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Applied Economics Letters

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Which economic freedoms influence per capita real

income?
a
Richard J. Cebula
a
Department of Finance , Jacksonville University , Jacksonville , FL , USA
Published online: 19 Jul 2012.

To cite this article: Richard J. Cebula (2013) Which economic freedoms influence per capita real income?, Applied Economics
Letters, 20:4, 368-372, DOI: 10.1080/13504851.2012.707768

To link to this article: http://dx.doi.org/10.1080/13504851.2012.707768

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 Applied Economics Letters, 2013, 20, 368–372

Which economic freedoms influence

per capita real income?
Richard J. Cebula
Department of Finance, Jacksonville University, Jacksonville, FL, USA
E-mail: Dr.RichardCebula@gmail.com

Several recent empirical studies find a strong, positive impact of economic

Downloaded by [Florida International University] at 13:45 11 January 2015

freedom on economic growth. This finding is predicated upon the argument

that increased economic freedom elevates the pace of economic activity
through incentives and other means and hence generates higher economic
growth. This study focuses on a similar, but not identical, potential impact
of higher economic freedom levels. In particular, this study investigates the
hypothesis that higher levels of economic freedom promote higher levels of
economic activity and hence higher levels of per capita real income. The
context of this empirical study is the 30 nations of the OECD over the
study period 2003 to 2006. Panel Least Squares (PLS) estimations reveal
that the level of per capita real income is an increasing function of business
freedom, freedom from corruption, investment freedom, monetary
freedom, government size freedom, trade freedom and property rights
freedom, whereas fiscal freedom, labour freedom and financial freedom
do not appear to influence per capita real income.
Keywords: per capita real Gross Domestic Product; economic freedom;
panel data; Fixed-Effects model

JEL Classification: P10; P12; P14; E20

I. Introduction higher levels of economic freedom promote higher

levels of economic activity and hence higher levels of
A number of studies have been conducted expressly to per capita real income. The context of this empirical
investigate the impact of economic freedom on eco- study is the 30 nations of the OECD over the study
nomic growth. These empirical studies typically find a period 2003 to 2006. The analysis consists of Panel
strong, positive impact of economic freedom, espe- Least Squares (PLS) estimations within the Fixed-
cially a measure of overall economic freedom, on the Effects model.
rate of economic growth (Tortensson, 1994; Ali and
Crain, 2002; Dawson, 2003). Indeed, the Cole’s
(2003, p. 196) study concludes that ‘. . . economic free- II. Context
dom is a significant factor in economic growth,
regardless of the basic theoretical framework’. This In this study, real income is measured by the per capita
finding is predicated upon the argument that increased real Gross Domestic Product (GDP) level, RPCY, in
economic freedom elevates the pace of economic activ- each of the nations studied over the 4-year study per-
ity through incentives and other means and hence iod 2003 to 2006. This measurement of real income is
generates higher economic growth rates. in principle compatible with most of the more recent
This study focuses on a similar, but not identical, related studies on macroeconomic growth, which
potential impact of higher economic freedom levels. In address the rate of change rather than the level of
particular, this study investigates the hypothesis that RPCY. The value of RPCY is made comparable
368 Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online # 2013 Taylor & Francis
http://www.tandfonline.com
http://dx.doi.org/10.1080/13504851.2012.707768
 Per capita real income and economic freedom
across nations by Purchasing Power Parity (PPP)
adjustments. Given the emphasis in this study on eco-
nomic freedom, it is hypothesized in this study that the
per capita real income level as defined depends directly
on economic freedom (FREEDOM) in each of its
various different forms, ceteris paribus:
RPCYjt ¼ fðFREEDOMnjtÞ; fFREEDOMnjt >0 ð1Þ
where RPCYjt is the level of the PPP-adjusted per
capita real GDP in OECD nation j in year t and
FREEDOMnjt refers to the value of economic free-
dom measure (index) n in nation j in year t. A higher
level of economic freedom promotes a higher real per
capita GDP by raising the level of economic activity.
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The Heritage Foundation (2008) has developed 10
measures of economic freedom, all of which are
expressly considered in this analysis. The first one we
describe is fiscal freedom, FF (Heritage Foundation,
2008, p. 13). Fiscal freedom reflects the freedom of
individuals and firms to keep and control their income
and wealth for their own use and benefit. A govern-
ment can impose fiscal burdens on economic activities
by generating revenues for itself – primarily through
taxation (but also from debt that in theory must ulti-
mately be paid off and that in fact must also be ser-
viced). Fiscal freedom is a measure of freedom from
the burden of government from the revenue side.
Technically, FF includes freedom from the tax burden
both in terms of personal income tax rates and the
overall amount of collected tax revenues as a percen-
tage of a nation’s GDP. The underlying idea is that
higher tax rates interfere on the one hand with the
ability of individuals and businesses to pursue their
goals in the marketplace, and on the other hand may
reduce, at least to some degree, the incentive to work,
save, invest or take risk. In any event, the higher the
FF index, the greater the freedom from government on
the tax/revenue side, the greater the level of economic
activity and hence the greater the real income level,
RPCY.
Another economic freedom is freedom from exces-
sive government size, or simply government size free-
dom, GSF (Heritage Foundation, 2008, pp. 13–14).
This index of economic freedom reflects the degree
of freedom in an economy from the burden of excessive
government in terms of expenditures. Alternatively,
GSF reflects the degree of freedom from excessive
government on the expenditure (as opposed to rev-
enue/tax) side. Arguably, government outlays com-
pete with private agents and interfere with natural
market processes, prices and interest rates by over-
stimulating demand, potentially diverting resources
through a ‘crowding out’ effect, one that could take
369
a variety of forms, including transactions crowding
out, financial crowding out and/or ultra-rationality
(David and Scadding, 1974; Carlson and Spencer,
1975; Abrams and Schmitz, 1978; Cebula, 1978). The
higher the GSF index, the greater the freedom from
excessive government size on the expenditure side and
thus the greater the levels of economic activity and
RPCY.
Business freedom, BF, addresses an individual’s
right to create, operate and close an enterprise/firm
without governmental interference. It is argued
(Heritage Foundation, 2008, p. 12) that burdensome,
redundant regulations are the most commonplace bar-
riers to the free conduct of entrepreneurial endea-
vours. In effect, regulations are regarded as a de
facto ‘. . . form of taxation that makes it difficult for
entrepreneurs to create value [goods and services]’.
The most important of these regulations ‘. . . are asso-
ciated with licensing new companies and businesses’
(Heritage Foundation, 2008, p. 12). It is expected that
the greater the degree of business freedom, the greater
the RPCY level.
Trade freedom, TF, is a reflection of the openness of
an economy to imports of goods and services from
other nations and the ability of citizens to interact
freely as buyers and sellers in the international/global
marketplace. The extent to which government hinders
the free flow of such commerce (through taxation of
imports and/or exports, bans, quotas and so forth) has
a direct impact on the ability of individuals to pursue
economic goals. Greater trade freedom promotes the
creation of wealth in the form of goods and services
and hence promotes higher RPCY levels (Heritage
Foundation, 2008, p. 13).
A free citizenry requires a steady and reliable cur-
rency as a medium of exchange and as a store of value.
Monetary freedom, MF, is reflected by a stable cur-
rency and market-determined prices. A high degree of
MF is typically characterized largely by an independent
central bank, policies supportive of low inflation and
the absence of price controls. Such conditions are com-
patible with citizens’ being able to rely on market prices
for the foreseeable future, as well as make savings,
investment and other long-term plans conducive to
higher RPCY levels (Heritage Foundation, 2008, p. 14).
Restrictions on foreign investment tend to limit
capital inflows and outflows and interfere with the
ability for capital to flow to its best and most efficient
use. Governmental actions that redirect capital flows
interfere with both the freedom of investors and peo-
ple and firms seeking that capital (Heritage
Foundation, 2008, p. 14). Investment freedom, IF, is
greater in a nation with fewer restrictions on invest-
ment; hence, it is hypothesized that greater investment
freedom promotes higher per capita real income levels.
 370
Financial Freedom (FINF) is associated with the
fact that essentially all nations impose some form of
supervision of banking institutions and the providers
of other financial services (Heritage Foundation,
2008, p. 14). In theory, such a supervision is intended
in principle to promote safety and soundness of the
financial system and to ensure that the financial ser-
vice industry is in conformity with fiduciary responsi-
bilities. However, excessive banking and financial
regulation by government restricts competition, inter-
feres with firm efficiency and elevates the costs of
entrepreneurial activity. Arguably, within ‘. . . a free
banking environment, the marketplace should be the
primary source of protection through such institutions
as independent auditors and information services’
(Heritage Foundation, 2008, p. 14). Such an oversight
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is quite different from burdensome or intrusive govern-
ment regulation or actual government ownership of
banks or other financial firms; the latter interfere with
the market mechanism in the efficient provision of
financial services to the economy. Thus, it is hypothe-
sized that the greater the degree of financial freedom,
the greater the level of per capita real income.
Secure property rights provide citizens the confi-
dence to engage in entrepreneurial activities, including
commercial activities, saving, investing and long-term
planning. The ability to accumulate private property is
the primary motivation in a market economy, and the
rule of law to protect the property rights is critical to a
fully functioning, efficient free market economy. The
greater the degree to which property rights are secured
under the rule of law and its application, that is, the
greater the degree of Property Rights Freedom (PRF),
the greater the level of per capita real income (Heritage
Foundation, 2008, pp. 14–15).
Political corruption manifests itself in many forms,
including the more obvious behaviours such as brib-
ery, extortion, embezzlement, graft and nepotism, and
it enables certain public officials to outright steal or
otherwise profit illegitimately from public funds.
Political corruption creates economic distortions.
Certain forms of corruption also interfere directly
with free markets, that is, limit individual liberty, by
outlawing activities such as private transportation and
construction services. In general, corruption infects all
parts of an economy and interferes with market effi-
ciency. Thus, the greater an economy’s freedom from
corruption (CORRF), the greater that economy’s
RPCY level (Heritage Foundation, 2008, p. 15).
Finally, there is labour freedom (LF). The ability of
workers to work as much as they wish and whenever
they want, subject to employment availability, is a key
dimension of economic freedom. Similarly, the ability
of businesses to contract freely for labour and to dis-
charge workers when they are no longer needed is a
R. J. Cebula
key mechanism for increasing productivity and sus-
taining production. The core principle of any market
is mutual free and voluntary exchange. The greater the
degree of labour freedom in an economy, the more
efficient and productive that economy is and hence the
greater the level of its per capita real income (Heritage
Foundation, 2008, p. 15).
Paralleling, in principle, the related literature on
economic growth to date, it is hypothesized (ceteris
paribus) that per capita real income is expected to be
an increasing function of each of the economic free-
dom measures considered here. Technically, ‘It is clear
that the 10 economic freedoms interact,’ that is, are
overlapping, although the exact mechanisms for this
interaction are not easily identifiable (Heritage
Foundation, 2008, p. 15). To address this multicolli-
nearity issue, five of the economic freedom indices are
lagged (FF, IF, CORRF, GSF and BF). The result of
this lagging is the absence of even a single correlation
coefficient among the economic freedom variables
that exceeds 0.342.
Notably, the Heritage Foundation (2008, p. 15)
weights each economic freedom measure equally so
as to prevent bias towards any given freedom or pol-
icy. Each economic freedom is graded using a scale
ranging from 0 to100, with 100 being the maximum
freedom. The higher the numerical value of any one of
these economic freedom indices, the greater the degree
of that corresponding economic freedom. An index
score of 100 indicates an economic environment or a
set of public policies that is the most conducive to and
compatible with economic freedom.
III. Empirical Results
Based on the economic freedom-based model of inves-
tigating the determination of per capita real income
described above, the following equation is to be
estimated:
RPCYjt ¼ fðBFj  1; FINFjt; FFjt  1; CORRFjt  1;
IFt  1; LFt; MFt; GSFt  1;
TFt; PRFt; TRÞ ð2Þ
Data were obtained from the following sources: the
Heritage Foundation (2008), the International
Monetary Fund (2008) and the OECD (2008). The
model represented in Equation 2 is to be estimated
by PLS. The model was first estimated using the
Random-Effects model and then using the Fixed-
Effects model. Performing the Hausman test [phtest
(fixed, random)] generated a p-value = 0.0481, so
 Per capita real income and economic freedom 371
Table 1. PLS estimates According to this PLS estimate, a one unit rise in the
BF index raises per capita real GDP (RPCY) by $154.
Dependent variable:
RPCY A one unit rise in CORRF raises RPCY by $114,
(a) (b) (c) whereas a one unit rise in IF raises RPCY by $275.
The RPCY rises by $651 with a one unit increase in
Explanatory variables -130 978 -129 185 -118 556 MF, while rising $167 with a one unit increase in GSF.
Constant
BF 153.66** 148.65** 137.29***
Finally, a one unit rise in TF elevates RPCY by $406,
(2.46) (2.34) (2.65) whereas a one unit rise in PRF elevates RPCY by $326.
FINF -30.64 -29.07 – These findings imply that the strongest economic
(-0.48) (-0.45) impacts on RPCY appear to be exercised by MF, TF,
FF 141.40 138.17 – PRF and IF, respectively. Meanwhile, the estimated
(1.51) (1.49)
CORRF 114.37** 115.06** 112.82***
coefficients on FF, FINF and LF are all statistically
(2.48) (2.52) (3.62) insignificant; indeed, two of these (FINF and LF)
IF 274.78*** 275.68*** 226.52*** exhibit negative coefficients. Furthermore, the TR
(3.24) (3.25) (4.54) variable is not statistically significant.
LF -107.44 -108.21 – As a test of robustness, the model is re-estimated with
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(-1.14) (-1.15)
MF 651.03*** 658.31*** 621.35***
the TR variable omitted. These PLS results are provided
(4.25) (4.18) (5.42) in Column (b) of Table 1. Clearly, these results are nearly
GSF 167.37*** 168.48*** 179.83*** identical to those shown in Column (a), both in terms of
(3.21) (3.26) (3.25) statistical significance and economic significance.
TF 405.76*** 386.64*** 358.07*** Finally, for the interested reader, the model is estimated
(3.22) (3.14) (3.06)
PRF 326.08*** 327.18*** 318.64***
with not only the trend variable omitted but also statis-
(5.64) (5.82) (6.94) tically insignificant variables FF, FINF and LF omitted
TR -230.31 -97.74 – from the model. As shown in Column (c) of Table 1, all
(0.24) (-0.16) seven of the remaining economic freedom variable coef-
R2 0.68 0.67 0.67 ficients exhibit positive signs and are statistically signifi-
adjR2 0.63 0.64 0.64
F 14.25*** 26.28*** 30.32***
cant at the 1% level. These results reinforce the
conclusion that the level of per capita real GDP in
Notes: The values provided in parentheses are t-values. PLS, OECD nations is an increasing function of business free-
Panel Least Squares. dom, freedom from corruption, investment freedom,
** and ***Denote statistic significance at the 2.5% and 5% monetary freedom, government size freedom, trade free-
levels, respectively.
dom and property rights freedom. Thus, of the 10 eco-
nomic freedom measures developed by the Heritage
that the study adopted the Fixed-Effects model. The Foundation (2008), 7 appear to significantly influence
model is estimated in a linear form, adopting the the level of per capita real income, with MF, TF, PRF
White (1980) correction; the results are shown in and IF exercising the highest economic impacts.
Table 1.
Eight of the 10 estimated coefficients shown in
Column (a) of Table 1 exhibit the expected signs, References
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