is that we can sum the measured distortions in each market to reach a total. That is, we do not have to worry about the effect that a change in a distortion in one market has on the value of the distortion in any other. Consider two markets in which the goods are substitutes. If we introduce a distortion in the first market, we can calculate the rent reallocation exactly as described in Figure 1. In the second market, the demand schedule will shift. To the extent that there is already an existing distortion in that market, the increase in demand will raise additional revenue and be captured fully when we measure the distortion in the second This is true if the supply schedule is horizontal. If it has a non-zero slope then in the second market there is going to be an indirect rent reallocation in addition to the direct effect captured in the higher

Thus the sum of the tax revenues plus the triangle losses in each market is a measure of the loss in (direct) economic freedom. These are losses in the sense that the government reallocates the resources directly in the case of taxation, and by forcing individuals to forego transactions in the case of the triangle losses. We saw from Figure 2 that indirect losses accumulate when goods are traded and that these losses are (roughly) proportional to the value of domestic production. Indirect losses in freedom also occur when demand shifts cause prices to change in secondary markets. Unfortunately these are less easy to measure and result from an adjustment on the part of individuals to the new configuration of demands and supplies induced by government policies.

The second principle is that for purposes of measurement, all distortions can be conceptualized as relative price Although tariffs and quotas have equivalence as far as rent transfer is concerned (although different people may receive the rent), their properties differ in other contexts, e.g. stability of equilibrium is affected by the choice of one or the other. Other measures such as content requirements, "health" restrictions and the like are difficult to assess, but ultimately can be converted into price increases.distortions. If there are quantity restrictions, or there are prohibitive restrictions, then, in principle, knowledge of the relevant demand and supply schedules would allow measurment of the direct losses. Figure 1 remains appropriate with only a slight change in emphasis. Let Q' be the restricted quantity. The "tax revenue" becomes a reallocated rent and is now measured as an indirect loss of freedom. The rent accrues to whichever group has the property rights to the restricted supply, and the rest of the analysis is the same. With a prohibitive tax, knowledge of the equilibrium quantity and the highest price that could be charged would allow us to identify one measure of lost freedom-rectangle P*Q in Figure 1, the product of the price and the equilibrium quantity. However, if we know the demand and supply schedules, then we can either calculate the area under the demand schdule, P*PQ, measure of the loss in freedom as well. Although conceptually possible, calculations of this sort are commonly done with respect to the impact of non-tariff barriers and are notoriously laborious.


What then are the lessons for a set of calculations based on this methodology? In the first instance, the level of total taxation (relative to income) gives a rough measure of the direct loss in freedom through government reallocation of rents. This includes revenue taken from all levels of As a matter of practice, government expenditures are probably a better measure than revenue since they include implicit taxes are well as currently identified taxes. One might also choose to double the tax burden as whatever is received distorts one margin, and then does so again as it is spent. We are ignoring the "triangle" losses by simply using spending, too.government. These kinds of data are comparatively easy to obtain. What about the more difficult measures of impediments? In study after study (Spindler and Still (1991), Spindler and Miyake (this volume)) we see examples of the myriad ways in which governments restrict choice. There is no magic formula here. The "correct" way to do the job is to estimate the distortions in each and every I have not chosen to develop various "ordinal" measures of economic freedom. In addition to having difficulty deciding what numerical values to place on particular characteristics, I have been unable to decide on a metric with which to aggregate the various categories. This is not the same thing as saying that the ordinal measures devised are not useful. Those by Spindler and Still (1988), and Spindler and Miayake (1990), for example, are both interesting and useful as they call attention to many features in various economies that are

But this is an enormous undertaking. One alternative is to consider only certain "sectors" of the economy. The rationale underlying an index is that the transaction is the unit of account. The distortion of transactions is what leads to the loss of economic freedom. Our problem is to identify a significant proportion of transactions to assure ourselves that we have a robust measure of the loss in economic freedom. But how have transactions based theories proceeded in the past? Recall the discussion underlying the early quantity theory (Friedman, 1968). Fisher wrote the quantity equation as MV=PT where the measures of velocity and prices referred to all transactions. What transpired in part was that it was difficult to measure all transactions, and, gradually, final transactions, national income, was substituted as an available In addition, of course, the theory itself evolved.measure. Although the theory looked the same mechanically, MVy=Pyy, the subscripts remind us that it refers to a different level of economic activity.

Another alternative is to construct a computable general equilibrium model of the economy and identify the major distortions. Such a framework is popular in many trade and tax policy contexts but requires a decision about which sectors are most important. Finally we may wish to move to an instrumental level and try to identify a measure that we think may be associated with some of the less easily measured forms of taxation. Having chosen such a measure, we then try to find a "test" of the measure in some dimensions. This is the tack chosen in the remainder of this paper.

Indexes of Economic Freedom

In this section of the paper I illustrate a method by which two (highly imperfect) measures of economic freedom can be devised. The principle behind both measures is that the loss in economic freedom arises from two sources: the overt taxation by government, and by the regulations that the government imposes. One natural measure of the direct taxation by government is the level of government expenditures: the real withdrawal resources from the economy for This ignores the issues raised in Easton (previous chapter, this volume) about the indirect losses in economic freedom associated with traded goods.reallocation. No such simple tool exists for measuring the levels of regulation and the attendant loss of economic freedom. This is the major problem confronting the measurment of economic freedom in this framework.

Let us assume for the moment that we have such an appropriate indicator. If we have such a measure we could add it to the direct costs and be finished. Difficulties arise from two sources. First, if we are unable to identify the actual losses associated with the unmeasured impediments to exchange, and are forced to choose a proxy measure, how do we link this to the better identified government spending measure in a consistent fashion? Second, we want the indirect losses to be comparable to the direct losses., i.e., with total revenue (or expenditure) we have a measure of all government taxation which is gathered throughout the economy. We are not concerned that a little further study will add a new unidentified amount of explicit revenue and hence cause a dramatic change in the measured loss in freedom from this source. With the measure of indirect costs, however, the more we study any particular economy, the more we are likely to discover regulatory impediments to free exchange. As a result there will be a tendency to identify higher costs with more closely scrutinized environments. This is likely to engender a spuriously high measure of loss for economically developed I have had to ignore (what were!) the Communist countries because information on "budgets" is so very different from that reported in the West.countries.

Weights and Measures

Let us consider a particular proxy for regulatory cost and develop a methodology for integrating the direct and indirect costs when the latter are measured by proxy. Suppose that regulations are developed and deployed by governments in proportion to the number of government employees. Thus a greater number of government employees per capita means a greater degree of regulatory activity. Assume further that the distortion in prices caused by regulatory activity is the same in each country. We have an overall loss index that looks like (1):

(1)Loss = F(G,E)

in which the Loss is equal to some function of government spending (in levels or more likely relative to national income) and the number of employees (either in levels or per capita). If we wish to generate an index of costs, then we can do so by providing a weighted average of government spending and employment. What weights should we use in the index?

Here I think the answer is clear. The weights must derive from the universe of transactions from which they were collected. For example, suppose that government revenue arises primarily from revenue collected by a tax on income. Suppose further that impediments to exchange are primarily located in final goods and services (as distinct from intermediate goods and services). In this case the value of trade in each market relative to the sum of the value of trades in both markets would be a reasonable weight. In the example of the Loss Index of equation 1, the weights might be specified as in equation 2,

(2) Loss=GQE1-Q , where Q = [WL/(Y+WL)]

where the Y is national income, WL, is labor income and Q is the share of labor income (transactions) in the value of all transactions under consideration.

Index F1

The first index I have constructed is a simple one. It relates the loss in freedom to the share of government expenditures in national income and the proportion of the population that works for the government. In this case the weights are equal since the transactions cover the same ground-the entire economy. Both government revenues and impediments to exchange introduced by government employees are present at all levels of exchange in the economy. So that a doubling of the inputs amounts to a doubling of the loss in freedom, I have taken the square root of both percentages:

(3)F1= (G/Y)0.5 (EMPL)0.5 ,

where (G/Y) is the proportion of all government spending relative to national income, and (EMPL) is the per capita employment of all government workers-national, "state" and A more sophisticated measure would identify direct revenue per employee and develop a sense of the number of "obstructive" bureaucrats.local.

Column 1 of Table 1 lists the countries in order of their loss in economic freedom-the index, F1, which is reported in column 2. The index itself runs between zero and unity with a higher score suggesting more impediments. To see how our sample is distributed, Figure 3 displays a plot of the distribution of the values of Index F1 with a few of the developed countries identified. The ranking of the countries calls attention to the limitations of the construction. It raises the question whether Senegal is really more free economically than Canada or whether Japan is more free than the U.S. What may be highlighted here is that the amount of bureaucratic obstruction per bureaucrat is different in the different countries. The presence of a number of African countries not known for their economic liberalism raises the same question although perhaps we might also need to ask if transactions are more free than our casual empiricism suggests. Perhaps there are a large number of transactions that take place outside the range of the government's interference. Among the developed countries, however, there is some correspondence with casual observation.

Click here to view Table 1: Economic Freedom Ratings

Click here to view Figure 3: Impediments to Freedom: Index F1

A Second Index

The first Index is just that. It is an index without any real dimensionality of its own. Until we can identify some way to test it for consistency and stability, there is little to be said for it other than that it picks up some variables that we might reasonably think are associated with economic freedom. The second index is more in the spirit of the cardinal measures that I have advocated. The attractiveness of using government spending as a measure of the distortion is enhanced if we set ourselves to calculating the per capita loss in income associated with government interference. In this case we compute government expenditure per head, displayed in the column labelled F2(G) in Table 1, and add it to the value we attach to the loss in economic freedom associated with the number of government employees, the column headed F2(E). The crux of the matter is to provide a sensible basis on which to evaluate the cost in economic freedom imposed by each government employee.

An approach to this pricing problem is to find some tradeoff between the utility diminishing properties of government employees and other aspects of life. To this end I have estimated an immigration function for the United States. In principle, immigration depends upon any number of economic factors and Determinants of immigration are notoriously cranky with simple measures like per capita GDP in one country relative to another generating "wrong signs" in the regression and the like. The results of the regressions should be judged in this context.constraints. My framework is to regress the rate of immigration from each country to the U.S. on the proportion of income spent by the government and the per capita number of government employees and several other variables including per capita income and whether the country imposed emmigration restrictions. This is written as equation 4:

(4)IMM = a0+a1(G/Y)+a2EMPL+a3log(GNP)+aiXi

where IMM is the amount of immigration into the U.S. from each country (1981-87) relative to the population of that country, (G/Y) is the share of all government spending in national income, EMPL is the per capita number of government workers, and log(GNP) is the logarithm of per capita The ratio (G/Y) is included to control for the revenue function of some government employees. This given the amount of revenue raised, the measure EMPL is linked to immigration.GDP. Among the variables included, the vector, Xi, in equation (4), were several different measures of emmigration restrictions and political and civil liberty indexes familiar to those who have followed this literature. Once the regression results have been calculated, ask the following question: What is the trade-off between income and the number of government More formally, immigration will take place only if there is some utility gain to emmigration (to the U.S.). If the change in immigration is zero, then the gain in utility is zero as well. Thus set dI=0 so that if utility (associated with the act of immigration) is held constant, (dU/dE)/(dU/dY) 1/2U = (a2/a3) which is the relative price of government employees., i.e., it is the tradeoff in terms of real income of those who are emmigrating (to the U.S. or Canada.)employees? This question can be answered by looking at the tradeoff between real income and the number of employees of government. A given level of immigration can be obtained by having either more government employees per capita or a lower level of domestic income. This means that we can attach a value to the number of employees of government-in this case the ratio between the estimated values of a2/a3.

A Regression Digression

The results of various regressions for the United States are presented in Table 2. The first regression shows that there is a negative relation between the rate of emigration to the U.S. and each government's spending although this is not of particular importance to our The rate of immigration (per thousand) to the U.S. from each country is the seven year total from 1981-87 divided by the 1986 population.analysis. At the same time, there is a positive relationship between the number of government employees per capita and emigration to the U.S. I have highlighted this result because the same pattern persists in all the regressions (both for the U.S. and Canada). The units of the dependent variable are per thousand of population. Thus an increase in government spending from 10% of national income to 20% of national income will lower the rate of immigration to the U.S. by 3 per thousand (from the immigrant's country.) Similarly, an increase in government employment per capita from 1 to 11-the extremes of the range, will be associated with an increase of roughly 13 per Of course these are estimated as a cross-section and as a result speak to extant levels of spending and employment, not to changes in a particular country. A more careful look at the time series would be appropriate.thousand. As is to be expected, the R2 is low and the standard error of the estimate is large relative to the mean of the dependent variable.

Click here to view Table 2: Rates of Immigration to the U.S., 1981-87

The second regression in the table, a more complete specification, indicates that although the t-values are marginal by traditional statistical standards, nonetheless the effect of per capita income and EM1, a dummy variable that identifies whether the country has any form of emigration restriction, are consistent with our This latter measure is derived from Spindler and Miyake (1990) where those with any restriction, their values 2-5 received a score of 1, and unimpeded emmigration received a 0.expectations. Higher income abroad reduces emigration to the U.S. A country with 10 percent higher income will reduce immigration to the U.S. by roughly 4 per thousand. Emigration restrictions imposed by foreign countries reduce it as well.

The third regression in the table shows the consequences of including Gastil and Wright's (1988) measure of political freedom. A similar pattern of results obtained when their measure of civil liberties was used as well-a result not reported. Unlike Friedman's (1988) finding that civil liberties predicted growth rates better than political freedom, I found both to be insignificant in predicting emigration to the It may be that they are more effective in predicting the total immigration from their respective countries, but this hypothesis I did not test.U.S. The third regression is also illustrative of several efforts to extend the analysis. The expenditure measure is different. In order to expand the sample it is limited to central government expenditures. A number of other experiments were tried with different measures of political freedom and dummy variables for regions and the like. Except for reducing the significance levels of all the variables, the signs and magnitudes remained as reported in Table 2.

A similar approach was taken to the Canadian immigration rate. These results are listed in the Appendix as Table A. Only four years (1984-87) of data are used and there is some indication that the influence of Canadian immigration restrictions changed during the period. Although the signs are consistently the same as those obtained for the U.S., the significance levels are lower. There are also fewer immigrants in comparison to the U.S.

Click here to view Appendix Table A: Rates of Immigration into Canada, 1984-87

There is a final observation to support the notion that something useful is being identified by the regression. I regressed the difference (suitably normalized to reflect the different sample size) of the rate of immigration from each country to Canada less the rate of immigration to the U.S., DIF, on the measure of each country's government expenditure and government employment. This is reported in Table 3. Since both countries are politically stable and share many attitudes and values, I was curious as to the effect of our two measures. As is apparent from the positive sign on (G/Y), those who come from countries which have relatively more government spending come to Canada, and from the negative sign of EMP, those who come from countries that have more government employees per head come to the U.S. This would be consistent with the casual observation that emigrants are selecting on the basis of whether they prefer relatively fewer impediments to the market or more government expenditure. During this period, Canadian policy has not been designed to admit the most economically able.

Click here to view Table 3: The Difference Between Per Capita Immigration to Canada and Per Capita Immigration to the United States

Constructing the Index

With the estimates of the coefficients on EMPL and log(PGDP) from which we form the ratio, a2/a3, we can develop our additive index. The weight on EMPL is roughly 0.4 x Y.23 This sub-index, which gives the value of EMPL in promoting emigration to the U.S., is reported in Table 2(E). The sum of the two sub-indexes, F2(G) and F2(E) is reported as F2. In addition, the final numerical column of Table 1 is a normalized score-the index F2 relative to per capita GDP. It is this magnitude that is reflected in the ranking of the final column. Figure 4 displays the plot of these per capita scores. It is interesting that among the developed nations the rank remains relatively similar to that devised in the first index. Unlike the first index, however, index F2 reflects the dollar value of the impediments.

Click here to view Figure 4: Impediments to Freedom: Index F2

Some Reflections

Although the indexes above are imperfect instruments, it seems to me that this technique for constructing a cardinal measure of freedom's loss has potential. A more useful approach would be to identify all the emmigrants from a country and evaluate their destinations in a simultaneous matrix. With some recognition of the barriers to emmigration and immigration, the evaluation placed by movers on the non-monetary economic characteristics of freedom may be identifiable. This is not the only way to measure the implicit characteristics of economic freedom, but it is one way.

A second extension is to identify bureaucrats engaged in the act of regulation and try to measure the losses they cause within one or another country in specific well defined situations. This could serve to sharpen the cost estimates directly.

A third problem is to tackle the losses in freedom imposed by particular regimes that effectively stymie certain kinds of economic transactions. Communist regimes need to be assessed differently than Western regimes-at least at this point. Likewise dictatorships may also need a different set of variables.

Finally, the estimates in Table 1 may be too generous. We undervalue the costs of freedom of government. Both revenue and expenditure distort. If resources are the vector, R, to which factor rewards, w, pertain, and outputs are denoted by the vector, Y, to which prices, p, are relevant, then it is not double counting to measure the losses in freedom as the sum of both sides of the equation: (w'-w)R(w')=(p'-p)Y(p') where the " ' " indicates a distortion from the free market price.


Agency for International Development. Development and the National Interest: U.S. Economic Assistance into the 21st Century. A Report by the Administrator of AID (1989). (no printing details)

Friedman, Milton. "The Quantity Theory" International Encyclopedia of the Social Sciences Volume X. Macmillan and Free Press (1968).

Friedman, Milton, "A Statistical Note on the Gastil-Wright Survey of Freedom" in Walker, Michael A., ed. Freedom, Democracy and Economic Welfare: Proceedings of an International Symposium. The Fraser Institute (1988).

Gastil, Raymond D. and Lindsay M. Wright, "The State of the World Political and Economic Freedom" in Walker, Michael A., ed. Freedom, Democracy and Economic Welfare: Proceedings of an International Symposium. The Fraser Institute (1988).

Harberger, Arnold C. "The Measurement of Waste" American Economic Review (May 1964): 58-76.

Heller, Peter S. and Alan A. Tait. Government Employment and Pay: Some International Comparisons International Monetary Fund Occasional Paper 24 (1983).

Russell, Bertrand. "Definition of Number" in James R. Newman, ed., The World of Mathematics Vol I. Simon and Schuster (1956) pp. 537-43.

Silverberg, Gene. The Structure of Economics. McGraw-Hill, (1978).

Spindler, Z. A. and L. Still. "Economic Freedom Rating: An Interim Report," in Walter Block, ed. Economic Freedom: Toward a Theory of Measurement Vancouver: The Fraser Institute, 1991.

Statistics Canada, Canada Yearbook 1990 (1989).

United States Department of Commerce, Bureau of the Census, Statistical Abstract of the United States 1990, (1989).

Wright, John M, ed. The Universal Almanac 1990. Andrews and McMeel: Kansas City (1989).


Milton Friedman wanted clarification of Table 1. Easton explained that column 1, Index F1, was separate from the total dollar index of Index F2, column 2, which was in turn composed of the two subindexes (in the next two columns). The per capita measures which were suggested (as an alternative to the gross dollar measures) at the previous conference were the final column of figures and provided the ordering for the countries along the right-hand side. Friedman felt that we should look at the components and see which performed better relative to peoples' judgment rather than rely exclusively on the aggregate index. Easton agreed that some measure of the usefulness of the measure is necessary, but none was developed in this paper.

Zane Spindler made two points about the assumption that government employees perform in the same obstructive ways. He suggested that the reason that India does not rank the way one would think is because an Indian government employee imposes a restriction in a very different way than a government employee in the U.S. Often the Indian government employee will sell the restriction. Second, with respect to immigration, a country may restrict immigration or emigration as a way of capturing the market for its regulation. Thus regulation would be correlated with immigration or emigration.

Juan Bendfeldt wondered whether there was a problem with the regression to the extent that there may be a correlation between government expenditures and government employees per capita. What does the government do with tax revenue? They hire employees. Easton responded that he had run the estimation as a two-stage least squares and although the significance level dropped, there was little change in the coefficients from such a correction. Zane Spindler pointed out that from his tables, although there is such a correlation, it is far from perfect suggesting that some governments are more effective in there use of employees.

Juan Bendfeldt felt that the use of emigration was a useful way of capturing the loss of freedom but that illegal immigration makes these data most unreliable. For example, outside of Guatemala city with 2 million people, the next four cities of Central America with the greatest population are in the United States! They send money back, and so we can see roughly how many people there are abroad. Further, government employment is difficult to measure. There are non-government institutions that function only for the government, and contracting-out is another way to evade responsibility in the official budget but still obtain additional services. Easton did not have any specific information on either of these issues other than the data sources referred to in the paper. Easton remarked that there were no migration data comparable to the International Monetary Fund's, Direction of Trade.

Alan Stockman wondered how U.S. immigration quotas from different countries, would affect the measures Easton used. Second, since government spending is already in the regression equation, is it necessary to aggregate the measures in F2? Finally, thinking of the measures of F2(G) and F2(E) as related to the "bundling issue" in the Jones/Stockman paper (this volume), is this classification an "E" component or a "G" component: a theoretical categorization or one of convenience, and might they not serve to offset or ameliorate one another? Easton argued that his measures were for conceptual reasons as government expenditures crudely capture tax revenue reallocation issues, while the number of government employees were meant to correlate with the degree of regulatory interference with the economy. Perhaps they offset one another to some extent, he maintained, but then the regression is simply picking-up a net effect. As far as the effect of specific U.S. quotas, even though the U.S. had a different system than Canada during this period (Canada used a point count over certain specific characteristics), the similarity of the results for the two countries suggested that it was a useful indicator and gave some confidence in the results.

James Ahiakpor wondered if using both the wage bill and national income in the weights of equation 2 reflected double counting. Easton argued that you need to double count since each is a separate source of distortion. What the double counting in the weights does (in equation 2) is to allow the aggregation of both sources of the distortions. The weights themselves sum to unity. This is not really double counting, but it is a way of assuring that many layers of distortion can be analyzed in a consistent fashion.

Milton Friedman commented that the regressions (1 and 2) show that the higher the percent of income spent by government, the lower the level of emigration. This may reflect the inadequacy of measured income. It is disturbing from the point of view of relying on the ratio of government spending to income. Juan Bendfeldt pointed out that the measure of government's take may be nonlinear. A 13% take from a developing country may be more important than a taking of 40% in a developed country. He found in Guatemala that every time revenue went above 7.7%, the government ran into trouble with decreased national growth. Perhaps there is a "neutral" point of smallest damage, he suggested. Alan Stockman pointed out that the (negative) correlation between the government share of income and emigration means that government spending provides benefits as well as tax losses. The loss of economic freedom should be "added" to welfare. For the measure of economic freedom, however, they should not be netted out. Easton agreed saying the sign of the relationship does not matter since (we agree) that government spending reduces economic freedom which is what it is being calculated. What the regression serves to do is to price government employees. Where this would lead to trouble is if government employees were seen as handing out goodies and thus were valued not for their role as obstructing but for their role in providing benefits. Recall Table 3 takes the relative amounts of immigration between Canada and the U.S. Milton Friedman agreed that high government spending brings benefits as well as costs, but argued that it may also reflect the inability of governments to spend in low income countries in the same way they can in high income countries.

James Ahiakpor was unclear why the optimum tariff didn't lead to a proper measure of welfare. Easton responded that it would if we had the appropriate valuation of economic freedom-that is the tariff maximized a full, freedom inclusive measure of welfare, but then it would balance out the gain in income with that of the loss of economic freedom imposed by the tax.

Alan Stockman wondered if we can get black market data on the right way to emigrate. In Hong Kong they sell a magazine called "Emigrate." Juan Bendfeldt answered that there are such data. In Guatamala there are tours advertized in which they guarantee that they will get you into the Unites States. With the new immigration laws, the cost went up to $7,000. Immigrants expect to repay it within two years. Many Chinese have paid $15,000 to get a Guatemalan passport. The data are available strictly from the newspaper. Alan Stockman suggested that The Liberty Fund could fund a project to gather these kinds of data.

Rating Economic Freedom: Capital Market Controls and Money

Jack Carr, University of Toronto


WHEN I WAS ASKED BY the Fraser Institute to examine the degree of economic freedom in domestic capital markets I thought this was a very interesting and feasible research project. I quickly agreed to undertake this research. I made my decision without having attended or read the output from the first two conferences on economic freedom. I have since corrected that deficiency and have given considerable thought to the question. I am now much more humble about the nature of progress that can be made on this research topic.

Before proceeding to analyze economic freedom in domestic financial markets there are a number of important issues to discuss. These issues have been addressed in the first two conferences, but there was no clear consensus on a number of these issues. A resolution of these issues is absolutely vital before any empirical examination can take place. I will try to avoid repetition of the earlier discussion but I feel it is imperative to clarify these issues and state my position on these matters.

Is Economic Freedom a Means or an End?

In the second conference Milton Friedman (my most respected teacher) stated that for him economic freedom (as well as political freedom) is an end by itself. There is a problem in making economic freedom one of the arguments in an objective function. By doing so one arbitrarily decides the issue of whether economic freedom is a good thing. For a number of us, this is an inherently obvious point. However there will be those who do not hold this view. They may have other objective functions. They may believe that income equality or income security should be ends and hence should be arguments in an objective function. Different individuals may posit different objective functions. This being the case it is near impossible to conduct a rational debate among individuals with different points of view. Each individual will posit their own objective function and there will be no way to choose among competing functions. Hence there would be no objective way to decide on various public policies.

This issue is very much like the issue of the role of tastes and preferences in explaining economic behaviour. A number of economic facts can be explained by adoption of a particular utility function. In addition, changes in the data can almost always be explained by resorting to changes in the utility function (i.e. changes in tastes and preferences). My methodological bias is to try to explain as much as possible without resorting to specific utility functions. Similarly, I propose to start with a very general objective function. In this objective function economic freedom will not appear (it will be a means not an end).

Consider a general individual utility function (for which one can get almost universal support)

(1)Ui = f(X)

where Ui is the utility of the ith individual and X is a vector of goods and services (including leisure).

All economists, whether free marketers or not should have no objections to the utility function in (1). In this utility function, economic freedom does not appear as an argument. An increase in economic freedom (holding X constant) does not lead to an increase in utility.

Although economic freedom does not appear as an argument in (1); nevertheless, traditional economic theory would yield an important utility enhancing role to economic freedom.

Consider the case where an individual consumes 2 goods, X1 and X2, has a fixed income, and faces fixed prices. In a world with complete economic freedom, equilibrium A in Figure 1 will represent the point of maximum utility for this particular individual. Now suppose the state imposes a restriction on the operation of free markets; the state forbids the production or sale of X1. The constrained equilibrium in this case is B. Clearly at B the individual is at a lower level of utility than A. Restrictions on the freedom to freely choose those commodities which maximize utility will result in a lowering of utility. In this example, less economic freedom always leads to a loss of utility. Economic freedom is a means of allowing individuals to reach maximum satisfaction. It should be noted that similar examples could be constructed on the production side of the economy.

Click here to view Figure 1: Economic Freedom and Utility

This proposition concerning free markets is an example of what is perhaps the most famous and (perhaps most important) proposition in all of economics and that is the proposition of gains from trade. Free exchange maximizes the gains from trade. Any restriction on free exchange will eliminate profitable opportunities of gains from trade and hence will reduce the overall level of welfare.

The methodology adopted in this paper will be to assume a generalized utility function where economic freedom is not an end. We will then examine economic theory to see how economic freedom affects the operation of the economy. A complete research strategy should test these propositions concerning economic freedom. (These tests are not carried out in this paper.)

Definition of Economic Freedom

If there was one question that was not resolved in either of the first two conferences it was the definition of economic freedom. Everyone agreed that economic freedom was multi-dimensional and a nebulous concept at best. As a student of Milton Friedman I will adopt his methodology that "you cannot define a measure without knowing what the purpose of the measure is" (p. 15, draft of second conference). For one purpose you may adopt one definition and for another purpose you may adopt another definition.

One should note that the problem of finding an empirical counterpart to a theoretical concept is almost universal in economics. Consider an example from monetary economics. The concept of money is crucial in monetary economics. However there has been considerable debate over the exact definition of money. There is a large continuum of financial assets. Where you draw the line and call one set money and the other non-money financial assets is a very difficult problem. Economic theory offers little guidance. What one has to ask is for what purpose one is defining money. For this, economic theory is a necessity. If one has an economic theory that says that the money supply is a prime determinant of the price level, then one can adopt a definition of the money supply which best predicts the price It should be noted that a particular data set is used to define money. One would need another data set to test the proposition that money influences prices.level.

It is this approach that I propose to adopt with respect to the definition of economic freedom. In the previous section we have argued that economic freedom leads to increased levels of utility. One can define economic freedom as that index which best predicts levels of utility. However such a definition is inoperable because utility is not measurable. In addition we desire a definition of economic freedom which is applicable to a country as a whole and not to each individual. With a lot of hand-waving we can use some definition of income as a proxy for utility. To arrive at an aggregate measure, we would add up individual income and obtain national income.

Now we would define economic freedom as that index which best predicts levels of national One could debate for a long time which definition of national income to choose. Regardless of the definition, one would want to define income as permanent income.income. In this sense, the index of economic freedom would be like the index of leading economic indicators. Both are multidimensional and both are meant to predict national income. It is important to note that national income by itself cannot be used as a measure of economic freedom. Economic freedom is only one of a number of factors determining national income. One needs a complete theory of income and economic growth in order to define economic freedom. It should be noted that economists have no good answer to the fundamental question of why some countries are rich and some are poor and why some countries grow at a fast pace and others grow slowly. For simplicity assume a neoclassical production function

(2)Y = f(K,L,A,EF)

where Y is national income, K is capital, L is labour, A is land including national resources, and EF is an index of economic freedom.

Clearly there can be two countries with the same amount of economic freedom but different levels of national income because there are different levels of the other factors of production. Similarly there can be two countries with the same factors of production but different levels of income. One country may have free markets and the other country may have restrictions which prevent factors moving to where they can contribute most to national income.

In summary, I propose to define economic freedom as that index which adds the greatest explaining power (i.e. has the largest partial correlation coefficient or equivalently the largest "t" value) to the national income equation, given all the other factors determining national income.

One data set would be used to define economic freedom. Clearly one would need other data set to test the propositions that economic freedom is an important determinant of national income.

There are important policy reasons why the proposition of the influence of economic freedom on national well-being should be tested. If restrictions on economic freedom can be shown to lower income levels, a strong case can be made to eliminate these restrictions. Hence one wants to define economic freedom in order to better understand its role in influencing national well-being. Once it can be demonstrated that economic freedom is welfare enhancing, there is a stronger possibility of convincing governments to allow greater degrees of economic freedom.

Difficulty in Applying Any Definition of Economic Freedom

From a theoretical point of view the methodology outlined in the previous section seems simple enough. However, this methodology is very difficult to implement in the real world. The example illustrated in Figure 1 is a clear example of a government restriction that reduces economic well-being. Unfortunately there are a large number of government actions which are not as clear-cut. The government undertakes a large number of actions. The question is which of these actions are restrictions on economic freedom and as a consequence welfare reducing. In an initial examination of government actions it is not obvious which actions should be placed in the freedom reduction category. (In fact, I will argue that in the absence of a well defined economic theory, it is impossible to classify government actions.) Consider the following examples from financial markets.

(a)A number of researchers (see White (1984)) have claimed that the period 1795-1845 in Scottish banking could be characterized as a free banking period. This period would be characterized as one with no restrictions on banking. This view has been challenged by Carr and Mathewson (Also see Rothbard (1988).1988). We argued that three Scottish banks enjoyed the privileges of limited liability granted by the Scottish Parliament. All other banks had to accept unlimited liability. Entry was free but not on the same terms as the three limited liability banks. Is this restriction of unlimited liability a relevant restriction on economic freedom? One cannot answer this question in the absence of some economic theory explaining the importance of the liability rule. The accepted wisdom of the time was that the unlimited liability restriction for new entrants was in the public interest. It protected depositors and protected the integrity of the banking system. Mathewson and I argued that this restriction was in the private interest of th three limited liability banks. Competition was allowed but the playing field was not level. I would argue that this restriction reduced economic freedom and lowered national income. The restriction did raise the income of the owners of the three limited liability banks (assuming that the entire income was not dissipated in rent seeking activities). One cannot characterize government actions unless one understands the effects of these actions and the rationale for these actions. As the above example illustrates, this is not an easy matter to do.

(b)In 1934 in the United States and in 1967 in Canada, deposit insurance was enacted. Did this action reduce economic freedom? Friedman and Schwartz (1963) argued that deposit insurance was necessary to eliminate the contagion effect inherent in bank runs. Carr and Mathewson (1989) present a private interest explanation of deposit insurance. We argue that this scheme subsidized small banks (typically new entrants) at the expense of large incumbent banks. If Friedman and Schwartz are correct deposit insurance would increase national income. According to this interpretation deposit insurance would be desired by all banks as it would improve depositor confidence in the banking system. This view would argue for government rules mandating deposit insurance. These rules could not be interpreted as reducing freedom as they would be desired by all economic agents. On the other hand I would argue that such schemes would reduce national income. Large banks would oppose such rules and small banks would desire them. Clarly a resolution of this issue is needed for a correct definition of economic freedom. Clearly such a resolution is not a simple matter.

(c)Most countries impose restrictions on both the asset and liability side of a number of financial intermediaries. In Canada, the asset portfolio of insurance companies is restricted. Are these restrictions reductions in freedom? Or are these restrictions the result of the most efficient way for insurance companies to post bonds. The liabilities of insurance companies are very long-term. Insurance companies can sell insurance policies to policyholders promising them a particular investment policy. After funds are collected insurance companies could change the investment policy to the detriment of policyholders. Both parties know about the possibility of such opportunistic behaviour. The problem for the insurance company is to find the most efficient way to post bonds which guarantee no change in the riskiness of its portfolio after an insurance policy is purchased. Regulation may be the optimal form of bonding. If such is the case all economic agents desire such regulation and it cannot be viewed as freedomreducing. In addition such restrictions, according to this theory, would not reduce national income.

These are but three of many examples of the difficulty of defining which governmental actions reduce economic freedom. In addition to these difficulties, there are the difficulties of knowing which restrictions on economic freedom are binding? Which restrictions do economic agents easily get around? Faced with these difficulties researchers may throw up their hands and argue that it is impossible to define economic freedom. However I have taken to heart one of the prime messages of the first conference that `anything worth doing is worth doing imperfectly.' It is hoped through conferences like these one can slowly converge on the optimal definition of economic freedom.

The above discussion indicates that a detailed knowledge of each country examined is needed to even begin to define economic freedom. At the outset I must admit that I do not possess this knowledge. I know most about financial markets in Canada. Next I know about the U.S. situation. However the farther geographically I get from Canada the less detailed knowledge I possess. Hopefully the conference will correct some of these defects. For future research, given the knowledge required for this research, I would suggest collaborative efforts by scholars chosen from the various countries to be examined.

Rating Economic Freedom in the Money and Capital Market Sectors

Financial Deregulation in the Seventies and Eighties

The purpose of this paper is to rate the level of economic freedom that currently exists in the financial sectors of a number of countries. The countries I propose to examine are Canada, the United States, the United Kingdom, Japan, West Germany and France. If this exercise were done twenty years ago for these same six countries I am convinced that the level of economic freedom in this sector of the economy for all six countries would be substantially less than it is today. In the '70s and '80s financial deregulation has played a significant role in raising the level of economic freedom. Before I embark on the empirical task of rating economic freedom I would like to address the question of why there has been an almost universal movement to freer financial markets.

One hypothesis would be that governments value economic freedom higher today than they did twenty years ago. Unfortunately I do not think there is any evidence to support this hypothesis. The hypothesis I propose to explain worldwide financial deregulation is consistent with the private interest theory of regulation I described in the previous section. I believe financial regulation was adopted, to a large extent, to protect local monopolies. This regulation was in the private interest of the owners of the local monopolies (or the cartels). This regulation was not in the general public interest. In the '70s and '80s financial innovation led to the development of close substitutes for these monopoly This is consistent with the view of Milton Friedman that although monopoly can exist in the short-run it cannot exist in the long-run (unless it is fully protected by government).services. With the elimination of the monopoly, it was no longer in the interest of the former monopolists to maintain the economic restrictions. As a consequence, these economic restrictions were abandoned. Consider the following three examples.

(a)Since 1933 commercial banks in the United States had been prohibited from paying interest on demand deposits. In addition the Fed through Regulation Q limited the interest rate that commercial banks could pay on time deposits. One interpretation of these interest rate restrictions is that they were put in place to eliminate commercial bank competition for deposit funds. These interest rate restrictions in essence enforced a commercial bank cartel. In the late '60s and '70s inflation in the United States became both high and volatile. This led to high and volatile interest rates which increased the cost to depositors of keeping funds in commercial banks. High and volatile interest rates led to financial innovation. (As the returns to innovation increase, one would expect an increase in innovation). Brokers developed money market mutual funds which were essentially a way to pay interest on demand deposit. With the development of this substitute for a bank deposit, it was no longer in the interest of banks t have the government maintain interest rate restrictions. In 1980 the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was passed and in 1982 the Garn-St. Germain Act was passed which had the effect (among other things) of removing interest rate controls on It should be noted that the 1933 prohibition of interest on demand deposits was not repealed. However banks were allowed to issue negotiable order of withdrawal (NOW) accounts which were in effect a way of issuing interest-bearing demand It should be noted that this example is consistent with the private interest theory of regulation. It is difficult to argue that these interest rate restrictions were in the public interest from 1930 to 1980 (presumably to prevent destructive competition in the banking system leading to a complete collapse of the system) and they were no longer in the public interest in the 1980s (when bank failures continued at a significant rate).

(b)Regulations in the province of Ontario essentially prevented foreign securities firms from entering the Canadian market. Although some people argued that it was in the public interest to have the securities industry controlled by Canadians clearly such protection was in the private interest of Canadian securities firms. In July 1987 the Canadian securities market experienced what became known as the Little Deregulation of the London security market in October 1986 was known as the Big Bang.Bang. One of the provisions of this deregulation was to allow foreign securities firms into the Canadian market. What is the explanation for this deregulation? I don't believe that this deregulation was due to the Canadian authorities finally seeing the light. This deregulation was forced on the Canadian authorities. Canadian firms in the 1980s were finding that they had alternatives to raising funds other than the use of the Canadian capital market. With deregulation in other countries, Canadian firms could more easily raise funds on world capital markets and bypass the local securities firms. Th Canadian firms needed international linkages in order to compete. As such Canadian firms now found it in their interest to have the government allow foreign firms into the Canadian capital A similar story could be told about transportation deregulation. Airline deregulation in the U.S. forced similar deregulation in Canada. A large part of the Canadian population have easy access to U.S. airports. Similarly, U.S. trucking and train deregulation forced Canadian deregulation. Goods going from Vancouver to Montreal could just as easily use U.S. routes as Canadian Again this example supports the private interest theory of regulation.

(c)On October 27, 1986 substantial deregulation occurred for financial institutions operating in the City of London (this deregulation was known as the Big Bang). On this date the practice of fixed minimum commissions for trading securities on the London stock exchange was eliminated. This change was forced on the LSE by the British government. Why did the British government bring about such a change. Again I would argue that fixed minimum commissions prevented broker competition and hence was in the private interest of stock brokers. However since the mid-1970s broker commissions were being deregulated on world stock exchanges. Investors could trade stock on a number of world exchanges. Deregulation in New York and other markets forced deregulation in One may ask why it was necessary for the government to force the LSE to change its rule. Why didn't the LSE change the rules by itself. A possible answer to this question is that not all brokers would be hurt by international competition. Those brokers dealing in securities which were listed solely on the LSE would not be hurt by international deregulation. Clearly, international competition would reduce political support for fixed minimum commissions and with reduced political support such a policy was no longer politically viable.London. Again this example supports the private interest theory of This example traces British deregulation to U.S. deregulation. Commissions on the NYSE were deregulated in the mid-1970s. One can ask what started this whole process off. Why did the NYSE deregulate commissions. A possible answer is that financial institutions were accounting for a larger and larger share of trading volume of the NYSE. The development of computers allowed large institutions to trade blocks of share off the NYSE. To be competitive, the NYSE had to reduce commission fees for their customers. Hence this example also illustrates the importance of substitute products in eroding monopoly positions.regulation.

Empirical Rating of Economic Freedom in Money and Capital Markets

As instructed I will assign for each category in each country an integer on a scale of zero to ten. Ten will represent the highest freedom rating and zero will represent the lowest. It will be obvious that such rating schemes are highly judgemental. However their main purpose will be in comparing one country relative to another. Table 2 presents the ratings of each category for each country.

Click here to view Table 2: Economic Freedom Rating

(a) Regulation of the Central Bank

(i) Is the power of the central bank to print money restricted?

The question of the existence of a central bank should be dealt with before examining the powers of the central bank. A standard proposition in monetary theory has been the necessity of government (either acting on its own or through a central bank) to control the money supply. Almost all monetary authorities today monopolize the issue of banknotes. The economic rationalization for this monopoly has been that the issue of banknotes is a natural monopoly. Banknote issue is considered a public good. Recently this view has been attacked primarily by proponents of free The modern attack on this view started with Klein (1974). For a complete analysis of the free banking position see Selgin (1988).banking. Free banking advocates recommend abolishing central banks and allowing for competition among private producers in the issuing of currency.

I could spend considerable time discussing this issue but unfortunately for the empirical purposes at hand the issue is moot. All the countries I examine in this study have active central banks and there is little likelihood that this situation will change. If the main purpose of an index of economic freedom is comparative (either comparing different countries at one point in time or one country at different points in time) then for present purposes one does not have to resolve the debate over competitive note issue. Again this is another example of an issue which is still hotly debated in economics. It is not an easy matter to decide whether restrictions on private note issue are in fact restrictions on economic freedom which led to a reduction in national income.

The following are the salient points on central banks in the six countries The description of the activities of the central banks is taken from Fair (1979).examined.


The Bank of Canada is wholly owned by the government of Canada. In fact the Minister of Finance holds all Bank of Canada shares. Technically the Bank is responsible to its sole shareholder, the Minister of Finance. The Bank of Canada has a statutory duty to maintain the domestic value of the currency, to control the external value of the currency and to maintain full employment. The government has the power to issue directives to the Bank. In practice, the Bank cannot follow a monetary policy different from that desired by the government and no directives have ever been issued. The Governor of the Bank of Canada is appointed for a 7 year term and the Bank is accountable to Parliament.

United States

The Federal Reserve System is a federal government agency consisting of 12 banks whose stock is owned by commercial bank members. The Federal Reserve has a statutory duty to supervise the banking system. The Federal Reserve is responsible to Congress; it must report twice a year on its policies. This report is to Congress and not to the President or Executive. The Federal Reserve is formally independent of government; however, as a practical matter the Fed is in continuous discussions with the Executive branch. The Chairman of the Federal Reserve System is designated by the President for a four year term (which is renewable).

United Kingdom

Since 1946 the Bank of England has been 100% owned by the government. The Bank has a statutory duty to supervise the banking system. The Bank of England is not independent of the government. The Bank is subject to the directions of Treasury, although in practice decisions over monetary policy are reached jointly. On a few rare occasions disagreements between the Bank and Treasury have been publicized. The Bank of England is not accountable to Parliament although as a matter of courtesy files its annual report with Parliament. The Governor is appointed by the government for five years (term is renewable).


The Bank of Japan is 55% government owned and 45% privately owned. The Bank has a statutory duty to maintain the domestic value of the currency and to control credit expansion. Actions such as changes in banks' reserve ratios require the approval of the Minister of Finance. Open market operations and discount rate changes do not require government approval. The Bank is accountable to the Japanese Diet. The Governor is appointed by cabinet for a 5-year term (renewable).

West Germany

The Bundesbank is 100% owned by the government. It has statutory duties to maintain the domestic value of the currency, to supervise the banking system and to facilitate the clearing of cheques. The government has separate powers to fix exchange rates and regulate the inflow of foreign capital. The Bundesbank is independent of parliament and is independent of the federal government. The federal government may ask for decisions to be deferred to a maximum of two weeks. The Bundesbank has an obligation to support the economic policy of the government but the important point to note is that this obligation is limited by the statutory duty of the Bundesbank to safeguard the currency. Conflicts between the Bank and the government have occurred but have not been of great significance. The Governor is appointed by the President on the nomination of the federal government for an 8 year term.


The Bank of France is wholly owned by the government. The Bank has a statutory duty to control credit expansion and to supervise the banking system. The Ministry of Economics fully controls Bank policy. This control extends even to the day-to-day operation. There is no accountability of the Bank to the French Parliament. The Governor of the Bank is appointed by the President on the advice of cabinet for an indefinite term. The President can dismiss the Governor at any time.

As the above descriptions of the central banks show, no central bank is restricted by some external rule in its control of the money supply. A Gold Standard rule would greatly reduce the discretionary powers of the central bank. A Gold Standard will not guarantee short-run price level stability but such a standard would guarantee long-run price level stability. However, it is unlikely that any country will relinquish control over its money supply and adopt some sort of commodity standard. A monetary growth rule as proposed by Milton Friedman would also restrict the arbitrary power of the central bank. Again none of the six central banks have such restrictions.

Statutory restrictions seem the greatest for the Bundesbank. Although the Bundesbank is required to support the economic policy of the government; this support is tempered by its obligation to safeguard the domestic value of its currency. Because of this obligation I will give the Bundesbank a rating of 6. The Federal Reserve is technically independent of the executive branch and I will give it a rating of 5. I give the central banks of Canada, U.K. and Japan a somewhat lower rating of 4. My reasons are as follows. All three of these central banks are subject to significant control from the government of the day. In Canada and the U.K., the Bank is subject to government directives. In Japan the Minister of Finance has been noted for announcing by himself discount rate policy.

In addition these central banks all engage in moral suasion' in their conduct of monetary policy. In Canada, the Bank of Canada has made requests of chartered banks for which they have no legal authority. In the past the Bank of Canada has requested that the chartered banks limit their loans to sales finance companies. Also the Bank of Canada asked the chartered banks to voluntarily agree to a secondary reserve ratio' (this was before a change in the Bank Act which gave such a power to the Bank of Canada). The implied threat had been that through changes in reserve requirements (which the Bank has no power to make anymore) or open market operations or some other Bank action that banks could be punished for non-compliance. This use of moral suasion is a fundamental violation to the rule of law. Fortunately for Canada, as the number of banks have increased, the use of moral suasion has diminished for obvious reasons.

In the U.K., the Bank of England works through conventions and understandings with the See Revell (1973).banks. The actions of the Bank of England have been described as conducting business through informal and friendly conversations as if the Governor was a senior partner in the banking firm' dealing with junior partners (the banks).

In Japan moral suasion is known as `window guidance.' The Bank of Japan determines each bank's reserve requirements and informally negotiates each bank's quarterly lending ceiling. As such it is difficult to expect individual banks to resist a request from the Bank of Japan to refrain from selling U.S. It should be noted that the Federal Reserve is not adverse to making such requests. However, with the large number of U.S. banks such a request is bound to be ineffective.dollars. Again such actions are contrary to the basic principle of the rule of law.

The Bank of France is completely controlled by the government. There is no restraint on the government's ability to use the printing presses to finance government expenditures. As such I gave the Bank of France the lowest rating for economic freedom; a rating of 3.

(ii)Has the central bank succeeded in providing a stable monetary environment?

The major goal of any monetary system is to provide for a stable currency so that private contracts can be made with the minimum amount of uncertainty. In such an environment where the freedom to engage in exchanges of all kind is maximized, national income will be maximized. This question can clearly be evaluated more objectively than the previous question.

Table 1 presents the inflation rates for our six countries for the last five years. In terms of average inflation rates Japan and West Germany experienced the lowest inflation rates whereas the U.K. and France experienced the highest inflation rates. Inflation is a source of government revenue. The higher the inflation rate the higher is the tax on cash balances. In addition for tax systems which are not fully indexed, higher inflation rates in effect mean higher average income tax rates. (These increases in tax rates are particularly pernicious since they occur without any specific act of parliament or congress). Finally if inflation is unexpected, this unexpected inflation reduces the real cost of government debt (i.e. this unexpected inflation is in effect a partial repudiation of the debt).

Click here to view Table 1: Inflation Rates 1984-1988

Economists are concerned not only with average inflation but also the volatility of inflation. The more volatile inflation, the more unexpected inflation one will observe. The more volatile inflation the more difficult it is to negotiate long-term contracts. In the late '70s the high and volatile inflation rate made it very difficult (and costly) to issue long-term debt.

Hence both high and variable inflation rates are harmful to the economy and harmful to overall economic freedom. In giving rankings to the performance of various countries one should note that standards change over time. After the double digit inflation of the '70s, Canada's inflation rate of 4% is considered low by most economic observers. However when inflation reached 4% in the late 1960s this was deemed to be a national emergency and a Royal Commission was appointed to investigate the causes of the inflation problem.

Since Japan and West Germany have the lowest inflation rate and relatively low inflation volatility they receive a rating of 9. Canada has a slightly higher inflation rate than the U.S. but it has a more stable inflation rate. I awarded the U.S. and Canada a rating of 7. France has a slightly lower inflation rate than the U.K. but the volatility is much greater. I awarded France a rating of 5 and the U.K. a rating of 6.

(b)Regulation of the commercial banks

(i)Is there free entry into the commercial banking business?

This again is one of those questions for which there is no easy answer. Take the example of Canada. Up until the Bank Act of 1981 it was almost impossible for foreigners to set up a bank in Canada and it was extremely difficult for new domestic firms to enter the field. (A separate act of Parliament was required to set up a Bank.) Although new banks were rare, there were many new entrants into financial institutions which were providing services which were close substitutes to those provided by banks (e.g. trust companies, mortgage loan companies, savings and loans, credit unions, caisse populaires and suitcase banks).

The key question is how effective was the restriction on bank entry? Although non-bank financial intermediaries could enter, it is important to note that the banks had a monopoly on the clearing mechanism. Hence these substitute banks could compete effectively in the provision of time deposits but couldn't compete effectively in the demand deposit market. After 1981 in Canada, a separate act of Parliament was no longer needed to incorporate a bank, entry of foreign banks were These foreign banks are known as Schedule B banks. They are restricted in their ability to branch and on the share of the market they are allowed. The recent Canada-U.S. Free Trade Agreement has freed U.S. Schedule B banks from these restrictions.permitted, and the chartered banks' monopoly of the clearing system was eliminated. Currently, competition in the banking industry is very healthy in Canada. As such I give Canada an 8 in ease of entry.

In the U.S., banks can be incorporated nationally or at the state level. All national banks have to belong to the Federal Reserve system and state banks have the option of joining the Federal Reserve system. One advantage of belonging to the Fed is obtaining the cheque clearing services provided by the Fed. The large number of U.S. banks would be an indication that entry into the banking field in the U.S. is relatively easy. However the large number of U.S. banks is partially due to the restrictions on branching that exist in the U.S. In some cities (e.g. Chicago) banks are only allowed one branch. In some states banks can branch within the city but not outside the city. Branching across state lines is forbidden. There are those who contend that loopholes in the statutes (i.e. the use of bank holding companies) can be found that do in fact allow for more branching than would at first appear to be the case. However, it seems clear that the anti-branching provisions of the federal and state governments severelylimit competition in the U.S. market. Because of these anti-competitive restrictions I would rate the U.S. banking system a 6 on freedom of entry.

In the U.K., London is a large international banking centre. Foreign entry is relatively easy although there are some restrictions (the U.K. has certain reciprocity requirements). In the U.K. the Bank of England has the authority to deny a banking licence. A rating of 8 is given to the U.K.

Japan has substantial barriers to foreign banks. There are large administrative barriers to foreign banks. In addition, domestic banks are granted more favourable capital-asset ratios. Because of these barriers Japan is given a 4.

West Germany has a large number of banks (in 1988 there existed 4,438 banks). There are 58 foreign bank branches. In West Germany, there are a number of conditions to be met in order to obtain a banking licence. Once these conditions are met, the banks have a right in law to be granted a licence. One possible measure of the increasing competition in the banking market is the falling interest rate margins for German From 1983 to 1987 interest rate margins fell by about .4 of a per cent.banks. A score of 8 is given to West Germany.

In France banking has a large degree of government involvement. Three of the four largest retail banks still belong to the state. Because of the large involvement of government run banks, a score of 2 was given on freedom of entry into the French banking market.

(ii) Are deposits insured by a government agency?

In the introduction I argued that deposit insurance is one of those issues where the effects on economic freedom are very contentious. The conventional wisdom is that government mandated deposit insurance is in the public interest protecting against bank runs. This argument depends critically on the belief that bank depositors face sufficiently high marginal costs of information that they are unable to distinguish between firm-specific shocks and industry wide shocks. I reject this argument. I argue that deposit insurance is in the private interest of smaller banks and is a restriction on economic freedom. (As such it is very much like the anti-branching provisions in the U.S.). Deposit insurance encourages more risk taking of the banks and results in more Not one Canadian bank failed during the Great Depression but there were bank failures after deposit insurance was introduced in 1967.bankruptcies.

Deposit insurance was first started in Canada in 1967. De jure, the current limit is $60,000 Canadian but de facto there seems to be no limit. In the U.S. deposit insurance was initiated in 1934 and the current limit is $100,000 U.S. Both systems are non-risk rated. A rating of 5 is given to both Canada and the U.S. In the United Kingdom government run deposit insurance only came into force in Building societies have their own scheme.1982. The insurance covers 75% of the first "20,000 of bank Foreign banks can be exempted if they have their own scheme in their home country.deposits. The British system of co-insurance tends to minimize the moral hazard problem of the insurance scheme. Depositors still have an interest in monitoring the riskiness of the bank's portfolio. A rating of 6 is given to the U.K.

Japan has a government run system of deposit insurance that insured deposits in 1986 to a maximum of 3 million yen. This limit was expected to increase to 10 million yen. Japan gets a score of 5. West Germany has no compulsory deposit insurance scheme. Private banks set up their own Deposit Protection fund in 1976. Given the voluntary nature of the German scheme, a score of 8 is given.

No evidence of any deposit insurance scheme could be discovered for France. However, given the fact that three of the four largest banks are publicly owned the government in effect guarantees bank deposit. A score of 5 is awarded for France.

(iii) Are there reserve requirements on the banks?

There is an argument in monetary economics that fractional reserve banking is inherently unstable. One aspect of this argument is that because of fractional reserves, that in times of banking panics, even very solid and safe banks will experience runs. This argument depends for its validity on the same assumptions needed to favour government imposed deposit insurance. It requires an inability of depositors to distinguish between firm-secific and industry wide shocks. In such a world only a bank with a 100% reserve will be spared a run. If one believes in free banking then there is no need to have any imposed legal reserve The Bank of Canada is proposing a complete abolishment of reserve requirements for the Canadian banking system.requirement. Banks will have their own optimal reserve ratio and depositors will know what reserves each bank maintains.

Hence this is another one of those contentious issues. One school of thought would argue for 100% reserves. Another would argue that any formal reserve requirement is an undue regulation on banks. Such reserve requirements act as a tax on banks (a tax that other financial institutions do not have to bear and hence impairs the competitiveness of the banks). In addition these legal reserves perform no economic function. These reserves cannot be called upon by the bank in times of financial This was a bitter lesson that U.S. banks discovered during the Great Depression.crises.

It should be noted that even among economists who favour 100% required reserves, there would be no agreement that a 30% reserve ratio is superior to a 20% reserve ratio because there would be no reason to believe that banks subject to a 30% ratio would have less risky portfolios than banks subject to a 20% ratio. Clearly 100% is better than either 30% or 20% but it is not clear that 30% is superior to 20%.

No country in our sample has 100% reserve requirements. All these countries have a fractional reserve banking system. From 1960 to 1984 the average reserve requirement on bank deposits was 6% for Canada, 8% for the U.S., 7% for the U.K., 3% for Japan, 11% for West Germany and 4% for This data is taken from Brock (1989). It is interesting to note that many Latin American and African countries have both high reserve requirements and high inflation rates. For Latin American countries reserve requirements are in the 30 to 40% range.France. There is too small a variation to award any difference in scores. All countries are awarded a 5.

(iv) Are there interest rate ceilings on what the banks can pay on deposits?

Usury laws are perhaps one of the earliest forms of restriction on economic freedom. Usury laws have been very common in the banking field. Currently there are no effective restrictions on what banks can pay on deposits in both Canada and the United States. In the U.S. interest is not allowed on demand deposits. However the use of NOW and Super NOW accounts effectively gets around this restriction. Also DIDMCA has gotten rid of the Regulation Q ceiling on time deposits. Due to this relatively free environment I will give both Canada and the U.S. a score of 9.

I could find no evidence of effective interest rate restrictions for the U.K. and West Germany. Both of these countries get a rating of 9.

In France there are no interest bearing current accounts (as is allowed for in most European countries). In addition, for term deposits below 100,000 francs the maximum rate of interest is 5.5%. Because of these restrictions on the ability of banks to freely raise deposit funds France gets a rating of 3.

In Japan interest rates on deposits with commercial and other banks are limited by ceilings under the Temporary Interest Rates Adjustment Law and guidelines set by the Bank of Japan. No interest has been allowed on current accounts since 1944. It is estimated that almost two thirds of Japanese savings deposits remain under interest rate constraints. The Ministry of Finance sets maximum interest rates for money market certificates $69,000 or lower. Overall, about one third of deposits are under interest rate controls. This represents a subsidy to Japanese banks. The total value of these subsidies to Japanese banks has been estimated at about 3.7 trillion yen or 1% of See Euromoney, February 1988, p. 37. It should be noted that these interest rate controls exist in Japan in spite of attempts at deregulation. In addition, it should be noted that some observers claim that Japanese banks do in fact get around some of the interest rate controls. If this is the case the estimate of the subsidy will be on the high side.GNP. Because of these substantial interest rate restrictions, Japan gets a rating of 3.

(v) Can banks enter the security business?

Banks, almost everywhere, have restrictions on the product lines they can Part of this is due to the desire of regulators to restrict the riskiness of banks' portfolios in a regime of non-risk rated deposit insurance.offer. One important restriction is on the ability of banks to enter the security business. Firms can borrow either from banks or from capital markets. Restrictions on the ability of banks to enter the security business greatly hamper the ability of banks to compete on the asset side of their balance sheet. I would interpret such restrictions as one impairing economic freedom and enacted primarily to protect the private interest of security dealers. However there is a public interest argument which is advanced to support this restriction. Suppose a bank owns stock of a certain corporation. This bank would have a conflict of interest if it decides to make a loan to this corporation. Because of this potential conflict the government enacts conflict of interest and self dealing provisions to protect bank depositors (and possibly certain classes of bank shareholders). Separation of banks and security dealers is one way to avoid conflit of In Canada, no one can own more than 10% of a chartered bank. The rationale for this restriction is to prevent the bank from self-dealing (e.g. making loans to its major shareholder). Such restrictions prevent the existence of major shareholders and this may very well prevent significant shareholder monitoring of management because of the free rider problem.interest.

The important point to note is that conflicts of interest arise very frequently in economic exchange (this is essentially what economists call the principle-agent problem). Whenever a broker advises a client to buy or sell a stock the broker is in a potential conflict (because he earns commission on the transaction). Either through bond posting or reputational effect the conflict will be solved or in the absence of a solution, the acts of advice giving and stock trading will be separated. If conflicts are so severe, then the market will by itself separate out the activities which are in conflict. There is no need for artificial government separation of the activities.

In July 1987 the Little Bang in Canada resulted in brokers and banks no longer being kept apart. As a result of this deregulation, five of Canada's six largest banks rushed to buy brokerage and security firms. Because of this relative free environment, I will give a 9 to Canada.

The Glass-Steagall Act has kept banks and stockbrokers apart in the U.S. since 1933. Although the years have seen some erosion of Glass-Steagall, essentially U.S. banks have been unable to underwrite corporate securities as many European banks do. Through bank holding companies there has also been erosion of Glass-Steagall. The U.S. Congress is currently considering changes to As of September 30, 1986 there were 6,550 bank holding companies in the U.S. Through this form of organization U.S. banks have been able to avoid some of the anti-branching restrictions and some of the product line restrictions imposed on them.Glass-Steagall. In addition, at the beginning of this year the Fed decided to allow bank holding companies to underwrite corporate debt and to consider allowing them to underwrite corporate equities within a year. As of now there are still substantial restrictions on the ability of banks to underwrite corporate securities. A rating of 4 is given to the U.S.

The Big Bang in the U.K. in October, 1986 opened up the possibility of full membership on the London Stock Exchange to domestic depository and other financial intermediaries. Prior to the Big Bang there was a traditional division in the U.K. between banks and brokers. Now all large British and foreign banks have entered the security business either through merger or starting up new firms. A score of 9 is given to the U.K.

Japanese law allows Japanese banks to own no more than 5% of a securities This rule is known as Article 65 and dates back to the time of U.S. occupation. Essentially Article 65 is importation by the occupation administrators of Glass-Steagall into Japan.firm. However there is a substanital loophole in the law. The law does not stop a bank's associates from having holdings in securities firms. In effect Japanese banks do own securities firms. Japanese banks are allowed to trade in everything but equities and they trade in these through the security companies they control. It should be noted that new products introduced by Japanese banks require approval by the Minister of Finance. Since it would appear that U.S. and Japanese restrictions are similar but the Japanese restrictions are not as effective. A rating of 6 is given to Japan.

In West Germany, the German universal banks act as brokers, there is no separate profession of stock broker. A score of 10 is given to West Germany.

Stockbroking firms in France had until The year of Le Petit Bang. The monopoly existed from the time of Napoléon.1988 a monopoly on securities trading. Last year the capital in France's 61 stockbrokers was opened up. Now banks, insurance companies and other financial institutions are allowed equity ownership in the `agents de change,' the small number of companies which essentially run the The monopoly was broken primarily because of the development of substitutes. It was estimated that at the height of the bull market, the LSE traded 25 to 30% of the shares of the top quarter of French companies. See International Management, January 1989, p.18.Bourse. Since last year, 30 of the 45 brokers operating in Paris had been bought and major French banks have been the largest investors. A score of 8 is given to France.

(c) Regulation of Capital Flow

(i) Are there exchange controls?

Canada has no exchange controls. A rating of 10 is given to Canada.

Although the U.S. has no exchange controls, there are certain restrictions for security reasons. Receipts of funds from Cuba, the People's Republic of Kampuchea, the Democratic People's Republic of Korea and the Socialist Republic of Vietnam are generally prohibited, in addition to certain types of payments from the Socialist People's Libyan Arab Jamahiriya. Also there are certain reporting requirements. Travellers entering or leaving the United States carrying more than $10,000 U.S. in cash or negotiable instruments must report this or face confiscation of the property. A rating of 9 is given to the United States.

All forms of exchange controls were abolished in the U.K. in 1979. Currently the U.K. has no exchange controls. A score of 10 is given. Similarly West Germany has no exchange controls and a score of 10 is given.

Exchange controls were substantially liberalized in Japan under the Foreign Exchange and Foreign Control Law. The limited exchange control system is operated primarily by the Ministry of Finance, the Ministry of International Trade and Industry and the Bank of Japan (acting as the agent for the government). Unrestricted non-resident accounts in yen may be opened by any non-resident with any authorized bank in Japan. Both residents and non-residents may acquire foreign currency deposits with authorized banks in Japan and the freely exportable limit is 5 million yen. Overseas deposits by resident individuals up to the equivalent of 10 million yen are subject to automatic approval by the Bank of Japan. Capital transactions are in principle free unless required to follow certain procedures. For example, foreign loans by banks are legally subject to prior notice with a waiting period but in a large number of cases they can be made upon notification. Because of these restrictions a rating of 7 is given to Japan.

Exchange controls exist in France and are administered by the Bank of France. In March, 1989, they were liberalized. Now holders of French francs are able to lend them freely abroad. All inward and outward payments must be made through approved banking intermediaries by bank transfer. However individuals may not hold a foreign bank account or have a foreign currency account in France. It is expected that these controls will disappear by the end of next year. France is awarded a score of 4.

(ii) Can foreigners invest freely in the domestic economy?

There are a number of restrictions on foreign investment into Canada. There are specific restrictions in the financial, broadcasting and uranium sectors. For example, foreign schedule B banks are limited to 16% of the Under the Free Trade Agreement, U.S. banks are exempt from this Inward direct investment is governed by the Investment Canada Act. Under the terms of this act, new foreign investments are in general subject to notification requirements but not to For U.S. companies, the Free Trade Agreement has modified these Direct acquisition of businesses with assets over $5 million and indirect acquisitions for business exceeding $50 million are subject to review. Acquisitions below these limits and investments in new businesses in culturally sensitive' sectors may also be As one can imagine industries try to convince the government that they are culturally sensitive in order to receive protection from foreign competition.reviewed. Investment subject to a review must be shown to yield net benefit to Canada. There is a large amount of subjectivity in this test. Under this rule the Canadian government can either encourage or discourage foreign investment. Although investment controls in Canada in the 80s are substantially more liberal' than they wre in the 70s, Canada still has in place extensive controls over foreign investment. A score of 4 is given to Canada.

In the U.S. investments in banks are subject to federal and state banking regulations. Ownership of U.S. agricultural land by foreigners (or by U.S. corporations which is more than 5% foreign owned) must be reported to the U.S. Department of Agriculture. Also certain states impose restrictions on purchase of land by foreign nationals. The Trade Bill of 1988 required review of certain foreign takeovers of American firms and allowed the President to oppose takeovers in industries which would endanger national security. National security is interpreted to include among others the oil, natural resources and defence sectors. By March of 1989 the Pentagon was reviewing 35 proposed takeovers and was under pressure to even be more active in this field. National security may become the catch-all category in the U.S. just as culturally sensitive industries play the same role in Canada. Nevertheless the U.S. has less stringent foreign investment controls than Canada. I rated the U.S. a score of 7.

There are no general restrictions on foreign ownership in the U.K. With the exception of South Africa, both direct and portfolio investments may be made by foreigners. However, the foreign takeovers of companies that by their size or nature constitute a vital part of British industry may be subject to considerations under the Fair Trading Act of 1973. Also the government has the power under the Industry Act of 1975 to prevent or undo undesirable takeovers of important manufacturing undertakings. In 1988 the British government imposed a 15% ceiling on non-British shareholdings in Rolls-Royce (the aero-engine maker privitized in 1987). As can be seen the British government has discretionary power to oppose any significant foreign takeover. The power exists, whether the current government chooses to use it or not. The U.K. gets a score of 5.

In Japan the Foreign Exchange and Foreign Trade Control Law governs inward investment. The foreign investor must make a report to the Minister of Finance. The establishment of branch operations, acquisition of a major equity interest, the acquisition of shares in unlisted companies, the acquisition of 10% or more of shares in a listed company and any change in the business objectives of a company more than 33% foreign owned all come under direct investment regulations. These regulations empower requests or orders for suspension or modification of any aspect of the transaction that the minister deems to adversely affect Japanese national security, public order, public safety, the activity of Japanese enterprises in related lines of activity, the general performance of the economy or for the maintenance of mutual equality of treatment of direct investment with other countries. It will be noted that the Minister can disallow foreign investment because the foreign competition harms domestic firms. The provisions lace very stringent controls on foreign investment.

In addition the government restricts foreign investment (and private investment) in water supplies, the postal service, telephone service, telex and telegram, tobacco, industrial alcohol and salt. Also certain corporations are listed as protected corporations' and have a limit on total foreign ownership in them. Japan gets a score of 2.

West Germany has very little in the way of controls on foreign investment. Nonresident direct investment, purchases of real estate in Germany for investment or personal use and purchases of German or foreign equities do not require approval. The only industry wholly closed to private enterprise is the post office. In all industries except banking and insurance 100% foreign ownership is permitted. West Germany gets a score of 9 on freedom of investment controls.

The French government requires prior approval for foreign direct investment in a large number of industries. Direct investments are generally considered those which acquire 20% or more of outstanding shares. The Treasury is entitled to issue a finding within 1 month to forbid the foreign investment should such investment be deemed to jeopardize public health, order, security or defence. In addition there are restrictions to foreign investment in a large number of industries. French governments have traditionally intervened to protect French industry from international Sometimes the French government has prevented takeovers by increasing the cost to the foreign firm of the takeover. Such actions as asking for guarantees to keep the management French and to ensure all French nationals keep their jobs are typical examples.competition. The powers of the Ministers in France are not as all pervasive as those in Japan. France receives a rating of 3.

(d)Regulation of the Stock Market

(i)Are there fixed commissions on stock transactions?

Fixed commissions on stock exchanges is indicative of a broker's cartel in stock trading. In Canada stock commissions are subject to individual negotiations. The Securities Act Amendments of 1975 in the U.S. instructed the Securities and Exchange Commission to outlaw fixed brokerage rates on the NYSE. The Big Bang in London brought about freely negotiated brokerage rates. Each of these countries score 10.

In Japan brokerage fees are charged according to a rigid non-negotiable schedule set by the Tokyo Stock Exchange and approved by the Ministry of Finance. Brokerage fees are generally more expensive for large transactions than in other countries but cheaper for small As would be expected average commissions on the TSE are higher than those charged on the NYSE. With more and more international competition, this differential may be difficult to maintain.transactions. Japan gets a rating of 2. Germany and France also have fixed commissions. They also receive a rating of 2.

(ii)Are there restrictions against insider trading?

Insider trading laws are perhaps the most debated in deciding their effect on economic freedom. There are those who believe that insider trading represents a violation of a fundamental trust. On the other side it is argued that insider trading laws prevent individuals from acquiring information which is important in stock evaluation. Without the free flow of information, the whole efficiency of the stock market can be threatened. I would argue that the market itself can punish any abuse of privileged If a firm deems that trading by certain individuals could be harmful to its owners, then employment contracts can have clauses which prevent such trading.position. The threat to the free flow of information imposed by insider trading rules represents a fundamental threat to the efficiency of the stock market and to fundamental economic freedom. The right to acquire information and act on that information is a fundamental economic right.

The Companies Act of 1952 in Canada makes it an offense for a director to speculate in any of the company's securities. The main problem was uncertainty over the meaning of speculation (generally the term only referred to short sales). The securities act of 1966 required directors to disclose dealings in their own company shares and stated that if a director made use of confidential information for his own benefit which if known publicly would affect the price of shares, the director is liable for compensation to any person or companies for losses suffered.

In 1988 new insider trading rules were introduced in Ontario which gave the Ontario Securities Commission (OSC) a much wider latitude in introducing circumstantial evidence. The use of circumstantial evidence in criminal prosecutions cannot be considered as one which accords with the basic principles of justice. Also the definition of an insider was widened to include so-called tipees - any investor who receives confidential information not available to the marketplace in order to make trading profits. This definition would seem to include any entrepreneur who invests resources to uncover valuable information. Is it desirable to forbid company executives, lawyers, secretaries, analysts, arbitrageurs, investment bankers, shop-floor workers and middle managers from trading in company stock? Calling these people insiders will certainly discourage the collection of valuable information. In addition insider trading penalties were increased from a $2,000 fine and/or a 6-month jail term to a fine up to 3 times the insider trading profits and/or two years in It should be noted that after the Boesky case in the U.S., the OSC spent almost 2 years and $1 million investigating insider trading. As a result of this investigation, 3 individuals face losing their rights to trade stock for using information to make trading profits.jail. Given Canada's extensive insider trading regulations (although there have been very few prosecutions) a rating of 4 is given to Canada has had one high profile insider trading case and the government (of British Columbia) lost this case; the case of the former Premier of British Columbia (William Bennett, Jr.) trading in the shares of Doman Industries Ltd.Canada.

Insider trading prosecutions have been very frequent in the U.S. and very rare in Canada. At the end of 1988, President Reagan signed a bill increasing insider trading penalties and making companies potentially liable for insider trading by their employees. Maximum criminal penalties are now 10 years and the maximum fine is $1 million for individuals and $2.5 million for corporations. This bill allows the SEC to seek civil fines against companies if they "knowingly or recklessly" fail to detect and prevent insider trading by their employees. Because of the large number of prosecutions, a rating of 2 is given to the U.S.

The Companies Act of 1985 in the U.K. defines the circumstances where directors are not allowed to deal in shares of the company: when there are price sensitive matters under discussion and 2 months prior to the announcement of results and dividends. The Financial Services Act of 1986 gave the Secretary of State the power to appoint inspectors to investigate possible insider trading. A legal problem in the definition of an insider revolved around the meaning of the work obtained'. The trial judge in the Fisher case (a London barrister and businessman charged with insider trading) acquitted Fisher because he ruled Fisher was given the information and did not actively seek it. The Law lords recently ruled on appeal that people who deal in shares on the basis of what they know to be unpublished price-sensitive information are guilty of insider trading no matter how the information came into their possession. At the time of this ruling in April of 1989 the Department of Trade and Industry had 45 cases of insidertrading under various stages of investigation. In the U.K. insider trading is a criminal offence punishable with jail terms up to 7 years. A rating of 3 is given to the U.K.

Insider trading is illegal in Japan but the definition of an insider is fuzzy and it is not clear what constitutes inside information. Violations of the insider trading law are not subject to criminal penalties. As a result, up to now, insider trading has not been taken too seriously in Japan. In May of 1988 Japan introduced a tougher new insider trading regulatory code. It is not clear whether this is an effective code. A rating of 7 is given to Japan.

West Germany has no legislation concerning insider trading. As such a rating of 9 is given.

Since 1967 the "Commission des Operations de Bourse" has imposed criminal sanctions for insider trading and the spreading of false or misleading information. In addition directors and certain designated employees are required to disclose stock exchange transactions in their company's stock. French authorities have a reputation for lax enforcement of insider trading rules. As a consequence France receives a rating of 5.

(iii)Is there a securities regulator?

Here as in all questions of regulation there are the two opposing theories of regulation. One would be that securities regulation is in the public interest ensuring a well-run securities market and protecting the consumer of security services. The other theory of regulation would argue that this regulation is protectionist and favours private interests. We will take this latter interpretation and assume that over-all the securities regulator infringes on economic freedom.

In Canada securities regulation is a provincial matter. There is no federal regulator. Canada does have active provincial regulators. The fact that there are 10 separate regulators does provide some competition in the regulatory market. This impinges on the ability of regulators to control the market. Too stringent regulation may cause firms to move to other provinces. As such a rating of 5 is given to Canada.

The U.S. does have a very active federal securities regulatory. The Securities and Exchange Commission (SEC) regulates almost every aspect of the securities industry. The U.S. receives a rating of 3.

The Big Bang in London brought about a new system of regulation of the investment business. This new system has been described as a `structure of self-regulation within a statutory framework.' Regulation depends on the specific rules established by the Securities and Investment Board (SIB - consists of 18 members appointed by the Secretary of State and the Governor of the Bank of The SIB is the overall regulatory agency under the Act. It can investigate and prosecute. The SIB has the power to withdraw or suspend authorization to carry on an investment business if a firm fails the `fit and proper test.' England), the various Self Regulatory Organizations (SRO's), Recognized Investment Exchanges (RIE's) and Recognized Professional Bodies (RPB's).

It should be noted that the SIB has similar authority to the SEC. However because of the existence of competing regulatory bodies a rating of 4 is given to the U.K.

In Japan the 1948 Securities Exchange Law created a Securities and Exchange Commission but it was abolished in 1952. The Department of Securities administers security regulation under the direction of the Finance Minister. Hence the Finance Minister is the chief securities regulator. This sytem is inferior to an SEC system because there is no independence of the regulator from the government. The government is the regulator itself. Such a system has the potential of involving more rent seeking activity than a SEC system. A score of 2 is given to Japan.

The securities market in Germany is basically self regulatory. There is no securities act comparable to the U.S. or Canada. There is no regulatory agency like the SEC. The self governing stock exchanges (of which there are 8) make their own rules concerning the trading of securities. A score of 8 is given to West Germany.

The Commission des Operations des Bourse (COB) was created in 1967. It supervises the public insurance and trading of securities similar to the SEC. However unlike the SEC, the COB cannot prosecute offenders, has a small budget and only about 13 investigators. France gets a rating of 5.

Overall Rating and Conclusions

There is no easy way to arrive at an overall rating for each country. Twelve ratings have been given to each country in four categories. I propose to give each category a weighting of 25%. Within each category the weighting scheme is shown in Table 2. The provision of a stable monetary environment is considered to be essential to the freedom of contract. This gets a weight of 20%. The five questions on regulation of banks each get equal weight of 5% and the two questions on regulation of capital flows get equal weight of 12.5%. In the regulation of the stock market the question of fixed commissions gets a weight of 5% and the other two questions get a weight of 10%.

West Germany with a rating of 8.3 ranks number 1 in terms of economic freedom in money and capital markets. Canada, U.S. and the U.K. are for all practical purposes tied for second place with ratings between 6.1 and 6.6. Japan ranks next with a rating of 5.3 and the worse performance is recorded by France with a rating of 4.3.


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Tom DiLorenzo suggested that there is over $100 billion per year allocation of U.S. government loans, loan guarantees, and government sponsored enterprises like Fanny-May and Ginny-May and off budget items that crowds out private allocations for which some sort of measure should be made. Walter Block liked the table at the end and felt that the weights were reasonable, but would change the rating on the U.S. for insider trading to a 2 rather than a 5. He also saw no difference between government deposit insurance and government house insurance, and thus felt it should be privatized from the perspective of economic freedom. Portfolio regulation on insurance companies is also an abridgement of freedom. Similarly stock market regulation is also a restriction on economic liberty. It is a restriction on a private company, the stock exchange, who agree on the rules for whoever wants to play. The fractional reserve system seems to require the government to intervene in the face of banking bankruptcy, and Blocksaw no economic justification for such a stance as it prevents bankruptcy from playing its role in the economic system. Milton Friedman asked Walter Block whether government provisions for bankruptcy reduce economic freedom, to which Block responded, "yes." Friedman pointed out that bankruptcy is a legal arrangement by which bad debts are allocated, and may not qualify as a restriction. Bernard Siegan indicated that bankruptcy provisions were considered by Justice Marshall in 1827 as a violation of the obligation of contract clause of the Constitution unless both parties agreed. But more to the point of the paper, he did not see a consistent thread of a maximization of economic liberty through the absence of coercion. Carr replied that in the paper he looked at how restrictions affected economic well-being. If there are restrictions that are meaningful, then they have to be judged by some standard. If they reduce freedom to transact in financial markets, then they reduce economic well-being.

Edward Crane did not like the 5 given to the U.S. for deposit insurance which he feels should be private - if at all. This in turn would give rise to a demand for a market accounting of financial institutions' portfolios. Carr argued that the ranking reflected relative levels. Canada and the U.S. are the same so both get a 5. Milton Friedman argued that there may be some occasions when government interventions are justified. For example, deposit insurance, established in 1934, laid the foundation for recovery from the Depression. Today there is no justification for such an intervention. Going back to the bankruptcy issue, he asked Siegan to suggest what Marshall would have done as an alternative to bankruptcy legislation. Siegan said suit would be brought against the offender as in any other failure to pay a contract. Friedman pointed out that the issue is not an argument of principle since there is government intervention in both potential processes. The question is which is the most effective way of enforcig this type of contract. Block maintained that there is a violation of economic liberty, regardless of economic efficiency. The bankrupt should be treated as a thief. Clifford Lewis wondered whether market failure was a good argument for intervention in this context. Friedman remarked that he, too, was skeptical of many examples of market failure, but in some cases, you have to choose among alternatives, both of which may be coercive and lead to a choice that balances among the levels of coerciveness and efficiency.

Carr, responding to the argument that portfolio regulation reduces economic freedom, suggested that when we observe ubiquitous legislated rules governing insurance companies portfolios, and we are unable to see who this benefits in the industry, it may be that it protects freedom. For example, if the public wants to be protected from a one-time shift in portfolios by insurance companies, and the least costly way of doing so is through legislation, then the companies themselves may acquiesce happily. We cannot just dismiss the rules as freedom reducing. Furthermore, Canada went through the Depression with fractional reserve banking, no deposit insurance and no bank failures. The only failures have been recent during the period in which deposit insurance has been in force. There is no incentive to monitor portfolios now, and the response is clear.

Ed Crane wanted Milton Friedman to reconsider his approach to market failure. Look at the $200 billion in liabilities to S&L's the deposit insurance system has caused, he requested, and consider the problem as a matter of principle. Tax withholding is another issue that reduces freedom. Friedman responded that on the tax withholding point, he had supported it as a measure taken in the midst of the Second World War, but there was little justification for it in peace time. On the more general point, he agreed that the government's action causes incentives that may not be desirable, but in certain cases, at particular times, the actions are justified. If it needs the money to fight a war, it is hard to stand on principle in the face of necessity. Gerald Scully maintained that Friedman trivialized the difference between contract and bankruptcy. Bankruptcy is an ordered allocation of assets, while enforcement of contract law means rendering a judgment which may mean payment of more than is currently available andmust be paid over time. Bankruptcy reduces freedom from this perspective. Friedman wondered whether driving on the right side of the road reduces freedom. In Block's sense, yes, he suggested, but since we need some mechanism to decide certain issues, he viewed bankruptcy as one set of rules. Siegan pointed out that the penalty for the contract may affect the kinds of contracts into which one enters. Bankruptcy is one set of rules, while the law of contract is another. Friedman argued that in principle, since some decision must be made about the rules of the contract, bankruptcy is just one set of rules like any other. Carr suggested that bankruptcy does not prevent contracts. It is for residual claimants. Some way of allocating assets and settling contracts is needed.

Alan Reynolds felt that changes in economic progress can be related to economic freedom even though Carr does remark that the levels of economic progress are very different and may not be related directly to levels of economic freedom. DiLorenzo felt that the production function does not reflect the effects of economic freedom. Carr responded that the production function is just a method for organizing our thoughts about these issues. If one wants to do the simple correlation between economic freedom and GNP, fine, but economic freedom can also be included as an input. Walter Block was unhappy with identifying economic freedom with economic welfare such as GNP. Carr responded that if you accept the production function in which economic freedom is another factor, then the next step is to try to get an empirical measure of the inputs. When one tries to get an empirical counterpart to the theoretical measure, there are problems - the usual problems. In any production function analysis some method is needed for dciding what is the "best" definition in the context of some specific problem. There is no absolute definition of economic freedom. Using a problem to identify a characterization of economic freedom is the only way to proceed. There may be better ways to proceed, but he did not see them on the table.

Measuring Economic Freedom

This section is missing

Prospecting for the "Homework" Measures of Economic Freedom: A Summary

Z. A. Spindler and J. F. We acknowledge the assistance of L. Still in the preparation of a section of our original paper and financial support from Challenge 90.Miyake, Simon Fraser University

"If it is worth doing, it is worth doing imperfectly."
-Rating Economic Freedom II Symposium, 1988, published as Walter Block, ed., Economic Freedom: Toward a Theory of Measurement, Vancouver: The Fraser Institute, 1991.W. Block


WE STARTED OUR PAPER ENTITLED "The `Homework' Measures of Economic Freedom," which was prepared for the "Rating Economic Freedom IV Symposium" with the aphorism given above. It was gleaned from Walter Block's remarks at the end of the "Rating Economic Freedom II Symposium." In those remarks, Block listed the freedom measures that are the subject of this paper. These diverse measures were suggested by various Symposium II participants as part of their "homework" assigned in an earlier session. This aphorism and historical note were intended to explain our paper's title and subsequent designation of the freedom measures contained within, as well as our meta-methodological perspective.

Our task for the Fourth Symposium was to explore whether the measures listed had statistical analogues in data collected or processed by others. In our explorations, we neither searched for nor obtained perfection. Instead, what we did was a rather exhaustive (or at least exhausting!) search of existing literature and data sources for measures which at least approximated the (sometimes fuzzy) "Homework Measure of Freedom" desiderata. We then used that data to make a first stab at providing ratings for each measure when ratings were not given by the original source. We also tried to be more or less methodical about marking our path and providing some commentary on the problems of, and reasons for, treading it.

Further, in an attempt to make some sense of these fairly diverse measures, we separated them into documentation, discussion, and presentation sections. In order, these sections were government size, tax measures, government regulation, indirect measures and civil rights measures.

Where possible, we also calculated Spearman Rank Correlations between measures within sections and across sections. These correlations suggested that a few alternative measures within sections, and even across sections, were sometimes reasonably close substitutes in terms of measuring the extent of freedom in any given country. That in turn suggested that our resources might be better devoted to developing to a higher state of perfection fewer key indicators.

Since our original paper was very long, we have chosen to incorporate only the essential elements from our data explorations into a summary section giving a "concordance" between the original descriptions given in Block's listing and our versions of the "homework" measures along with our sources and rating scheme. Our original discussions, rationales and source data can be found in our original paper which, for a limited time, will be available from the authors or The Fraser Institute. We have also included our summary statistics, and, of course, our summary table of country economic freedom ratings.

Click here to view Table 1: Basic Data Matrix

Concordance: Measures of "Homework" Measures of Economic Freedom

In this section we give the abbreviated code which appears in our "Summary Rating Table," the associated original description of the variable from Block's list, a) the associated proxy we have found for that variable, b) the source(s) of our proxy, c) the date(s) of the data, and d) the verbal or numerical basis for our ratings, where appropriate. When we have not provided an equivalent measure for a specific measure on the original list, it is either because that measure is approximately the same as one we have provided or because we have not been able to find anything approximating the requested This is especially true of item 8 of which a number of subparts are duplicated elsewhere or are impossible to find. Indeed, we have given a detailed description of only one measure-8f-in the body of the paper. A second measure-8b (or 8-2)-we have proxied by the Draft Freedom Rating originally developed by Spindler and Still (1988) and printed out that measure in the SUMMARY RATING TABLE. measure.

Click here to view Table HMF 1 "Restrictions on International Trade"

Click here to view Table HMF 2 "Restrictions on Immigration"

Click here to view Table HMF 3 "Restrictions on Emigration"

Click here to view Table HMF 4 "Government Spending /GNP by Selected Categories"

Click here to view Table HMF 5 "Education - Whatever the State Monopolizes"

Click here to view Table HMF 6 Freedom of Travel, Freedom to Relocate One's Domicile, Absence of Internal Passports"

Click here to view Table HMF 7 "Total Government Spending/(Net National Product + Transfer Payments)"

Click here to view Table HMF 8f "Official Price Level/Blackmarket Price Level"

Click here to view Table HMF 9a "Aggregate Tax Rate"

Click here to view Table HMF 9b "Ratio of the Top Marginal Income Tax Rate to the Average Income Tax Rate"

Click here to view Table HMF 10 "Reaction Index = (Government Deficit + the Underground Economy)/GNP"

Click here to view Table HMF 11 "Ratio of Total Government Debt to Total Debt Outstanding"

Click here to view Table HMF 12 "Ratio of the Exchange Adjusted Price of a Standard Basket of Commodities in the Domestic Economy to the World Price of Those Same Commodities"

Click here to view Table HMF 13 "Price Relative as a Measure of Regulatory Restriction"

Click here to view Table HMF 14 "Fraction of Total Income Devoted to Various Expenditures by the Median Household"

Click here to view Table HMF 15 "Fraction of Total Agricultural Output Marketed by Government Agencies"

Click here to view Table HMF 16 "Emigration Rate as a Ratio to the Birth Rate"

Click here to view Table HMF 17 "Marginal Tax Rate of a Person with an Income Twice the Mean"

Click here to view Table HMF 18 "Highest Marginal Tax Rate Minus the Base Marginal Tax Rate"

Click here to view Table HMF 19 "Government Expenditures as a Share of GDP"

Click here to view Table HMF 20 "Tariff Revenue Divided by Total Value of Trade"

Click here to view Table HMF 21 "Inflation Rate during Last Five Years"

Click here to view Table HMF 22 "Share of Aggregate Output Subject to Price Controls"

Click here to view Table HMF 23 "Government Employment as a Share of Total Employment"

Click here to view Table HMF 24 "Property Rights"

Descriptive Statistics Tables

For the purpose of interpreting the following tables, remember that r is significant at 0.05 for all r ³ 0.30 for n ³ 30.

Section A

Click here to view Table II. Government Size

Click here to view Table III. Tax Measures

Click here to view Table IV Government Regulations

Click here to view Table V. Indirect Measures of Economic Freedom

Click here to view Table VI. Civil Rights Measures

Click here to view Section B

Click here to view Section C


Looking at HMF19, government spending relative to income, Milton Friedman argued that it indicates that India is the freest country among eleven which he used in discussing the Gwartney et al. paper. Since we would all agree that India is not the freest economically, why did this occur? If a country has 90% of its population in agriculture, then it is impossible for the government to spend any large fraction of their income. Somehow, he argued, we must modify this ratio to account for the level of income or the fraction of the population in agriculture, to have a useful measure. This points to the limitation of a technique that ranks 169 countries about which we know relatively little and the need to use the same measures for each.

James Ahiakpor suggested that the agricultural/urban mix should be considered in any ranking. He wondered if use of government employment and government expenditures is not double counting. Alan Stockman wondered about any suggested adjustment for agriculture or any other adjustment for the government's inability to interfere with economic freedom. Why do we want to adjust. For example, suppose personal computers make it more difficult for the government to infringe on economic freedom. He did not think we would want to "adjust" for computers. There is in fact an increase in economic freedom. If taxes are hard to collect, then it interferes less. Milton Friedman responded that the ratio of government expenditure to income may not be a good measure in these circumstances. Instead, the government interferes with freedom of movement, fixing prices and the like.

Arthur Denzau pointed out that property rights are difficult to measure. He gave the example of South Africa in which the legal system works very smoothly and well, but where blacks are unable to participate in certain lines of business in any way. Gwartney mentioned that although India looks relatively free according to the G/Y measure, it is less free along the other dimensions: number of government enterprises in many sectors, or price controls. These are part of the regulation dimension. Other countries like Guatamala and Honduras rank surprisingly high, and he argued, that it is because of the absence of the regulatory dimension. Mike Walker noted that Canada has 407 quasi-governmental companies. Juan Bendfeldt argued that the underground economy and emigration are both symptoms of diminished economic freedom.

Richard Stroup argued that if entry is not prohibited, then even if the government runs the trains, it matters little in terms of economic freedom. Apart from subsidies, counting government employees is over emphasizing the problems. James Gwartney replied that government almost always uses taxes, restricts entry, or restricts competitors. He gave examples in the U.S. of the post office and public schools. Walter Block argued that the very act of taxation which underwrites government enterprises reduces freedom. Edward Hudgins emphasized that the enforcement of laws on the books is often problematic and that the measurement of the informal sector may give some guide to how constraining it is. Stephen Easton remarked that a problem with public companies is that they create an expectation of further interference. He gave as an example public bus companies that typically need to enlarge their routes as they are continually losing money on those that they have. In the process they continually reduce the activity of private companies. Arthur Denzau pointed out that expectations are always difficult to measure. Rick Stroup argued that this is the same problem that we always face with prices and the like. The government budget captures all these effects. You need a handle on government regulation. Government enterprise is not a problem except as it is a function of regulation or restriction on entry.

Alan Stockman suggested that G/Y might not be a good measure of restrictions on economic freedom. G alone is a better measure. If you have $100 worth of government spending and income that is $200 or income that is $300, then the economic freedom that is lost is still $100. Why should we adjust by wealth or income instead of measuring the number of goods the government is taking away. Ron Jones stressed that both absolute and relative measures were useful in different contexts. Easton mentioned that by using the dollar approach as was done in his papers, evaluating economic growth may be more difficult as government expenditure policies may gather increased revenue simply because of the expansion of economic activity. This leads to the conclusion that governments of expanding economies have expanded their role, while governments of contracting countries appear to improve in comparison. Similarly, cross country comparisons are difficult.

James Ahiakpor suggested that some trade taxes are for the purpose of raising revenue and are not serious impingements on international trade. Milton Friedman argued that tariff revenue has no relationship to economic freedom whatsoever. He indicated that prior to 1860 Japan had no tariff revenue, nor any trade. Further, emphasizing Ahiakpor's point, he stressed that a level of tariff equal to a general tax domestically does not interfere with trade at all. What interferes with trade is the difference between the level of tariff and domestic tax. A large country will have less trade, all else equal than a small country, so tariff revenue is simply misleading. Some acknowledgment of country size must temper the trade tax kinds of claims about economic freedom. When Easton did this, Friedman recalled, he used the full expenditure levels on the goods rather than simply the amount of the tariff.

Arthur Denzau wondered what was actually used for exchange rates in some of the countries, and further how data on black markets had been collected. Gwartney wondered about what tax rates were being counted and Spindler responded that senior government rates were collected. John Goodman said that Swedish central government tax rates were about 40%, but rates rose to 70% when other levels of government taxes were included.

Milton Friedman argued that government spending rather than the various tax rates as a measure of government activity should be used. Ratios of top tax rates to bottom rates would seem to be a very insensitive measure of what one wishes to measure. Ratio of government debt to total debt would seem to be totally inappropriate for anything in which we are interested.

In the general discussion that ensued, total government expenditures (GNP account based) were distinguished from total government spending or total government purchases which include transfers or other kinds of spending not counted in the national income accounts. The use of marginal versus total taxes was discussed with the burden of the marginal being contrasted with the effect of the redistribution of the average. Ron Jones referred to Figure 4 in the Jones and Stockman paper to argue that the loss in economic freedom will always outweigh the level of tax revenue and that loss will increase as tax rates rise even though revenues rise and then fall. Alan Stockman argued that the wedge of the tax is the marginal tax and is relevant for the consumer surplus losses calculated in both Easton, and the Jones and Stockman paper. If the tax rate is increasing, then the average tells you what the government takes. Therefore both are needed. Milton Friedman claimed that he had no difficulty in recognizing that both the average and the marginal are important components of economic freedom but that the ratio of the top marginal tax to the average tax can be foolish since the ratio will be the same if the marginal rate is 20% and the average 10% as it would be if the top marginal rate is 90% and the average is 45%. Richard Stroup stressed that there is a problem with the high marginal rates as they may apply to a very small group of people, and he wondered how one can deal with this. James Gwartney responded that they tried to use some income based measure ranking a country lower if the high rate kicked-in earlier in the tax system. Stroup responded by suggesting that the different tax rates might have to be weighted by the number of people affected.

Measuring Economic Liberty

This section is missing

Milton and Rose Friedman's Experiment

This section is missing

Politicizing Prices

This section is missing

Labour Markets and Liberty

This section is missing

International Comparisons of Taxes and Government Spending

Alan Reynolds, The Hudson Institute


THE SPECIFIC DETAILS OF THE structure of taxation were largely neglected before the mid-1970s-relegated to a minor branch of "microeconomics." Instead, the superstars of the economics profession battled over whether budget deficits or money supplies were the best way to manipulate private spending, and thus manage aggregate demand. In a 1960 essay, Tobin favored "restriction of consumption by [an] increase in personal income tax at all levels," in order "to bring under public decision the broad allocation of national output." In a 1971 book on taxation, Thurow stressed that "the aim of the macroeconomic policymaker is to raise or lower the demand," and that "different taxes have different effects [only] because they affect the incomes of groups with different propensities to consumer or invest." In such cases, any effect of steep tax rates in discouraging productive effort were either brushed aside with flimsy logic and surveys, or simply ignored. Taxes were only considered a device for discouraging demand, not for discouraging supply. Neglect of tax incentives was a natural outcome of the Keynesian fetish. In his classic 1937 essay on "Mr. Keynes and the Classics," Hicks writes that, "I assume that...the quantity of physical equipment of all kinds available can be taken as fixed. I assume homogeneous labor." With both physical and human capital thus assumed to be insignificant, there was no reason for Keynesian economists to worry how they might be affected by tax policies. Incentives to produce were considered less interesting than incentives to consume, since demand was thought to create its own supply.

By the mid-1970s, though, Keynesian "demand management" had been discredited by the experience of chronic stagflation, and the effects of various taxes and subsidies on human behavior and incentives began to receive considerably more attention. This was partly due to intellectual advances, such as the pioneering work of Mirrlees on the theory of optimal taxation, and the renewed emphasis on the microeconomic conditions for economic growth among "new classical" economists, such as Barro and Davies. Under the banner of "supply-side economics," a new band of unapologetic pro-capitalist politicians, led by Jack Kemp, Ronald Reagan and Margaret Thatcher, turned tax reform into a major, worldwide movement. By the end of the 1980s, over 50 countries-including all major industrial countries-had significantly reduced their highest marginal tax rates (see Appendix). Limited interest in similar reforms (which often encompass privatization and deregulation as well as reduced tax rates), has even spread to the Soviet Union, Poland, Hungary, China and Vietnam.

Taxes are an important part of the cost of production, as well as the cost of living. People generally have to produce more to earn more, except in cases of theft or legal "rent-seeking" (wasteful, negative-sum games involving the abuse of government power to acquire lucrative special privileges at the expense of others). It follows that a tax system which penalizes added income will also penalize added output. Aside from the unrealistic, hypothetical case of non-distorting taxes (e.g., a tax of so many dollars per person), the specific details of the tax structure have an enormous impact on behavior of individuals, and therefore of entire economies. Most taxes introduce a "wedge" between what a productive activity is worth to consumers and what the suppliers of labor and capital actually receive. Just as excise taxes on liquor and tobacco are partly designed to discourage the use of those products, taxes on earning additional personal or business income must likewise discourage the process of wealth-creation that lead to such increased income. When taxes on effort and savings are high, for example, choices are distorted in favor of additional leisure rather than additional income and in favor of current consumption rather than future consumption. The typical welfare state blend of demoralizing taxes on success and generous subsidies for failure tends to produce fewer successes and more failures.

At one extreme, the compulsion of taxation could be used to purchase all goods and services, which could then be distributed to individuals on the basis of various criteria, particularly political influence. Workers and investors would, in effect, endorse their entire paychecks over to government agencies, which would then decide who gets what sort of food, housing and shelter. Such a system would have enormous difficulties in motivating people to produce up to their true potential, since they would have so little choice as to how the fruits of their efforts would be used. The political marketplace, even in its most democratic forms, typically offers the electorate only an infrequent choice between two or three package deals. Voters might want some parts of the package offered by one political party, some parts of those offered by another, and many things (such as maximum individual choice) that are not offered by either. The package deals that are offered are often meaningless anyway, since political officials who get votes by offering something they do not deliver cannot be sued for fraud.

A so-called "national economy" is nothing more than the activities of individuals that involve producing and trading with one another. Not so long ago, many observers thought the extent of government control over these activities would become more and more extensive and detailed, leaving fewer and fewer economic decisions to individuals. Heilbroner, writing in 1959, expressed a view that remained common if not dominant among Anglo-American intellectuals in the first three decades of the postwar era:

As a means of beginning the huge transformation of a society, an economic authoritarian command has every advantage over the incentives of enterprise....Taking the long perspective of the decades ahead, it is difficult to ignore the relative `efficiency' of authoritarian over parliamentary regimes as a means of inaugurating growth....Today and over the foreseeable future, traditional capitalism throughout most of the world has been thrown on a defensive from which it is doubtful that it can ever recover.... [The] road to abundance lead subtly but surely into the society of control....[The] trend of all industrialized nations, ourselves included [is] toward some form of economic collectivism.

The confident consensus of the early postwar era - that economic liberty would be increasingly obsolete, replaced by governmental control - has been undermined by the evident stagnation or decline of living standards in countries with socialist economies. The alleged advantages of authoritarian planning have also been refuted by the vibrant success of every economy that instead moved in the direction of reducing government barriers to commerce and government disincentives to personal effort, investment and entrepreneurship. The embarrassing success of capitalist economies, most obviously in Asia, has now put socialism on a defensive from which it is doubtful that it can ever recover. One reason is the increased international mobility of capital, including human capital, and the new information technologies that make it impossible to conceal how well or how badly an economy is performing. Gordon thus notes "the restrictions capital mobility and tax competition impose on [a country's] tax policy."

Governments, like companies, must compete in producing the most value at the lowest possible cost. Countries in which the marginal cost of government is relatively high, particularly in relation to the value of government services, will find it more difficult to attract and retain physical capital, financial capital and human capital. Just as so-called "tax havens" attract investment and immigrants, countries with punitive tax systems face chronic "capital flight," and a "brain drain." When the effects of taxation on international movement of resources are considered (as in Gordon), the results can be quite different than when each country is analyzed as an isolated island.

In addition to the new concern about keeping tax expenses competitive among industrial economies, which is a key issue in the effort to integrate European economies by 1992, there is also renewed interest in "market-oriented" reforms in the Third World and Communist countries. Unfortunately, the literature on "market-oriented" reform tends to be extremely vague, typically calling attention to objectives rather than specific policies to achieve those objectives. Wilson and Gordon, of the University of Michigan's Center for Research on Economic Development, thus define reform in such terms as "promoting the private sector" and "ending capital flight and promoting foreign investment." Within seven such empty boxes, there is virtually no mention of taxation, except to "shift taxation burden away from export sector." In rare cases when specific policies are mentioned, they are not obviously "market-oriented." For example, Wilson and Gordon suggest "ending government fixing of the exchange rate." Yet defining a weak currency in terms of a more credible currency (or gold), and making it freely convertible, has always been a necessary, though not sufficient, component of all successful plans for stopping a runaway inflation - most recently in Hong Kong, Israel and Bolivia (Bruno).

There have been relatively few systematic attempts to compare taxes and government spending between countries. The few global comparisons that have been undertaken by official agencies, such as the International Monetary Fund or U.S. State Department, typically rely on diplomatic obfuscations ("market-oriented reforms" or "outward-looking strategies") and unacceptable simplifications. One such simplification is to look at tax receipts as a percentage of gross national product (GNP) or gross domestic product (GDP). Another is to focus on one particular tax, usually the corporate profits tax. A third simplification, related to the other two, is to look only at average tax rates on existing income rather than marginal tax rates on additions to output and income.

Taxes "As a Percentage of GNP" Ignores Incentives

A recent book from the International Monetary Fund, entitled Supply-Side Tax Policy: It's Relevance to Developing Countries (Gandhi, pp. 27 & 46), illustrates a common confusion between marginal tax rates and average tax revenues actually collected at those rates:

Revenues from personal income taxes in industrial countries are generally much higher than in developing countries both in relation to gross domestic product and as a share of total tax revenue. Presumably this explains why the great bulk of the literature on the incentive effects of tax regimes and of changes in marginal tax rates on labor, savings, and investment decisions pertains to the developed world....Regressions show that the ratio of income taxes to total revenue (as well as to GDP) and the growth rate of output are negatively related and that the regression coefficients are significant, but this result does not hold in all specifications.

In these remarks, the IMF economists are simply treating the amount of money collected from income taxes as equivalent to the impact of these and other taxes on incentives. Because revenues from income taxes are a tiny fraction of GDP, writes Tanzi, "it can be concluded that these taxes are much less developing countries than in developed countries." Yet taxes can have extremely damaging effects on efficient economic activity without yielding significant revenues. Indeed, the more damaging the tax system is, the less revenue it will yield over time, because incomes and sales will stagnate or decline in the overtaxed sector, and more and more productive activity will disappear into the tax-free "underground economy." This is actually most obvious in developing countries, where extremely high tax rates often push most productive activity underground, thus yielding little or no revenue. Failure to generate revenue, though, certainly does not mean the high tax rates have no bad effects, as Tanzi and other IMF economists suggest. On the contrary, underground enterprises lose economies of scale by the necessity to stay small in order to avoid detection. They also lose efficiencies of communication, such as the ability to advertise or to efficiently recruit the best workers. Even the vital efficiencies of a monetary economy are often lost, as commerce instead resorts to primitive barter in order to avoid both explicit taxes and also to avoid the tax on cash balances due to chronic devaluation and inflation.

Ironically, the bibliography of the IMF volume cites a few of the earliest studies on the effects of changes in marginal rates in developing countries, including Reynolds, Rabushka-Bartlett and Wanniski. All of these comparative studies emphasize very clearly that steep tax rates both damage economic growth and make taxes virtually uncollectible. Since GDP grows slowly, if at all, the tax base likewise grows slowly, if at all. Far from indicating that "the incentive effects of...changes in marginal tax rates" are insignificant in developing countries, as the IMF volume repeatedly suggests, the poor revenue yield from extremely high tax rates instead indicates that marginal tax rates can be sharply reduced, with the government then collecting a smaller increment of an expanding economy rather than attempting to collect a huge percentage of zero growth.

Excessive Emphasis on Corporate Income Taxes

Another excessive simplification is to focus almost exclusively on a single category of taxes. Most of the IMF volume thus concentrates on income taxes, as though production decisions and costs were completely unaffected by Social Security taxes, sales taxes or tariffs. Even worse, many international comparisons have been limited to only the corporate income tax. A recent report for the U.S. Agency for International Development, by Frost & Sullivan Inc., ranks the "investment climate for international business" by 14 criteria, such as "labor conditions" and "regime stability." Following the State Department as the "primary source," only 2 of the 14 criteria listed by Frost and Sullivan have to do with tax policy. The only taxes that matter, in this State Department-AID view, are the "level of corporate taxes" and "investment the form of tax holidays...and subsidies."

This quasi-official emphasis on corporate taxes and subsidies is far too narrow on both factual and theoretical grounds. At the factual level, corporations typically exert sufficient political clout to keep corporate tax rates relatively low, particularly for foreign corporations, and subsidies and special tax breaks relatively high. Prior to 1989 tax reforms, for example, the highest corporate tax rates were 33-35% in Mexico, Brazil and Argentina, while maximum individual tax rates were 45-50%. One reason that large multinational corporations are often able to gain preferential tax treatment, aside from their obvious importance as a source of funds for politicians, is that the employment consequences of a large company locating in a country, or leaving, are far more conspicuous than the inability of a small, local enterprise to even get started (without evading taxes and regulations).

It is not even correct to regard the corporate tax as the only relevant direct tax on the income of business enterprises, since many domestic businesses are not incorporated, and are thus taxed at the higher rates typically imposed on individual income. Even incorporated domestic firms do not qualify for the "tax holidays" apparently favored by State Department researchers, and instead bear higher tax rates to compensate for revenue loss of a temporary zero tax on new foreign competitors.

Corporations are not organic entities that are able to bear tax burdens, any more than their buildings can bear a tax. A tax on corporate profits must either be paid by those who invest in the company, those who work for it, or those who buy its products. But replacing any corporate profits tax with a more obvious and direct tax on a company's stockholders, workers and customers would have a similar effect in reducing the company's opportunities for profitable production, and its offers of employment.

The familiar distinction between "business taxes" and "people taxes," which is the subject of considerable corporate lobbying (sometimes disguised as "studies") is essentially irrelevant. All taxes are paid by individual producers, as suppliers of labor and capital. It is relatively insignificant, in most cases, whether taxes are direct or indirect, corporate or personal. Capital and labor bear all taxes, either through lower incomes or higher prices. Indeed any tax itself may be considered a price -the price of government -so that all taxes might thus be properly included in a broad concept of the "cost of living." Since accounting conventions instead count only sales taxes as part of the cost of living, substituting an income tax for a sales tax may appear to reduce the usual measures of consumer prices. Yet the reality of reduced purchasing power for producers would not be changed at all, even though the burden might be shifted from some people to others.

Any "consumption tax" must actually fall on producers, because consumption is the only motive for production. Moreover, the whole purpose of taxes is to divert a portion of production away from uses determined by markets toward uses determined by political authorities, so that any form of taxation must reduce real rewards to producers in the market economy. A proper comparison of taxation between countries must therefore attempt to include the combined effects of all taxes.

Spending Measures the Average, Not Marginal, Burden

Although expressing tax receipts as a percent of GNP is a wholly inadequate measure of the distortions and disincentives of a tax system, the same is not true of government spending as a percent of GNP (or GDP). The ratio of government spending to GNP has considerable merit as a rough measure of the average burden of government activities on the voluntary activities of private producers and consumers. Wolf estimates that "a 10% increase in the ratio of government spending to GDP results in an expected decrease of 1% in the average annual rate of growth in GDP" among developed countries, and a 4% decrease among low-income countries. Spending ratios, though, are incomplete, static and too aggregated.

Government purchases of goods and services (as opposed to transfer payments) represent one form of claim on society's productive resources (labor, capital and natural resources) that are allocated through political decisions rather than through markets. At reasonably full employment, resources devoted to politically-determined uses are simply unavailable for market-determined uses, regardless of whether the government's purchases are financed by taxes, borrowing or creating new money. Persons employed by the government cannot simultaneously be employed in producing what consumers choose to buy. Energy and land devoted to government offices cannot simultaneously be used to produce, say, food, clothing or shelter (which are still mainly produced and marketed by the private sector, even in most socialist economies).

Subsidies and other transfer payments are often said to be different than purchases, since they "merely" redistribute purchasing power among people in the private sector rather than deflecting resources from private to governmental uses. Yet this observation neglects incentives. The essence of most transfer payments is to take part of the rewards away from productive individuals and firms and give them to those who do not work, do not plant crops, or do not manage viable enterprises. That is, transfer payments punish success in the marketplace and reward failure (they also punish those who lack political clout and reward those who can best manipulate the political system). Because transfer payments are a huge burden on the productive portion of the private sector, they cannot be ignored. If all that government did was to transfer more and more resources from workers to non-workers, for example, the result would surely be fewer workers and more non-workers, reducing the amount of real output left to redistribute. As Gwartney and Stroup observe, "While the income transfers do not directly reduce total income, the substitution effect associated with the transfer will induce both the taxpayer-donors and the transfer recipients to reduce their work effort." For certain analytical purposes, it may indeed be legitimate to separate transfer payments from purchases, and even to further divide government purchases between capital outlays and current consumption, or between substitutes for private services (e.g., nationalized health insurance) and services that the private sector is not permitted to provide (e.g., defense, currency). But the use of total government spending is nonetheless almost always sufficient to capture the general burden of strictly fiscal costs of government, even though it excludes important regulatory costs and uncertainties.

Although government spending thus approximates the true burden of government on the private sector, the ratio of government spending to GNP only measures the average burden at the moment, not the marginal burden over time. Two countries could have the same percentage of GNP currently channeled through government and yet have enormously different marginal tax burdens on future additions to GNP. The country with the lower marginal penalty on added output and income would experience more rapid growth of real GNP, so that real government spending could increase just as rapidly as in the country with higher marginal tax rates and yet nonetheless become smaller over time as a percentage of GNP. For this reason, current government spending as a percentage of current GNP should not be assigned too high a weight in evaluating the dynamic trends toward more or less economic liberty. In many cases, a reduction in marginal tax rates can reduce the future ratio of government spending to GNP by increasing private GNP. Indeed, an econometric comparison of 63 countries, by Koester and Kormendi, estimates that "a 10% revenue neutral reduction in marginal tax rates would yield a 12.8% increase in per capita income for LDCs and a 6.1% increase...for non-LDCs."

Ratios of Public Debt to GNP

Just as the ratio of government spending to GNP can increase because of relative weakness in private GNP, rather than unusual growth of government, the ratio of government deficits or debt to GNP may likewise conceal more than it reveals. Past debts may decline as a percentage of GNP because the central bank is buying too much debt with new bank reserves or currency. Such an inflationary monetary policy inflates nominal GNP relative to older debt issued at fixed interest rates. Switching to a less-inflationary monetary regime, as the U.S. did in the 1980s, may therefore appear to increase debt relative to GNP. Yet the more responsible method of financing government debt is nonetheless a beneficial reduction of the "inflation tax" on those who hold cash balances and older bonds. To the extent that governments can be bound by a credible commitment to non-inflationary methods of financing their debts, they will be able to issue new debt (for emergencies or capital outlays) at lower interest rates, thus reducing interest outlays and the nominal budget deficit.

Using chronic inflation to reduce the ratio of domestic debt to GNP is often worse than futile, since it can virtually destroy the government's ability to raise funds through either taxation or additional debt, as an IMF study by Blejer and Chu points out:

If inflation brings about a fall in the capacity to raise taxes, to collect the inflation tax on the monetary base, and to borrow abroad, it will also increase the risk of default on the public debt...As such, it may reduce the willingness of individuals to lend to the government. This attitude on the part of the public will be reinforced by the fact that the deterioration of the inflationary situation will increase the probability of adoption of adjustment programs that might include ...higher income taxes on interest incomes....When individuals receive nominal interest payments, they are taxed on the total of these payments without an adjustment for the effect of inflation. This fact, per se, would induce a shift from financial assets (including government bonds) toward real assets or foreign investments, since the unrealized capital gains on real assets are tax free while the foreign investments are often totally tax free.

Blejer and Chu also note that "the fiscal deficit is, under any circumstances, a crude tool for assessing the impact of fiscal policy on the economy." In a situation of high inflation, though, conventional measures of the budget deficit become virtually useless. Attempts to reduce nominal budget deficits through "adjustment programs" involving higher income taxes can prove disastrous to incentives, as well as having the adverse effects on the financial system that were emphasized by Blejer and Chu (e.g., provoking capital flight and destroying the ability of government to sell bonds rather than printing money). Despite the enormous emphasis typically given to nominal budget deficits, particularly among developing countries, this appears far less useful than a detailed investigation of the structure of taxes and expenditures, as well as the possible abuse of inflationary methods of financing deficits.

There is a somewhat better case to be made for comparing accumulated debt-to-GNP ratios between governments, rather than just current budget deficits. Those who analyze debts of developing countries often place undue emphasis on foreign debt, and insufficient attention to domestic debt - which is often much larger and always pays a higher rate of interest. The rationale for emphasizing foreign debt is that debts denominated in a foreign currency must be serviced from hard currency earnings, which requires either a trade surplus in excess of interest outlays on foreign debt or a net capital inflow (i.e., a reversal of "capital flight"). A large foreign debt might also appear to encourage inflation in countries like the United States, where the debt is in the debtor's own currency. For developing countries, though, the common IMF advice to repeatedly devalue currencies will raise the amount of domestic currency needed to pay the equivalent amount of dollars to creditors. That effect of devaluation increases the nominal budget deficit, which has to be financed with new money because chronic devaluation destroys the market for government bonds. Once again, the usual emphasis on symptoms of bad policies - namely, budget deficits and foreign debts - may actually lead to policies that make these symptoms even worse, such as chronic currency debasement and oppressive taxation. The prolonged efforts to impose "austerity" on troubled economies (which invariably means austerity for the private sector) is as flawed in concept as it has proven in practice. It is not possible to improve the creditworthiness of debtors by reducing their prospective income.

Gordon points out some other difficulties arising from excessive emphasis on foreign debt:

Because of the tax system, governments of countries with a higher inflation rate must pay a higher real interest on their debt. This is necessary in equilibrium to compensate those who purchase the debt for their higher taxable income....A high inflation country could borrow in a foreign currency (for example, debt denominated in dollars), and use the funds to retire any debt issued in its own currency.

The idea of using debt-for-equity swaps to reduce the foreign debt of developing countries illustrates a common confusion arising from insufficient attention to domestic debt, and to the necessity of financing that debt honestly, without simply issuing new money. Aside from direct swaps of foreign debt for new shares of privatized companies, any other debt-equity swap requires providing foreign creditors with more domestic currency, such as pesos, with which to make direct or portfolio equity investments. If the added pesos are simply printed, the result is higher inflation. If new domestic bonds are instead sold to acquire the needed pesos, this merely substitutes high-cost domestic debt for foreign debt that bears a lower interest expense.

Although the ratio of overall foreign and domestic government debt to GNP may provide a rough guide to the future average burden on taxpayers, it must be handled with great care. Whether the debt can be financed in an inflationary or non-inflationary manner (that is, whether a viable market for fixed-income bonds can be restored) is often at least as important as the current level of debt itself, though the two issues cannot be entirely separated. Moreover, the marginal cost of taxation can usually be alleviated, with favorable effects on future economic expansion. A larger economy, particularly one with low inflation, can more easily service existing debts, and also finance plant and equipment with new issues of private equity instead of new government debt. In the absence of any single measure that adequately captures important marginal and dynamic elements of alternative methods of servicing past debts, it appears preferable to instead focus on minimizing government consumption expenditures and transfer payments, while reforming the tax, tariff and regulatory structure to make the marginal cost of government less damaging to productive effort and investment.

How to Compare Tax Structures

The Table, "Maximum Tax Rates," summarizes the key features of tax systems among five Latin American countries. Under the category "Individual Income Tax," we use the maximum marginal tax rate (reported for a number of countries in the Appendix) and the income level, or "threshold," at which individuals and unincorporated enterprises encounter that highest tax bracket. The thresholds are expressed in U.S. dollars (and rounded) to make them comparable, using market exchange rates at the end of 1988. Wherever key features of the tax system are automatically indexed for inflation, such as individual thresholds in Argentina, this is indicated by the word "indexed" in the appropriate category. In general, the lower the maximum tax rate and higher the threshold, the higher a country would rank in this particular tax category. A number of countries have no income tax at all, so Bolivia's new 10% flat tax (with value-added taxes deducted from it) only scores 9 on a scale of 1-to-10, rather than a "perfect 10." Bolivia's combined income-VAT rate is so low, that the low threshold (which exempts double the low minimum wage) scarcely matters.

Click here to view Table: Maximum Tax Rates: 1989

Although Mexico's newly-reduced 40% tax rate for 1989 does not appear much worse than Argentina's reduced 35% rate, the top tax rate in Mexico is reached by people with only one-fourth the level of those in Argentina's highest bracket. Moreover, the absence of indexing in Mexico (there was some de facto indexing only in 1979-82) could make the difference even wider in the future. To make matters worse, moving from Mexico's 38% bracket (at an income of only about $7000 a year) to the 40% bracket at $13,000 involves subjecting total income to the 40% rate, not simply the marginal increase. For these reasons, Argentina (and the similar tax in El Salvador) gets a score of 5 in this category, and Mexico is downgraded to a 3. Brazil's low tax rate, cut in half for 1989, is partly offset by the low threshold and recent repeal of indexing, but still rates a 6.

The fact that Mexico's individual tax system still looks relatively harmful, despite two recent reforms cutting the tax rate to 40% from 55%, is another lesson in why tax revenues can be an extremely misleading guide to the importance of tax rates. Mexico's top tax rate was 35% in the mid-1960s, and the threshold at which top rate applied remained reasonably high well into the 1970s -about $120,000 in 1979, for example. As chronic currency devaluations and virulent inflation pushed more and more people into the highest tax brackets, though, economic activity either stopped or went underground, provoking further currency crises, etc. Mexico thus provided an extreme example of the "stagflation" that infected many countries even earlier, and for the same reasons - mainly, easy money and punitive taxation (see Reynolds, 1985). By the early 1980s, the largely tax-exempt "informal" sector was already estimated to account for 42% of Mexico's urban employment (Inter-American Development Bank, 1987). At the same time that Mexico's tax rates were at an all-time high, and thresholds reduced to one-tenth of what they were in 1979, revenues from Mexico's individual income tax have fallen dramatically in real terms.

Expressing individual tax receipts in 1980 pesos, using the consumer price index, real revenues fell by 82% from 1982 to 1987 - from $121.2 billion to $66.6 billion (in 1980 pesos). Since real GDP also declined, revenues did not fall so badly "as a percentage of GDP," but that method of calculation ignores the bad effects of onerous taxes on GDP itself. Governments cannot pay their bills with "percentages of GDP," but instead need growth of real revenues, which ultimately must come from growth of the real tax base (mainly, private jobs and profits).

The next category in the table, Social Security, assumes that all payroll taxes are borne by workers, even if ostensibly financed by employers. Employers are indifferent between paying higher wages or higher wage-related taxes, and the sum of the two cannot exceed the workers' marginal product or the employer will go bankrupt. Social Security tax is Argentina's disaster area. The employer and employee each pay 13% of wages and salaries for state pensions. Employers also pay 4.5% for social health, and employees 3%. Employers alone pay another 9% for a family allowance fund, plus 5% for a housing fund. It all adds up to an astonishing 47.5%. The 47.5% is also the marginal burden since there is, as the table indicates, no limit, or ceiling, on the amount of income subject to these taxes. In countries where there is such a limit, the approximate maximum tax is shown. A maximum Social Security tax means the marginal rate on added income declines to zero at some income, since added income brings no added tax. Moreover, the ceiling on income subject to this tax, where it exists at all, is not terribly high within this sample, so three countries with such a limit gain 1 or 2 added points in our ratings.

Corporations can almost always deduct Social Security tax payments from the corporate income tax, but this is not always the case with individuals (even in the U.S.). In Argentina, individuals are supposed to pay 16% for Social Security and health, but only 10% (including, quite reasonably, private pension plans) can be deducted from income tax. In reality, the Social Security tax is so onerous that employers and employees have a powerful incentive to evade the tax and split the savings. In the process, they must also evade individual income taxes (which wouldn't be so bad if they were not added to huge Social Security taxes) simply in order to avoid detection. Tanzi shows that Argentina's absurd Social Security taxes collect relatively little revenue - only 3.4% of GDP, less than half of what Brazil collects. The individual income tax, when rates were much higher than they are now, collected virtually nothing - less than one-half of one percent of GDP. This illustrates, once again, why revenues are such a poor guide to the destructive nature of punitive tax rates.

Argentina clearly rates a score of 1 on Social Security tax, only because we're not handing out zeros. El Salvador is the best in this group, with a tax that declines to 1% on employers and employees as income rises, and then stops altogether at a modest level. To make it even better, ordinary workers can deduct their Social Security tax from income tax. Give El Salvador a 7 for this tax. Mexico and Bolivia each get a 5, for different reasons (Mexico's tax has a ceiling, Bolivia's is deductible). Brazil rates a 3 for high tax rates (albeit with a ceiling), and no deduction for individuals.

The next category is VAT or sales taxes, which would include turnover taxes and excises as well. Some of the best economies in the world, such as Japan and the U.S., have gotten along just fine with very modest sales taxes, which has to give nearly all the Latin American countries a low score. The worst, perhaps in the world, is surely Brazil. Brazil slaps a variety of sales taxes on everything, including services, with rates up to 300%. On domestic sales taxes alone, Brazil gets a score of 1. And that isn't even counting steep sales taxes on imports (which have recently been reduced a bit).

Tariffs are somewhat beyond the scope of this paper, since they are an implicit subsidy to protected industries as well as a revenue source. It is worth recalling, though, the idea of prohibitive tariffs - tariffs that yield little or no revenue because they make it impossible to conduct the activity being taxed. The relevance is that there are prohibitive taxes, as well as prohibitive tariffs, and these too yield less revenue than a lower tax would yield. Mexico, for example, found that revenues fell when tax rates were increased from 10% to 30% on minks and jewels (Gil Diaz). The sharp reduction of tariffs in Chile was followed by so much more rapid an economic expansion that the effect on overall revenues (not just the tariffs themselves) was undoubtedly positive.

Scoring other countries on sales tax, Bolivia's deductible VAT is the best, but there are still some 30-50% taxes on "sins" and "luxuries" that brings the score down to 5. El Salvador also distorts choices with selective taxes on consumer goods the government doesn't like, though these taxes are not nearly as bad as in Brazil. El Salvador's stamp tax of 2-5% on all sorts of documents is a primitive nuisance. Give El Salvador and Argentina a 4. Mexico's VAT is fairly new, introduced at a lower rate at the start of the decade, and it may be no coincidence that the economy's worst performance in history (and therefore falling real revenues from other sources) has been while the VAT has been in effect. To be generous, score Mexico a 3 on sales taxes.

Wealth tax should properly include property, gift and inheritance taxes, which are not very significant in this particular group of countries. There are, though, direct taxes on corporate net worth in four countries in our sample, and one on individual net worth. In fairness, these taxes have to be viewed in combination with the following categories - taxes on individual investors and on corporate profits. Bolivia, for example, uses a corporate net worth as a virtual alternative to a corporate profits tax, and Argentina's wealth tax on individuals is combined with fairly light taxes on interest, dividends and capital gains. But those features will result in fairly good scores in the other categories. The sheer existence of any wealth tax, which is quite rare among successful economies, precludes a high score. After all, individuals and corporations acquire wealth out of after-tax income (which is also true of assets left to heirs), so it is an inherently nasty double tax on the virtues of acquiring assets and keeping debts down (as opposed to spending everything on champagne and caviar, and then buying more on credit).

Brazil gets a 10 for not having a wealth tax. Mexico gets a 6 for allowing a credit against business income tax. Bolivia's score is 5, El Salvador's is 4, and Argentina's (because individuals are included, at a higher rate) is 3.

Investor taxes obviously overlap with corporate and wealth taxes, but are separated in order to convey the flavor of the ways in which the overall tax system treats income from capital relative to income from labor. This distinction is rarely neat. Social Security taxes are clearly taxes on labor, and wealth taxes invariably exclude human capital (e.g., a doctorate degree). But consumption taxes fall on consumption from either labor income or capital assets. And although wages and salaries account for 76% of the individual income tax collections in Mexico, for example (Tanzi), income from noncorporate business and capital investments is small relative to labor income, so that a 24% share means non-human capital is nonetheless quite heavily taxed by the individual income tax.

Nearly all of our sample countries, like many advanced industrial countries, tax capital gains on financial assets relatively lightly, or not at all. A purist might properly object that this distorts investments toward assets expected to appreciate, rather than yield interest or dividends. Yet no country has found a practical way to tax capital gains in ways that theorists would prefer - which would involve full deduction of capital losses (which makes it easy to avoid the tax by timing strategies), indexing for inflation (which ought to apply to old assets too, though that would lose a lot of revenue), and taxation as gain accrue rather than when realized (which is simply too difficult). Any capital gains tax is essentially voluntary, since nobody has to sell the assets they have, or to buy more of the kinds of assets subject to that tax (a high capital gains tax in the U.S., for example, may well have made interest on junk bonds more attractive than holding stocks in promising new companies that do not yet pay dividends). Indeed, the problems are so tricky, and evasion so easy, that a low tax rate on capital gains may be the best of possible worlds. Mexico's capital gains tax of zero on stocks, though, looks a bit too generous, since revenues foregone must be replaced with some other tax.

For our comparative ratings, it is reasonable to assume that any low tax rate is almost always preferable to a higher tax rate. A country in which all tax rates are low and investors get no special deals will always get a better overall score (closer to 10) than a country that taxes the stuffing out of, say, payrolls and sales, and then gives a big break for capital gains. Tax breaks for investors are not obviously more desirable than tax breaks for, say, working overtime or going to school. Yet nearly everyone is both a worker and investor at some point in his or her life cycle, so tax relief for investors is better than taxing everything at steep rates.

Taxes on investors are too often a device for tilting capital toward uses determined by political rather than market forces. Argentina and Mexico give investors a special break on bonds issued by the government, for example, rather than bonds issued by private companies. Capital gains on certain investments in the same countries are completely exempt (usually investments in big companies), while other gains are not. Brazil's new 25% tax is less distortionary, and thus rates the same score of 5 given to Argentina and Mexico, whose rates are sometimes lower, sometimes higher. El Salvador's tax rates are the highest in this group, and investors don't fare much better, so the country gets a 3. Bolivia tops the list again, with rates of 10% or zero deserving an 8, even though letting Bolivians pay zero only on foreign investments sounds like an open invitation to capital flight (Balassa).

The final category is too often the first or only tax considered, namely, the corporate profits tax. In reality, this tax is almost always lower than individual income tax rates, and much lower than the combined effect of income, payroll and sales taxes on workers. Bolivia has virtually no corporate income tax, and thus rates a 9. Argentina, Brazil and El Salvador have comparable effective rates, for a score of 5. Mexico imposes compulsory profit sharing, at 10% of taxable profit, which cuts that country's score to 4.

The Table, "A Scorecard on Tax Regimes," summarizes the ratings discussed above. The trick is to weight the relative importance of various taxes. Weightings could be based on the relative importance of various taxes as revenue sources, but some of the worst taxes yield the least revenues. The individual income tax is surely by far the most important, since virtually all activity is subject to it. Indeed, the individual tax on corporate interest, dividends and capital gains is often more significant than the corporate tax itself. Having assigned a 40% weight to the individual income tax, the rest of the weighing scheme must be regarded as a matter of rather arbitrary judgement. Actually, the most onerous tax in each country merits the highest weight, so that Social Security tax could be given a higher weight in Argentina, consumption taxes a higher weight in Brazil, and so on. This notion seems worth exploring, but this paper will nonetheless use the same weight for each country.

Click here to view Table: A Scorecard on Tax Regimes

The tax scorecard may be compared with two very aggregate measures often used to evaluate countries, namely budget deficits and government spending expressed as a percentage of GDP.

Click here to view Table: Central Government Spending and Budget Deficits as a Percentage of Gross Domestic Product

These summary measures of government spending and borrowing, relative to the overall size of the economy, happen to rank countries in ways not so different from our tax scorecard (Bolivia is still the best and Mexico the worst). Yet these conventional aggregate measures nonetheless seem more primitive and misleading than our details about the tax structure. Looking at the ratio of spending to GDP, Argentina appears to be a country in which government is relatively small and unobtrusive, but its taxes and regulations are usually worse than those of Brazil. Bolivia really does have a small government, but was nonetheless forced to finance it with hyperinflationary money creation until 1986, when the top tax rate was slashed to 10% and real revenues soared (Reynolds, 1990). Besides, these measures are largely determined by past policies (including monetary policies that can inflate nominal interest rates and therefore the apparent deficit). A new government which plans significant reforms to increase individual choice and opportunity ought not to be prematurely condemned because of inherited debts, or even because of spending that may look high (relative to GDP) largely because private GDP is so low.


Systematic comparisons of tax and spending regimes are of interest to private entrepreneurs, professionals and investors, to help them to decide where to locate their skills and capital. For similar reasons, tax comparisons are of interest to government policymakers, to help them to understand whether their tax systems are competitive, attracting or repelling productive effort and investment. Conventional measures of spending and debt as a percentage of GNP often merely measure symptoms of other problems - including oppressive taxation, capricious regulations, insecure property rights, protected and subsidized government monopolies, and money of unpredictable value.

The details of the tax structure capture one of the principal means by which statism constrains the productive actions of individuals. These details can be measured with reasonable accuracy and (unlike spending "priorities") compared with minimal subjectivity. There is no reason to isolate a particular region, as we have done in this paper, because the competition for industrious people and their capital knows no national boundaries. An iron curtain may keep people's bodies within a country, against their will, but they will scarcely be motivated to work to their potential.

Case studies of national tax and spending systems would be a useful supplement to the relatively mechanical overview of this paper. Yet existing case studies, such as Pechman or Fels & Von Furstenberg, are usually written by several different economists, with different views on what is important. As a result, they are not suitable for comparative studies. There have been a few efforts to compare overall average tax rates (Marsden), and, far better, even marginal rates (Reynolds 1985, 1989; Rabushka-Bartlett). But the methodology of calculating the combined marginal effect of numerous taxes (some with deductions and ceilings) requires courageous assumptions and some complexity, which makes the exercise relatively inaccessible to busy businessmen and politicians (Frenkel). The concept of "average marginal rates" is also no substitute for the details. A country in which half the population (employees of multinationals) faced a 90% tax bracket, while the other half (farmers and cocaine merchants) were completely exempt might be said to have an "average marginal rate" of 45%, yet the effect would be much more discouraging and distorting than a flat 45% rate.

Assigning index numbers to the various elements of the tax code, such as the 1 to 10 scale used here, holds considerable promise as a relatively clear, and therefore effective, measure of this important aspect of economic liberty.

Click here to view Table: Maximum Marginal Tax Rates on Individual Income


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- "Latin American Debt: The Case for Radical Tax Reform," February 1988, in Goodman, John & Moritz-Baden, Ramona (eds.) The War of Ideas in Latin America, National Center for Policy Analysis, forthcoming. Also,"La Deuda Latinamericana: Por Una Reforma Fiscal Radical" Expansion, Mexico, August 16, 1989.

- "The IMF's Destructive Recipe of Devaluation and Austerity," Executive Briefing, Hudson Institute, March 1992.

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Tom DiLorenzo thought that some marginal measure should be used to see how government absorbs additional income each year. Alvin Rabushka worried that Price Waterhouse figures about tax rates may often refer to foreign residents, and domestic residents may be very different. The best source of evidence on this, he suggested, is from the International Bureau of Fiscal Documentation. Milton Friedman pointed out that the measurement of taxation goes hand in hand with the attempt to measure regulation. It makes no difference if the government taxes a company to prevent pollution or requires a company to install pollution equipment. They both create the same kind of distortions. Similarly, zoning regulation is a wealth tax. Alvin Rabushka mentioned that he had been involved in developing some measures of this kind of indirect taxation and that you have to be careful not to double count. For example, an overvalued exchange rate is an indirect tax on exporters. Thus if you study this problem area by area, you may pick-up some of this in specific categories.

Jack Carr mentioned that this assumes that more taxes reduce economic freedom. Yet a country like Israel may pay more taxes to safeguard its economic freedom in the future. You need to look at the whole to see what the taxes are spent on. Milton Friedman suggested that some of Israel's tax burden is for the military safeguarding of freedom, but there is a large component of their expenditures that reduce the economic freedom they are trying to safeguard. Alvin Rabushka took issue with Jack Carr arguing that although you might want to assess expenditures as to their freedom enhancing or diminishing effects, the cost of the taxes will reduce freedom regardless of the use to which they are put. A tax is a tax is a tax.

Easton argued that Reynolds should measure both the marginal and average tax rates. The marginal shows distortions, the average helps capture a total amount of the distortion. Milton Friedman pointed out that the cost of taxation is much higher than the proceeds to the government. James Gwartney reminded the audience that there are at least two tax rates that generate the same level of tax revenue, yet one may be more onerous than the other.

Juan Bendfeldt felt that other tax measures should be taken into account. The social security taxes should be considered. Further the quality of service should be counted in any measure. Regardless of the rates of tax, it is hard to tell what you are getting. The mix of both taxation and expenditure is an important element in considering the effect on economic freedom which may be diminished both from the tax and expenditure sides of the equation. Jack Carr responded that there is a complex problem here. If there is some kind of agreement-say an original confederation-and the winners are going to compensate the losers, then we run the risk of looking at the compensation devices and claiming that they are reductions in economic freedom. We need to know the nature of the original agreements in place to evaluate the pattern of taxes and expenditures. We are assuming that benefits should equal costs for every taxpayer. Further, we need to look at the whole tax system. If one country has a tax on gasoline and another a toll for road use, we will count the first as less free even though the cost of collecting the toll may far outweigh the costs of collecting the tax on gasoline. Walter Block suggested that this would not be a problem for an index as the tolls will be picked up in the regulation section which would correspond to a lower tax rate while the tax measure would be higher in the other country which would correspond with a lower cost of regulation.

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