Impacts of Economic Freedom on Economic Growth in Developing Countries45313

Investment freedom and property rights show negative effects on economic growth while monetary freedom and financial freedom have statistically insignificant effects.. This finding sugge

Impacts of Economic Freedom on Economic Growth

in Developing Countries

Dao Thi Bich Thuy (1)*

1 VNU University of Economics and Business, Vietnam National University, Hanoi, Vietnam

(*) Correspondence: thuydaokt@vnu.edu.vn

Abstract: The purpose of this study is to investigate the impact of economic freedom on economic growth The study is conducted with 65 developing countries worldwide in the period from 1995 to

2014 The Index of Economic Freedom published by the Heritage Foundation is employed at both overall level and dimensional level comprises of nine sub-indices The finding reveals that economic freedom is a growth stimulus factor as a higher degree of economic freedom results in a faster economic growth At the dimensional level, seven out of nine economic freedom sub-indices show statistically effects on economic growth, of which 5 have positive and 2 have negative growth effects Business freedom, government integrity, trade freedom, tax burden and government spending are among the positive growth effect factors Investment freedom and property rights show negative effects on economic growth while monetary freedom and financial freedom have statistically insignificant effects This finding suggests developing countries would experience higher economic growth when there is improvement in business freedom, higher government integrity and trade freedom, less tax burden and lower size of government spending, less freedom in investment outflows and weak property rights

Keywords: Economic growth; economic freedom index; developing countries

1 Introduction

Economic growth has always been at the heart of economic policy discussions, especially for developing countries, as a higher growth performance results in greater national output, potentially higher living standards for people and an enhanced ability to attain various economic and social objectives Among the many determinants of economic growth, interest is focused on economic freedom As Friedman, foreword in Gwartney et al (1996), views “free societies have arisen and persisted only because economic freedom is so much more productive economically than other methods of controlling economic activity” Conceptually, economic freedom refers to the level of freedom that individuals, entrepreneurs and businesses have to use their time and money in the way that they feel is best for them and free from unnecessary government restrictions and predation Economic freedom is believed to foster economic growth by affecting incentives, productive effort and the effectiveness of resource use (Erdal 2004)

There are various efforts to quantify economic freedom and among them the two most popular indexes are the Fraser Institute’s Economic Freedom Index and the Index of Economic Freedom produced by the Heritage Foundation The Fraser Institute defines

economic freedom as composed of personal choice, voluntary exchange, freedom to compete and protection of person and property The Fraser Institute’s Economic Freedom Index is established under five main dimensions which are size of government, legal structure and security of property rights, access to sound money, freedom to trade internationally and regulation of credit, labor, and business The Heritage Foundation defines economic freedom as “the absence of government coercion or constraint on the production, distribution or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself” In other words, people are free to work, produce, consume and invest in the ways they feel are most productive The Heritage Foundation Index of Economic Freedom is constructed based on the four pillars with 12 categories including rule of law (property rights, judicial effectiveness and government integrity), government size (tax burden, government spending and fiscal health), regulatory efficiency (business freedom, labor freedom and monetary freedom) and market openness (trade freedom, investment freedom and financial freedom)

The relation between economic freedom and economic growth has received a great attention in literature At the overall level of economic freedom, a positive relation between economic freedom and economic growth is found in many researches (Wu and Davis 1999; Gwartney et al 1999; De Haan and Sturm 2000; Hanson 2000; Heckelman 2000; Vega and Alvarez 2003; Razmi and Refaei 2013; Akin et at 2014; Gorlach and Roux 2015; Mehnatfar

et al 2015; Nadeem et al 2019)

At the disaggregated level of economic freedom, the outcome shows rather conflicting results Based on the Fraser Institute’s freedom index, Carlson and Lundström (2002) studied 74 countries for the period 1975-1995 and found a positive effect on economic growth of only legal structure and freedom to use alternative currencies while smaller government, in terms of consumption, transfers, and taxes, is harmful to economic growth Justesen (2008) found that a small size of government and less regulation of business are factors enhancing economic growth

Using 17 Middle East and East Asian countries’ data during 2000-2009, Razmi and Refaei (2013) showed that legal structure and security of property rights, freedom to trade internationally, regulation of labor, credit and business are positively related to economic growth, however, government size and access to sound money show a negative growth effect

The study by Akin et at (2014) for 94 different countries grouping into five different income groups to cover the period from 2000 to 2010 revealed that the size of government

is found to have a positive and statistically significant impact in upper-middle and lower-middle income groups while it is not significant in high and low income groups Legal system and property rights have a positive impact for all income groups Sound money is positively related to economic growth only in high income OECD and in lower-middle income groups Trade freedom has a negative effect in high income group but a positive effect in low income group And only in high income OECD and low income groups, there

is a positive and significant relation between regulation freedom and economic growth

Gorlach and Roux (2015) investigated the relationship between economic freedom and economic growth for 13 SADC countries from 2000 to 2009 and concluded that all five components which are size of government, legal structure and security of property rights, access to sound money, freedom to trade internationally, regulation of labor, credit and business are highly significant and positively related to economic growth but yet the magnitude of the coefficients varies

Nadeem et al (2019) analyzed the relationship between economic freedom index and GDP per capita growth of 5 South Asian countries over the period of 1990-2015 The study found a positive relation between GDP per capita growth and economic freedom However, while size of government, property rights protection, trade freedom and regulations positively affect economic growth, monetary freedom shows a negative effect

Using the Heritage Foundation’s freedom index, in his study for OECD nations in the 2003- 2007 period, Cebula (2011) found a positive relation between the growth rate of per capita real GDP and six forms of economic freedom which are fiscal freedom, business freedom, monetary freedom, property rights freedom, labor freedom and investment freedom The research by Hussain and Haque (2016) for 186 countries over the period

2013-2015 revealed that trade freedom, financial freedom, business freedom, labor freedom and fiscal freedom all have a positive impact on economic growth

The relationship between economic freedom and economic growth still deserves much of interest Our study focuses on this relationship in developing countries We seek to answer two main questions of whether economic freedom is growth stimulus factor and how each dimension of economic freedom affects economic growth in developing countries Answering to the second question is more of interest, for it would suggest appropriate policies that governments in developing countries can take in order to foster economic growth

2 Methodology

The theoretical framework of the study is set in the context of Solow growth model The economy’s production function takes the Cobb-Douglas form where total output depends on stocks of physical capital and labor







t t EF

where Y is total output, K is stock of physical capital and L is labor α and β are the factor intensity The degree of economic freedom EF is incorporated into the production function as a size effect The sign of θ reveals the relation between economic freedom and total output When θ takes a positive (negative) value, economic freedom shows a positive (negative) effect on total output In the case of θ equal to zero, economic freedom has no

effect on total output

Take the natural logarithm both sides of the production function, we can derive the growth equation as follow

LnYt   LnKt   LnLt   EFt (2)

The equation shows how growth in total output is determined by growth in stocks

of physical capital and labor and the change in the degree of economic freedom In particular, 1% increase in the stock of physical capital and 1% increase in the stock of labor

results in α% and β% increase in total output respectively Beside, 1 unit change in the degree

of economic freedom results in θ% change in total output

The empirical study is conducted with 65 developing countries worldwide in the period from 1995 to 2014 to investigate the impact of economic freedom on economic growth Index of Economic Freedom published by the Heritage Foundation is used to measure economic freedom The study aims to examine the growth effect of economic freedom at both overall and individual component level Due to the availability of data, 9 out of 12 dimensions of economic freedom index are considered including property rights (PRR), government integrity (GIN), tax burden (TAB), government spending (GSP), business freedom (BUF), monetary freedom (MOF), trade freedom (TRF), investment freedom (INF) and financial freedom (FIF) The regression equations for the 2 models are written as:

Model 1

t t t

t

LNGDP,   1 ,  2 ,  3 ,  , (3) Model 2

t t

t t

t t

LNGDP,   1 ,  2 ,  3 ,  4 ,  5 ,  4 ,

t t t

t t

where subscript i denotes country and t denotes time in year

The independent variable LNGDP is natural logarithm of GDP For the explanatory variables, LNK is natural logarithm of stock of physical capital, LNL is natural logarithm of stock of labor and EFI is economic freedom index Model 1 studies the effect of overall

economic freedom on economic growth whereas Model 2 investigates the growth effect of each dimension of economic freedom

Data for GDP, physical capital stock and labor are taken from the Penn World Table (Feenstra et al 2015) To adjust for the effect of inflation, GDP and physical capital stock are measured at a constant price level (in 2011 USD) The stock of labor is measured by the number of employed people Data for EFI and its 9 sub-indices are taken from the Index of Economic Freedom published by The Heritage Foundation The EFI has scores ranging from

0 to 100 with a higher score indicates a higher degree of economic freedom Similarly, the

score for each sub-index ranges from 0 to 100 The raise in the score value for each sub-index means the increase in economic freedom that it nominates

Data for all countries is collected in the same period of time that provides a strongly balanced panel data Panel data analysis requires controlling for time invariant and unobserved factors affecting the independent variables Since each country is specific on its own then the unobserved factors are referred to as country heterogeneity Regression analysis on panel data is conducted with STATA statistical software program Various diagnostics tests are conducted which show there are problems of cross-sectional dependence, serial correlations and heteroskedasticity With the presence of these problems

in data, Torres-Reyna 2007 suggests to use the generalized least square method

3 Results

The regression results are presented in Table 1

Table 1 Impact of economic freedom on economic growth in developing countries

Dependent variable: LNGDP: Natural logarithm of GDP

Explanatory variables Model 1 Model 2

Coefficient P - value Coefficient P - value

LNK: Natural logarithm stock of capital 0.677 0.000 0.674 0.000

LNL: Natural logarithm stock of labor 0.318 0.000 0.315 0.000

EFI: Overall economic freedom index 0.043 0.000 0.000

PRR: Property Right -0.024 0.004

GIN: Government Integrity 0.031 0.001

GSP: Government Spending 0.017 0.010

BUF: Business Freedom 0.050 0.000

MOF: Monetary Freedom 0.009 0.293

INF: Investment Freedom -0.024 0.001

FIF: Financial Freedom -0.011 0.120 CONSTANT 2.199 0.000 1.855 0.000

Source: The author’s own calculations (see Appendix)

As can be seen from the result table of Model 1, overall economic freedom index has

a statistically positive effect on the growth of GDP, that is, economic freedom promotes economic growth A higher degree of economic freedom in terms of better rule of law, lower government size, more regulatory efficiency and larger degree of market openness would results in a faster economic growth In order to gain a better understanding of how economic freedom affect economic growth, Model 2 reveals the outcome At the dimensional level, 7 out of 9 sub-indices of economic freedom show statistical effects on economic growth, of which 5 have positive and 2 have negative growth effects

Among the growth stimulus factor, business freedom has the strongest impact Business freedom reflects the extent to which the regulatory and infrastructure environments constrain the efficient operation of businesses Many regulations hinder business productivity and profitability and likely distort competition Burdensome and redundant regulations are the most common barriers to the free conduct of entrepreneurial activity Increase in business freedom by reducing burdensome barriers to conducting business including regulatory red tape and high transaction costs will decrease the cost of production to business firms that leads to an increase in aggregate supply and finally a higher total output

Government integrity has the second largest positive effect on economic growth Corruption erodes economic freedom by introducing insecurity and coercion into economic relations Systemic corruption of government institutions and decision-making is found with various practices such as bribery, extortion, nepotism, cronyism, patronage, embezzlement, and graft Improvement in government integrity with more transparency in government policymaking and governmental and civil service would increase public trust and economic vitality by reducing the transaction costs of economic activity and promoting fair competition Higher government integrity encourages economic activity and fosters economic growth

Next is the growth effect of tax burden In the Index of Economic Freedom, a higher score for tax burden sub-index means less tax burden imposed on economic activity With

a positive coefficient for tax burden variable, this suggests the lower the tax burden, the higher the economic growth Government taxes are imposed at individuals as well as business firms Lower tax burden increase the reward for individuals and businesses for their economic activity For individuals, lower income tax results in a higher personal income after tax that provides more incentive to undertake work Beside, higher income after tax induces people to consume more that stimulates aggregate demand and thus higher total output produced At the business firms, lower tax rates raise returns to business operation and increase firms’ incentives to pursue their goals in the marketplace and therefore increase the level of overall private-sector activity

Come fourth is trade freedom In many countries, government place restrictions on trade in the various form of tariffs, export taxes, trade quotas, outright trade bans or in the form of regulatory barriers related to health or safety Trade freedom allows the free flow of foreign commerce, direct production incentives for local producers to the goods in which they have a comparative advantage and enjoy the benefit of economies of scale from mass production Trade freedom also put advanced-technology products and services to the reach of local entrepreneurs and expand their own productive development This raises overall economic efficiency and economic growth

Finally, the size of government spending affects economic growth in different channels In a positive channel, government spending provides infrastructure, fund research for technology improvement, or human capital investment which increases productivity and thus faster economic growth In a negative channel, excessive government

spending crowds out private economic activity Government spending which is financed by taxes and borrowing will distort the market allocation of resources and decrease private investment incentives Even worse, the growth of public sector may lead to bureaucracy, lower productivity, inefficiency, and mounting public debt that hinders economic growth The effect of government spending on economic growth depends very much on which channel will dominate the other In the Index of Economic Freedom, a higher score for government spending sub-index means a lower size of government spending A positive coefficient for government spending variable reveals that lower size of government spending leads to higher economic growth When the burden of government spending is less private sector has more chance to develop as more economic resources are allocated to this sector and since private sector is more efficient than public sector, this would contribute positively to economic growth

The two economic freedom sub-indices including investment freedom and property rights are found to have negative effects on economic growth Firstly, a higher degree of investment freedom impedes economic growth This is not a surprise finding Investment freedom measures the free flows of capital across the borders, both inflows of international capital and outflows of domestic capital in the search for higher rates of return In the developing countries, economic growth relies very much on capital accumulation As shown in the result table, 1 percent increase in capital stock leads to 0.67 percent increase in GDP, more than double compared to that of labor of 0.31 In many countries, governments while encourage the inflows of foreign capital often place restrictions on the movement of domestic capital to limit the outflows of capital Therefore, a lower degree of investment freedom in terms of higher restrictions on capital outflows can increase the stock of domestic capital in the countries and help to faster economic growth

Property rights unexpectedly show a negative growth effect Property rights refer to the extent to which a country’s legal framework allows individuals to acquire, hold, and utilize private property, secured by clear laws that can be enforced effectively Secure property rights give citizens the confidence to undertake economic activity and make long-term plans because they know that their property are safe from unfair expropriation or theft One possible explanation for the negative growth effect of property rights in the developing countries would be that in many developing countries, private property rights, especially intellectual property rights are often violated Lack of or inadequate legal framework to protect intellectual property rights for foreign technology or new ideas would facilitate local businesses to expropriate advanced technology or new ideas that help to increase the production of goods and thus higher economic growth

4 Conclusions

Achievement of high and sustainable economic growth is considered a major objective for developing countries to increase their people’s living standards and in the hope

to close the income gap with developed countries The empirical study on growth effect of economic freedom for 65 developing countries worldwide in the 1995-2014 period provides

a robust evidence to support the idea that economic freedom indeed plays an important role

in stimulating economic growth Several policy implications can be withdrawn from the study’s finding Developing countries would experience higher economic growth if governments are ready to improve the level of economic freedom To do it, government should facilitate the development of private sector which seems to be more effective than public sector by creating a conducive business environment Efforts needed to lessen excessive business regulations, reduce burdensome barriers to conducting business and raise the degree of market friendliness for investors Government should improve government integrity as it helps to raise transparency, lower transaction costs of economic activity, increase public trust and confidence and promote fair competition Besides, there

is the need to lessen tax burden on business firms and provide more room for private sector

to grow via reducing the size of government spending For this, government should be ready to narrow its share in the nation’s economic activity Encouraging the inflow of foreign investment together with restrictions in the outflow of capital seems to be an effective policy as developing countries rely very much on capital contribution to economic growth Finally, while property rights show to have a negative effect on economic growth, government in developing countries must still pay attention to improve property rights because in the long run economic growth cannot be sustainable if property rights are seriously violated

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Appendix

Model 1

Model 2

_cons 2.199405 .1182935 18.59 0.000 1.967554 2.431256 efi 0432437 .0113521 3.81 0.000 020994 .0654934 lnl 3188659 .0118577 26.89 0.000 2956252 .3421066 lnk 6774394 .0119651 56.62 0.000 6539882 .7008905 lngdp Coef Std Err z P>|z| [95% Conf Interval] Prob > chi2 = 0.0000 Wald chi2(3) = 38718.47 max = 20 avg = 19.43077 Estimated coefficients = 4 Obs per group: min = 16 Estimated autocorrelations = 0 Number of groups = 65 Estimated covariances = 1 Number of obs = 1263 Correlation: no autocorrelation

Panels: homoskedastic

Coefficients: generalized least squares

Cross-sectional time-series FGLS regression

_cons 1.85563 .1440753 12.88 0.000 1.573247 2.138012 fif -.0114806 .0073906 -1.55 0.120 -.025966 .0030048 inf -.024131 .0070603 -3.42 0.001 -.0379689 -.0102931 trf 0191851 .0064908 2.96 0.003 0064634 .0319069 mof 0098186 .0093347 1.05 0.293 -.008477 .0281143 buf 0501158 .0093357 5.37 0.000 0318182 .0684134 gsp 0169165 .006555 2.58 0.010 0040689 029764 tab 0247616 .0092481 2.68 0.007 0066357 .0428875 goi 0312328 .0096825 3.23 0.001 0122555 .0502102 prr -.0239522 .0082739 -2.89 0.004 -.0401688 -.0077357 lnl 3156273 .0131435 24.01 0.000 2898665 .3413882 lnk 6742133 .0127111 53.04 0.000 .6493 .6991266 lngdp Coef Std Err z P>|z| [95% Conf Interval] Prob > chi2 = 0.0000 Wald chi2(11) = 41041.83 max = 20 avg = 18.84615 Estimated coefficients = 12 Obs per group: min = 12 Estimated autocorrelations = 0 Number of groups = 65 Estimated covariances = 1 Number of obs = 1225 Correlation: no autocorrelation

Panels: homoskedastic

Coefficients: generalized least squares

Cross-sectional time-series FGLS regression