Rating Global Economic Freedom
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.
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
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.
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.
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.
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
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
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
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.
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
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
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
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
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,
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
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
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
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
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
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
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 goods.country. 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.
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
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
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
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
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
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
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
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,
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,
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
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.
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 tax.market.
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 distorted.market.
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
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
(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.
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
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
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
Click here to view Figure 4: Impediments to Freedom: Index F2
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.
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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
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Mathematics Vol I. Simon and Schuster (1956) pp. 537-43.
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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
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
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
(1)Ui = f(X)
where Ui is the utility of the ith individual and X is a vector of goods and services
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
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
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
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
(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
(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 deposits.money. 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
routes.market. 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.
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).
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).
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
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
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
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
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
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 restriction.market. 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 terms.review. 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
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
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.
P. Brock, "Reserve Requirements and the Inflation Tax," Journal of Money, Credit
and Banking, February 1989.
S. Bronte, Japanese Finance: Markets and Institutions, Euromoney Publications: London,
J. Carr and F. Mathewson, "Unlimited Liability as a Barrier to Entry," Journal
of Political Economy, August, 1988.
_________, "The Effect of Deposit Insurance on Financial Institutions," Working
Paper Series No. 8903, University of Toronto, 1989.
D. Fair, "The Independence of the Central Banks", The Banker, October 1979.
M. Friedman and A. Schwartz, "Has the Government any Role in Money?" Journal of
Monetary Economics, January 1986.
__________, A Monetary History of the United States 1867-1960, Princeton University Press,
International Monetary Fund, Annual Report Exchange Arrangements and Exchange
Restrictions, Washington, D.C., 1988.
B. Klein, "The Competitive Supply of Money," Journal of Money, Credit and
Banking, November 1974.
Price Waterhouse, Doing Business in France, Price Waterhouse Center for Transnational
Taxation: France, 1985.
__________, Doing Business in Germany, Price Waterhouse: Frankfurt am Main, 1988.
__________, Doing Business in Japan, Price Waterhouse Center for Transnational Taxation:
__________, Doing Business in the United Kingdom, Price Waterhouse: London, 1987.
__________, Doing Business in the United States, Price Waterhouse: New York, 1988.
G. Penn, Banking Supervision: Regulation of the U.K. Banking Sector under the Banking Act
1987, Butterworths: London, 1989.
L. Pressnell (ed.), Money and Banking in Japan, MacMillan: 1973 (first published in Japan,
J. Revell, The British Financial System, MacMillan: London, 1973.
M. Rothbard, "The Myth of Free Banking in Scotland" in The Review of Austrian
Economics, vol. 2, edited by Rothbard, M. and Block, W.
J. Sasseen, "Can Paris Clean Up the Bourse," International Management, January
Schneider, et al., The German Banking System, 4th ed., F. Knapp: Frankfurt am Main, 1986.
G. Selgin, Theory of Free Banking: Money Supply under Competitive Note Issue, Totowa,
N.J.: Rowman and Littlefield, 1988.
Y. Suzuki, ed. The Japanese Financial System, Clarendon Press: Oxford, 1987.
M. Tatsura, Securities Regulation in Japan, University of Tokyo Press: Tokyo, 1970.
U.S. Department of Commerce, Foreign Economic Trends and Their Implications for the U.S.:
Canada, Washington, D.C., June 1989.
__________, Foreign Economic Trends and Their Implications for the U.S.: United Kingdom,
Washington, D.C., February 1987.
__________, Foreign Economic Trends and Their Implications for the U.S.: Federal Republic
of Germany, Washington, D.C., April 1989.
__________, Foreign Economic Trends and Their Implications for the U.S.: Japan,
Washington, D.C., October 1988.
__________, Foreign Economic Trends and Their Implications for the U.S.: France,
Washington, D.C., February 1989.
M. Walker, ed. Freedom, Democracy and Economic Welfare, Vancouver: The Fraser Institute,
L. White, Free Banking in Britain: Theory, Experience and Debate, 1800-1845, Cambridge
University Press, 1984.
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
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
"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
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
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
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 +
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
Click here to view Table HMF 11 "Ratio of Total Government Debt to Total Debt
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
Click here to view Table HMF 13 "Price Relative as a Measure of Regulatory
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
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
Click here to view Table HMF 18 "Highest Marginal Tax Rate Minus the Base Marginal
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
Click here to view Table HMF 23 "Government Employment as a Share of Total
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.
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
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
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 important...in 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 incentives...in the form of tax holidays...and
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
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
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
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
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
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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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
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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Last Modified: Wednesday, October 20, 1999.