Tag Archives: Shane Phillips

Does economic freedom matter among wealthy countries?

In response to my last post, alert Neighborhood Effects reader Shane Phillips writes:

Are there charts like these that just compare the nations in the top quintile? It’s good to know that economic freedom leads to these positive outcomes, but knowing the difference between the Central African Republic, for example, and the US doesn’t really tell me as much as the US vs other modern, developed countries would.

This is a great question and the answer is yes, there has been some attempt to examine these relationships in a sub-set of wealthier countries. One area in which this has been done is in the literature looking at the effect of government size on economic growth. Government size, remember, is just one aspect of economic freedom (in the EFW, the other components are “legal system and property rights,” “sound money,” “freedom to trade internationally,” and “regulation”).

Speaking broadly, most economists who have looked at this, tend to approach the question with the following theoretical relationship in mind:

government size and growth in theory

In other words, at low levels of government spending, additional spending may be able to increase growth by financing things like property protection and public goods. But at higher levels of government spending, marginal increases in government size detract from growth as taxes become more distortionary and as government becomes less effective.

Andreas Bergh and Magnus Henrekson have a very nice survey of this literature. The whole study is worth a read, but one of the more important findings is that while the relationship is fairly ambiguous when all countries are included, it is less-so when you look at the sub-sample of wealthy countries:

The literature on the relationship between the size of government and economic growth is full of seemingly contradictory findings. This conflict is largely explained by variations in definitions and the countries studied. An alternative approach—of limiting the focus to studies of the relationship in rich countries, measuring government size as total taxes or total expenditure relative to GDP and relying on panel data estimations with variation over time—reveals a more consistent picture. The most recent studies find a significant negative correlation: An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.

To me this suggests that the theoretical prediction may not be far from the mark. It’s interesting to note, by the way, that government size is generally negatively correlated with other aspects of economic freedom. So the freer, more-developed countries are often the ones with the largest public sectors. This helps explain why the relationship isn’t consistent across a larger sample: some of the countries with the smallest size governments are also those with the most regulation, the most barriers to trade, etc.

What about economic freedom more broadly defined? Has this been studied among the subset of relatively wealthy and relatively economically-free countries? I’m unaware of any formal studies, but as it turns out I’ve done some simple correlations myself. In the chart below, I graph economic freedom along with per capita GDP in OECD countries. The relationship is positive and statistically significant, though I’d caution that it is a small sample size and I have no control variables.

economic freedom and per capita GDP in OECDOne nice thing about focusing on the subset of OECD countries is that doing so allows me to examine the relationship between economic freedom and median income (which isn’t readily available for non-OECD countries). Per capita measures are problematic because they are sensitive to outliers. A handful of super-wealthy people in the U.S. or Luxembourg may give the false impression that everyone is wealthy. The median, however, doesn’t have this problem because it is unaffected by the levels at the extremes of the sample. Here the relationship is in terms of median income:

economic freedom and median income in oecdAs before, the same caveat applies: This is statistically significant; but it is a small sample and I have no control variables.