Determining economic freedom: democracy, political competition, and the wealth preservation struggle.

Author:Lipford, Jody W.
  1. Introduction

    The benefits of economic freedom are well-known and widely documented. In general, economic freedom has been shown to be associated with higher living standards, more rapid economic growth, longer life expectancy, and improved environmental quality (Clark and Lee 2006; Clark and Pearson 2007; Hanke and Walters 1997; Campbell and Rogers 2007). Not surprisingly, economic freedom is positively correlated with net migration, as people--both foreign and domestic--seek out economic opportunity (Ashby 2007; Watkins and Yandle 2009; Cebula and Clark 2011). (1)

    Although less attention has been paid to the determinants of economic freedom, the relevant research indicates multiple factors are at play. Some researchers, such as Spindler and Vanssay (2002) and La Porta et al. (1999), trace the origins of economic freedom to the constitutional level, where political constraints and common law traditions result in market-oriented policies that enhance wealth creation. Other researchers take the constitutional framework as given and examine the interworkings and responsiveness of the political system. Crampton (2002), for example, finds that voters who want more economic freedom are rewarded with it.

    Probing deeper into the determinants of wealth-enhancing governments, Knack (2002) finds that social capital and social trust contribute to better government management across the US states, while Bjornskov (2010) finds complementary results using international data.

    Yet, just as social cohesion enhances the institutions and policies that promote good government and economic freedom, factors that rend the social fabric undermine them. La Porta et al. (1999) focus on linguistic differences and find that ethnolinguistic fractionalization results in more government intervention, less efficient government, and lower levels of public goods provision, findings that square nicely with those of Easterly (2001). In addition, Heller (2009) finds that ethnic fractionalization impedes the economic reforms that would improve economic freedom. However, Knack's (2002) evidence on race in the United States seems at odds with these findings in that greater heterogeneity is associated with better quality government.

    Knack (2002) and Heller (2009) also explore the role of income inequality and find that greater income inequality is associated with lower quality government in the US states and with weaker institutions across countries, respectively.

    When researchers examine government expenditures instead of institutions, the evidence takes an interesting twist. La Porta et al. (1999) find that ethnolinguistic fractionalization is associated with smaller government, and Lindqvist and Ostling (2010) find similar results for strong democracies that are politically fractured.

    In this paper, we extend the analysis of economic freedom, following a simple but heretofore unexplored line of reasoning: in competitive, democratic, political settings, where citizens influence political outcomes through voting and interest groups, and where the cost of resource migration among competing states is low, those citizens who gain wealth (income) from economic freedom and pay to finance government will use their political influence to see that the level of economic freedom is high. In particular, we find that US states with relatively high levels of employment and broad-based tax systems have higher levels of economic freedom.

    Our paper proceeds as follows. The next section develops the theory underlying our empirical model. We then briefly discuss the Fraser Institute's measure of economic freedom for subnational governments before presenting and discussing empirical results. We offer comments on the policy implications of our analysis and some closing thoughts in the conclusion.

  2. Theory

    Our theory of the determinants of economic freedom applies to a federal system of independent states operating with separate elected governments and separate constitutions. The states form a republic with a common language and a homogeneous set of federally guaranteed rights and privileges. We are modeling the case of the United States. But our model could apply to France, Germany, or any other republic made up of separately governed states, departments, or lands where all citizens speak a common language, operate under a common legal system, and can exit and enter different states at low cost.

    Citizens located in any independent state can seek to influence political outcomes by making legislative appeals. Where voice is relatively ineffective, citizens can exercise the exit option (Hirschmann 1970). Any citizens--private or corporate--can exit their current state domicile and enter another state at low cost. Just the threat of exit exerts a disciplining effect on elected officials who seek to sustain wealth-creating enterprises in their home states. As Tiebout (1956) has taught us, the ability to vote with feet across a federal system generates a competitive equilibrium where states are more responsive to citizens' desires than would be the case for a collection of independent states where exit costs are high.

    Our theoretical analysis focuses on political action in a particular state and begins with a legislative commons, the political space provided by a constitution for legislator interaction in providing public goods, regulation, and redistribution to citizens and special interest groups. The theory of the legislative commons, well established in the literature, emphasizes a lack of constraints that ration entry and action across legislative members who seek to serve their constituencies and, when successful in doing so, keep their jobs (Alesina et al. 1999; Brubaker 1997; Buchanan and Wagner 1977). While there may be a balanced budget constraint, any given state can still borrow and spend. Legislators, when stymied, can produce bundles of regulation to accomplish goals if fiscal constraints become binding.

    Across the collection of states that form the nation, not all voters and interest groups are equal in the eyes of legislators, governors, and political party leaders. As Bueno de Mesquita and Smith (2011) point out, people who gain and hold political power worry less about the "interchangeables," the unorganized, rank and file voters, but worry a lot about the "influentials," who can sway public opinion. They never stop worrying about the "essentials," the members of the winning coalition that are critical to gaining office in the first place and then critical to preserving political power. In dictatorships, the ratio of essentials to interchangeables can be quite small, but not in democracies. In other words, the competitively elected politician in a given state democracy must satisfy essentials, which may be a large number, but must also serve and satisfy the broad electorate. When essentials cease to be satisfied, they can threaten to exit and relocate to another state. In making this calculation, the essentials and influentials face an understandable trade-off; they may not be so essential in another state setting. In other words, those considering the exit option face an opportunity cost when taking action.

    In our model, legislators in a particular state working the commons are motivated to make good on specific promises that were made to the essentials while also producing enough benefits to keep the interchangeables at rest. In the process, essentials are highly informed about what is going on and whether promises are kept. This is not necessarily so for the community of interchangeable voters; some are rationally ignorant, while others go beyond being rationally ignorant. They, as Caplan (2007) has explained, become irrational when expressing political preferences on economic policy. The expressive ones take popularly acceptable anti-market positions that have little bearing on special interest struggles that determine outcomes (Brennan and Lomasky 1993). Meanwhile, another part of the interchangeable community simply remains rationally ignorant and nonexpressive. But, of course, there is no such thing as a free grant, regulation, or transfer. As John C. Calhoun (1848) put it, there are taxpayers and tax spenders. Any benefit provided to the essentials will be paid for partly by them, since they are taxpayers and participants in the commonwealth, but paid for primarily by each taxpayer in the larger interchangeable community.

    But the interchangeables want government action also...

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