Provincial Economic Freedom in Canada 1981-1998: Introduction

The eleven components of the index of provincial economic freedom are divided among four major areas: I. Government Operations and Regulations; II. Takings and Discriminatory Taxation; III. Interprovincial Trade; and IV. Labour Market Regulations. A scale from zero to 10 was used to rate each component in the index. Ten is the highest possible score and indicates relatively high economic freedom while a score of zero is the lowest a jurisdiction can receive. Many of the components and definitions are adapted from the three editions of Economic Freedom of the World (Gwartney, Lawson, and Block 1996; Gwartney and Lawson 1997; Gwartney and Lawson 1998).

Government operations and regulations in the economy have an impact on consumer choice and economic freedom. The two broad functions of government consistent with economic freedom are limited to its protective capacities and its role in providing public goods. Most modern governments have ventured far beyond these functions and involve themselves in the direction of private production, the operation of businesses, the protection of government firms from the discipline of competition (both through the creation of monopolies and by subsidizing losses of government firms), the imposition of price controls, the redistribution of income and wealth, and numerous other discriminatory expenditures and regulatory activities. All these activities are contrary to economic freedom and are a burden to society.

Provincial governments have the authority to take a portion of an individual's income (through taxation) and either to transfer it to others or to use it to operate enterprises or agencies. Further, provincial governments have the power to set prices, limit entry into markets and occupations (through the establishment of marketing boards and regulation of professions and industries), mandate the provision of services by private parties (usually businesses), and impose any number of other regulations on individuals or businesses.

When consumption expenditures by government increase as a share of GDP, political expedience is substituted for market decisions and coordination. All things being equal, more public spending means less spending by individuals and households. "As government expenditures increase, more and more of these expenditures tend to be channelled toward activities outside of the protective and productive functions of government" (Gwartney, Lawson, and Block 1996: 23). As government begins to take over more portions of the economy, there is almost always a loss of efficiency. Research in progress at The Fraser Institute suggests that once government revenue is above approximately 30 percent of GDP there are substantial economic costs to the economy. Canadian governments have been above this level for decades. The complicated coordination of prices and output that the market handles free of charge requires an expensive bureaucracy to operate when it is under the auspices of a government organization.

For the last two decades, expenditures by provincial and local governments have been rising faster than the nominal GDP. Within total expenditures, there have been trends in the relative importance of the type of expenditure. Government expenditures fall under two broad categories: exhaustive and distributive. Exhaustive spending encompasses expenditures such as consumption spending and capital formation--e.g., varied services such as education, health care, and police protection. Distributive spending encompasses such expenditures as interest on the public debt and transfers to businesses and persons. In real terms, expenditure on goods and services, both consumption and capital, has grown slower than GDP over the past two decades. Government operations such as transfers to persons and businesses, and interest on the public debt have been growing much faster in real terms than GDP. This suggests that governments have been increasingly willing to abandon their traditional role and pursue other objectives. This shift has had negative consequences for economic freedom and economic well-being.

For most measurement years, the index uses total provincial government expenditures as a percentage of GDP from the Provincial Economic Accounts. The 1996 measure of this component uses the 1996 Financial Management System (FMS) data provided by Statistics Canada. Total provincial government expenditures (as measured by FMS accounts) as a percentage of GDP was used. This was used because the 1996 Provincial Economic Accounts data was not available when the index was being compiled.

Data Source : System of National Accounts, Provincial Economic Accounts, Annual Estimates disk version (1961-1996), Statistics Canada, Catalogue No. 13-213.

I(b). Size of Government-Operated Enterprises and
Debt Guarantees as a Percentage of GDP

A government-operated business enterprise represents the substitution of political coercion for market decision-making. Government enterprises are fundamentally different from private businesses. Their start-up capital is coercively appropriated from taxpayers whereas private firms obtain funds voluntarily from investors willing to risk their own wealth. An intelligent investor will not lend money without assurance that it will be recovered. Yet this is what the government does with taxpayers' money whenever it funds another dubious government enterprise. Investors typically calculate the returns of an investment relative to the investment's risk before investing. Bearing risk is one of the beneficial functions that these individuals perform. Without someone willing to accept these risks, society would have trouble advancing. Politicians calculate returns to investment in terms of votes, indifferent to the effect on the economy. Subsequent investment decisions of public-sector firms are made by political officials playing with the taxpayers' resources. Entrepreneurs who are capable of attracting financial capital know that they must return something of value to investors to be successful. The return politicians primarily worry about is their return to power. Needless to say, both groups have vastly different incentives. Subsidies, favourable tax treatment, and regulations are often used to protect state-operated firms from private competitors. If a government project fails to generate enough revenue to cover its costs, there is no bankruptcy mechanism to bring it to a halt. Public-sector enterprise stifles market forces by substituting politically pragmatic decisions for decisions based solely upon the financial situation of a firm. Government bureaucrats seldom lose their jobs for bad decisions whereas their private counterparts have levels of accountability unmatched in the public sector. Similar perverse incentives exist when debt guarantees are issued by the government. When protected by debt-guarantees, firms are able to engage in riskier or less profitable projects--at someone else's expense--than they might otherwise have. This creates distortion in the economy and results in a further erosion of decision-making based on competitive forces. By issuing these guarantees, the government becomes an influential partner in these firms.

To estimate the importance of government business decision-making within a province, we measure the value of total liabilities and net worth of government business enterprises and the value of government debt guarantees as a percentage of provincial GDP. This illustrates the relative size of such enterprises within provincial economies and allows for cross-provincial comparisons.

Data Source : Public Sector Assets and Liabilities, Historical Overview, Financial Management System, Statistics Canada, Catalogue No. 68-508. In the case of Quebec, the dollar value of the Quebec Pension Plan has been deducted, because for the other provinces this service is provided federally. Years 1993 and 1994 were obtained using the disk version of this dataset.

I(c). Price Controls

Price controls interfere with the freedom of buyers and sellers to undertake exchanges even when both parties agree on the terms of trade. Price controls are a forced transfer of property from a private owner to another individual. For example, if price controls on rental housing cut the rate of return of a property in half, half the property is seized from the owner since, presumably, landowners are in business to earn a living and not to subsidize tenants in high-rent cities. Surprisingly, in many cases this is a transfer from the poor to the middle class, as many rental operators are less wealthy then their tenants (Lehrer 1991). Since price controls constrain exchange and expropriate property from owners, they are inconsistent with economic freedom. The more price controls are used to distort prices, the larger are the associated inefficiencies.

This component measures the extent of price controls imposed by government on goods and services for each province.

Data Source : Research undertaken by Faisal Arman from provincial government regulations.

I(d). Regulatory Effort

One of the most important though often overlooked challenges to Canada's economic competitiveness has been the regulatory burdens imposed by all levels of government on businesses, large or small (Mihlar 1996). The ability of business to operate with increased efficiency and productivity (the essential requirement of a higher standard of living) is restricted by the ever expanding regulatory burdens imposed by well-meaning governments. Such burdens are costly and chaotic for business because they are inherently unpredictable. Politicians themselves rarely know which regulation or law will be in vogue in months to come. In the course of a year, the typical parliament enacts all sorts of statutes covering all types of activities. Often these deleterious activities receive little media coverage or public debate.

The number of regulations affecting people and businesses in Canada has escalated in the last two decades, and there has been an accompanying increase in the costs of compliance associated with such regulations. Regulatory burdens, like high taxation, are an impediment to additional investment and new jobs. This index measures the resources expended by provincial governments in implementing and maintaining regulations on businesses as a percentage of business revenue.

Data Source : Business revenue data was compiled from the Provincial Economic Accounts, Statistics Canada, Catalogue No. 13-213 (subtracting total government consumption from GDP). Government expenditure on regulation data was prepared on a public-accounts basis by Dr. Paul Reed, Senior Social Scientist, Statistics Canada, 1996.

II. Takings and Discriminatory Taxation

Modern governments are particularly likely to engage in activities that confiscate from one group and give to another. This is true for both the budgetary and regulatory policies of government. The justification often seems incomprehensible as there are no logical reasons why the government should pick the pockets of its citizens on behalf of farmers, fishers, or other receivers of subsidies. When governments play favourites and take from one group to transfer to another, or impose the costs of public services disproportionately on particular groups, they violate economic freedom. Our research has identified four domains where discriminatory behaviour in the political sphere is particularly important. These areas are (a) Transfers and subsidies as a percentage of GDP; (b) Top marginal tax rate and the income threshold at which it applies; (c) Direct corporate taxes as a percentage of corporate profits; and (d) Provincial sales tax.

II(a). Transfers and Subsidies as a Percentage of GDP

Transfers and subsidies violate the freedom of individuals to keep the value of their labour or investments. When governments tax one person in order to give money to another, they separate individuals from the fruits of their labour and reduce the real returns of such activity, lowering the incentive to be productive. This is true whether funds are transferred from the rich to the poor or, as is often the case, from the poor to the rich, from one racial group to another, or from the politically disorganized to the politically powerful. The taking of property, including labour services, without fully compensating the rightful owner is an infringement of economic freedom. The ratio of transfers and subsidies to GDP indicates the degree to which various provinces use their budgets to engage in taking and transfer activities. Low ratings are given to those provinces with the greatest portion of their GDP dedicated to transfers and subsidies.

The 1996 measure of this component uses 1995 Provincial Economic Accounts data. Data from 1996 was not available during the completion of the index.

Data Source : System of National Accounts, Provincial Economic Accounts, Annual Estimates disk version (1961-1996), Statistics Canada, Catalogue No. 13-213.

II(b). Top Marginal Tax Rate and the Income Threshold
at Which It Applies

High marginal tax rates discriminate against productive citizens and deny them the benefits of their efforts. In essence, such tax rates seize wealth from certain taxpayers without providing them an equivalent increase in service.

Generally, high marginal tax rates are a very inefficient form of raising government revenue, since people will often reduce their work effort and make other adjustments when a large proportion of their marginal earnings are taxed away--the existence of tax havens and other loopholes is well known. Also, when marginal taxes reach a certain level, the returns for dishonesty become very high. Under certain circumstances, a normally honest citizen will be induced to cheat by a revenue-hungry government. Thus, high marginal tax rates impose an additional cost --and loss of freedom--over and above the revenues transferred to the government. Taxes are, in effect, a negative subsidy applied to productive activity.

This component is based on the ratings used in the Economic Freedom of the World. It takes into account both the highest marginal tax rate as well as the income threshold at which it applies.

Data Source: "Finances of the Nation," Canadian Tax Foundation 1982, 1985, 1989, 1993, 1994, 1995, 1996, 1997 (entitled "The National Finances" before 1995).

II(c). Direct Corporate Taxes as a Percentage
of Corporate Profits

Within an economy, technical progress drives growth and is embodied in investment in new capital. High corporate taxes deter new investment while simultaneously reducing future economic well-being and the associated benefits of a higher standard of living. By forgoing the latest and most efficient technology, labour productivity is constrained. Labour productivity is the key to a higher standard of living since all production ultimately becomes consumption. The more efficient production is, the more products that the consumer can afford as wages are representative of labour productivity. The more a nation can produce, the more each citizen can receive. Weakening production therefore reduces a society's standard of living. High corporate tax rates impose costs over and above the revenues transferred to the government and result in lower levels of investment, less employment, and a slower growth rate. Though some activists claim that corporate taxes are simply paid by the rich, this is not the case. Taxes that reduce efficiency and limit production hurt everyone, irrespective of income bracket.

This component was calculated using the direct taxes paid by corporations as a percentage of corporate profits within each jurisdiction. Although, due to differences in tax code, it would be preferable to have a marginal measure, there is no accurate marginal measure for cross-provincial comparisons.

Data Source: "Provincial Economic Accounts," 13-213. Statistics Canada.

II(d). Provincial Sales Tax

Sales taxes on goods and services limit individual discretion in consumption choice as a result of the increased costs that they impose. Sales taxes create a gap between the cost of the good or service and the price that one must pay to obtain it. In a normal transaction, the person buying an item places more value on the item than the seller (or he would have no reason to purchase this item). Every transaction adds to the welfare of society by transferring this sliver of value (the difference between the value to the consumer and the price he pays) to the consumer. Taxes interrupt this beneficial exchange when the tax increases the cost of the item above the value of the object to the consumer. For example, if a consumer values a certain brand of molasses at three dollars a litre, and the sale price is two dollars, the consumer receives a net benefit of one dollar for every litre he purchases. This gain comes at the expense of no one and is a true gain for society. If taxes raise the price by 50 cents, then 50 cents of the previous gain is transferred to the government. When taxes raise the price of molasses past three dollars, the consumer will stop purchasing molasses (or rely on the black market for molasses) as its price is greater than the value the he places on it. Each purchase of a litre of molasses was a one dollar net benefit for society in the first two examples. In the first instance, the benefit was captured entirely by the consumer, and in the second, the government and the consumer split the benefit evenly. When the consumer halts his purchase of molasses, this represents a loss to society that is not captured by another part of society. Thus while sales taxes (or any other tax) raise revenue, there is, in the words of economists, a deadweight loss to society above the cost of the tax to the consumer. This loss is difficult to measure but there is no doubt that this loss exists and that it grows as the level of provincial sales tax rises.

This component measures the level of sales tax within each province. Values for 1994 were taken from the Manitoba Provincial Budget (1994). GST is not included in these calculations as it is a federally levied tax.

Data Source: "Finances of the Nation," Canadian Tax Foundation 1982, 1985, 1989, 1991, 1995, 1996, 1997 (entitled "The National Finances" before 1995).

III. Interprovincial Trade

Economists of all persuasions have recognized the efficiency gains made possible by free trade. If there were free trade among the Canadian provinces, residents of different provinces would gain from interprovincial divisions of labour, economies of scale, and specialization in areas where they have a comparative advantage.

Trade allows trading partners to produce a larger joint output than that which would have been produced separately. From this larger production each partner can benefit. An easy way to see how trade is beneficial is to examine the manufacture of automobiles. We can either purchase automobiles from domestic firms or we can import them. Importing automobiles requires an outflow of Canadian dollars. Our dollar has little intrinsic value embodied within it; it is not priceless art or precious metal. Those who accept Canadian dollars wish to exchange these slips of paper for something they want. If we imagine that the foreign exporters of automobiles desire Canadian wheat, then the Canadian dollar becomes an intermediary in the trade of automobiles for wheat. If the government imposes a tariff on the import of foreign automobiles, this drives up their price and lowers demand. This, in turn, lowers demand for Canadian wheat. Barriers to trade do not protect the Canadian economy from competitors; barriers only protect the particular industry--in this case, domestic manufacturers of automobiles--at the expense of another industry--in our example, farmers. This is equivalent to a transfer from farmers to automobile manufacturers without compensation, and represents a violation of economic freedom (Friedman 1996).

Freedom of exchange is central to economic freedom; hence any circumstance that makes it difficult for buyers and sellers of goods, services, capital, or labour to complete a mutually beneficial transaction can be defined as a "barrier" to trade (Trebilcock and Schwanen 1995). The data in this area focus on two types of restrictions: labour mobility and barriers to trade in food and agricultural products. The components in this area do not by any means cover all the barriers to trade that the provinces have erected but provide an illustrative sample of factors that are quantifiable. As a proxy measure for a kind of barrier that is difficult to evaluate, we believe that this component reflects the impediments to trade among the provinces.

III(a). Occupational Licensing

Each province is empowered to regulate occupational standards, licensing, certification, registration, and residency requirements. They are not, of course, required to regulate, but this option is often overlooked. Since provinces seldom work in tandem in this regard, these bureaucratic rules create barriers to mobility of labour. Such measures prevent the free movement of labour in seeking opportunities in other provinces freely and without hindrance. Subject to certain qualifications, any worker qualified for an occupation in one jurisdiction in Canada should have access to employment opportunities in any other jurisdiction. These restrictions were not created in order to protect consumers in each province, as national standards could serve this purpose if necessary, but instead to protect the interests of entrenched labour in their respective provinces. The restriction of mobility of labour is clearly a violation of individual economic freedom and one must ask if it is really necessary for provinces to restrict the free movement of beekeepers or hairdressers. The extent to which labour mobility is hampered in each province is reflected in the number of occupations that each province regulates. The higher the number of regulated occupations, the more labour mobility is restricted.

Data Source: R.G. Evans and W.T. Stanbury, "Occupational Regulation in Canada," a background study prepared for the Economic Council of Canada, Regulation Reference, 1980. Updated through to 1995/96 by Faisal Arman using provincial statute records.

III(b). Marketing Boards (Agricultural)

Marketing boards represent a significant regulatory instrument. The majority of new provincial marketing boards have been those with supply management powers that enable them to control the supply of products by setting prices and production quotas and by disposing of "surplus" output. Import controls are becoming a standard appendage of supply management (Evans and Stanbury 1980). In essence, marketing boards are cartels that regulate the supply, price, and flow of goods. This component measures the share of farm receipts influenced by supply management boards by province as a ratio of total farm receipts (Canadian Wheat Board payments are excluded from total farm receipts where necessary). The greater the share of farm receipts collected through supply management boards, the lower the score given in this component. These policies encourage less efficient land use and extract money from consumers to be passed to producers. Instead of sparking efficiency gains, our system of marketing boards has allowed less efficient producers to exist. This wastes precious resources and has undoubtedly lowered the standard of living of Canadians.

Data Source: Farm Cash Receipts and Payments Summary Report, Agricultural Division, Statistics Canada 1981, 1985, 1989, 1993, 1994, 1995, 1996, Catalogue No. 21-603 UPE.

IV: Regulation of the Labour Market

IV(a). Minimum Wage Legislation

High minimum wages increase unemployment. Minimum-wage legislation is often enacted in hopes of benefiting those with low incomes but, in fact, it has the perverse result of reducing demand for low-skilled workers and boosting demand for their more highly skilled counterparts. Thus, the costs of such policies are borne by those whom they were enacted to help. Empirical evidence from both developed and developing countries confirms the accuracy of these statements and serves as an important reminder to jurisdictions seeking to influence the market through legislation (Robinson 1997). The Economist magazine, when discussing the proposed national minimum-wage policy in Britain, said that the proposal "would fly in the face of economic logic" and that "most low-paid workers are not, in fact, poverty-stricken, but rather second-earners in middle-income households. Thus, the minimum wage is not a well-targeted instrument for helping the poor." Minimum wages drive up the cost of doing business which reduces jobs, hurting poor families further. The "reason why a minimum wage would not help the poorest homes is that many of them have no one in work. Worse, a minimum wage would destroy jobs--the more jobs the higher it is set--by stopping people willing to work at low wages from doing so" (The Economist 1997: 54-55).

This component measures the annual income earned by working at the minimum wage as a ratio of per-capita GDP. This is a measure of a province's ability to bear a higher wage since per-capita GDP is representative of the average productivity of the labour force. As the minimum wage grows to be a higher percentage of provincial per-capita GDP, there are increasingly negative economic consequences.

Data Source: Human Resources Development Canada, Statistics Canada and the Provincial Economic Accounts, Statistics Canada, 1961-1996 (disk version), Catalogue No. 13-213.

Methodology

Estimates for 1998

The estimates for 1998 used in Provincial Economic Freedom in Canada were based upon the 1996 data for each of the 11 components of the index. This year was chosen because there were data available for this year for most of the 11 components. Updates will be made to the index when newer data becomes available.

Weighting the Components

Each component of the index developed for Provincial Economic Freedom in Canada has a different influence on the economic freedom within a province. Some restrictions are inherently more detrimental to economic freedom than others. In light of this, a weighting scheme is needed to arrive at a final measure of provincial economic freedom.

After the data for each of the components were assembled, each province received a grade from zero through 10 for each component. Each component's grade was then weighted based on a system derived from the system used in the first two editions of Economic Freedom of the World (Gwartney, Lawson, and Block 1996; Gwartney and Lawson 1997). The weights used in Economic Freedom of the World were

based on a survey of the participants in the Fraser--Liberty Fund Symposia Series . . . We constructed a survey instrument which described the 17 components in our index and asked the participants of these conferences to provide us with their views concerning the weights that should be attached to each of the components. Since all of these people attended at least one of the conferences, we were reasonably sure of their familiarity with the concept of economic freedom and the factors that influence it. The average weight suggested by the respondents was then used to weight the components and derive the summary index for each of the years. (Gwartney and Lawson 1997: 7)

The weights for components taken directly from the Economic Freedom of the World were modified for use with the Canadian provinces, which are subject to political and economic conditions different from those at work in international states. Weights for components created specifically for Provincial Economic Freedom in Canada were calculated based on their assumed contribution to provincial economic freedom as compared to other items already included. These weights were then adjusted to total 100. (See Exhibit 1).

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