Economic Freedom of the World, 2002.

• Author: Gwartney, James D.
• Position: Scholarly Resource

For several years, the Economic Freedom of the World (EFW) annual reports published by a network of public-policy institutes, including the Fraser Institute and the Cato Institute, have presented an economic freedom index for a large set of nations around the world. (1) This index is designed to measure the degree to which a nation's policies and institutions protect its citizens' economic freedom. In this article, we explain the basic methodology employed in constructing the index and summarize the study's findings.

What Is Economic Freedom?

Any attempt to quantify economic freedom must begin with a solid theoretical understanding of the concept. The EFW report holds the key ingredients of economic freedom to be personal choice, voluntary exchange, freedom to compete, and protection of person and property. Institutions and policies are consistent with economic freedom when they provide an infrastructure for voluntary exchange and protect individuals and their property from aggressors who seek to use violence, coercion, and fraud to seize things that do not belong to them. Legal and monetary arrangements are especially important: governments promote economic freedom when they provide a legal structure and a law-enforcement system that protect the property rights of owners and enforce contracts in an even-handed manner. They also enhance economic freedom when they facilitate access to sound money. In some cases, the government itself may provide a currency of stable value. In other instances, it may simply remove obstacles that retard the use of sound money that is provided by others, including private organizations and other governments.

However, economic freedom also requires governments to refrain from many activities. They must refrain from actions that interfere with personal choice, voluntary exchange, and the freedom to enter and compete in labor and product markets. Economic freedom is reduced when taxes, government expenditures, and regulations are substituted for personal choice, voluntary exchange, and market coordination. Restrictions that limit entry into occupations and business activities also retard economic freedom.

Measurement of Economic Freedom

Table 1 indicates the structure of the index used in Economic Freedom of the World: 2004 Annual Report (Gwartney and Lawson 2004). The index measures the degree of economic freedom present in five major areas: (1) size of government: expenditures, taxes, and enterprises; (2) legal structure and security of property rights; (3) access to sound money; (4) freedom to trade internationally; and (5) regulation of credit, labor, and business. Within the five major areas, twenty-one components are incorporated into the index, but many of those components are themselves made up of several subcomponents. Counting the various subcomponents, the EFW index utilizes thirty-eight distinct pieces of data. Each component and subcomponent is placed on a scale from 0 to 10 that reflects the distribution of the underlying data. The component ratings within each area are averaged to derive ratings for each of the five areas. In turn, the summary rating is the average of the five area ratings. The next few sections give brief explanations of the components incorporated into each of the five areas and their relationship to economic freedom.

Size of Government: Expenditures, Taxes, and Enterprises

The four components of this area indicate the extent to which countries rely on individual choice and markets rather than on the political process to allocate resources and goods and services. When government spending increases relative to spending by individuals, households, and businesses, government decision making is substituted for personal choice, and economic freedom is reduced. The first two components pertain to this issue. Government consumption as a share of total consumption (1A in the table 1 outline) and transfers and subsidies as a share of gross domestic product (GDP) (1B) are indicators of the size of government. When government consumption is a larger share of the total, political choice has been substituted for private choice. Similarly, when governments tax some people in order to make transfers to others, they reduce individuals' freedom to keep what they earn. Thus, the greater the share of transfers and subsidies in an economy, the less economic freedom there is.

The third component (1C) in this area measures the extent to which countries use private rather than government enterprises to produce goods and services. Government firms play by rules that differ from those to which private enterprises are subject. They do not depend on consumers for their revenue or on investors for risk capital, and they often operate in protected markets. Thus, economic freedom is reduced when government enterprises produce a larger share of total output.

The fourth component (1D) is based on the top marginal income tax rate (Di) and on the top marginal income and payroll tax rate and the income threshold (Dii) at which both apply. These two subcomponents are averaged to calculate 1D. High marginal tax rates that apply at relatively low income levels also indicate reliance on government. Such rates deny individuals the fruits of their labor. Thus, countries with high marginal tax rates are rated lower.

Taken together, these four components measure the degree of a country's reliance on personal choice and markets rather than on government budgets and political decision making. Therefore, countries with low levels of government spending as a share of total spending, with a smaller government enterprise sector, and with lower marginal tax rates earn the highest ratings in this area.

Legal Structure and Security of Property Rights

Protection of persons and their rightfully acquired property is a central element of both economic freedom and a civil society. Indeed, it is the most important function of government. Area 2 focuses on this issue. The key ingredients of a legal system consistent with economic freedom are rule of law, security of property rights, an independent judiciary, and an impartial court system.

Components that indicate how well the protective function of government is performed were assembled from two sources: the International Country Risk Guide and the Global Competitiveness Report (various years for both). The ratings from both are based on surveys. The correlation coefficient between the two sets of data for countries included in both sets was 0.748. This high correlation increases our confidence in the reliability of the country ratings in this area even when they are based solely on data from the International Country Risk Guide.

Security of property rights, protected by the rule of law, is essential to economic freedom. Freedom to exchange, for example, is meaningless if individuals do not have secure rights to property, including the fruits of their labor. Failure of a country's legal system to provide for the security of property rights, enforcement of contracts, and the mutually agreeable settlement of disputes will undermine the operation of a market-exchange system. If individuals and businesses lack confidence that contracts will be enforced and that the fruits of their productive efforts will be protected, their incentive to engage in productive activity will be eroded. Furthermore, poor performance in this area is sure to deter investment. Therefore, it is highly unlikely that countries with low ratings in this area will be able to achieve and sustain high rates of growth.

Access to Sound Money

Money oils the wheels of exchange. An absence of sound money undermines gains from trade. Inflation is a monetary phenomenon that arises when the supply of money outstrips the demand for it. In addition, when the rate of inflation increases, it also tends to become more volatile. High and volatile rates of inflation distort relative prices, alter the fundamental terms of long-term contracts, and make it virtually impossible for individuals and businesses to plan sensibly for the future. Sound money is essential to protect property rights and thus economic freedom. Inflation erodes the value of property held in monetary instruments. When governments use money creation to finance their expenditures, they are in effect expropriating citizens' property and violating their economic freedom.

The source of the sound money makes little difference. The important thing is that individuals have access to it. Thus, in addition to data on a country's inflation and its government's monetary policy, it is important to consider how difficult it is to use alternative, more stable currencies. If bankers can offer saving and checking...