Subnational economic freedom and performance in the United States and Canada.

Author:Bennett, Daniel L.
Position:Critical essay
 
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During his illustrious career spanning more than half a century, Richard Vedder has tirelessly advocated for limited government and free enterprise. Much of his scholarship has focused on examining how fiscal and labor market policies consistent with the principles of economic freedom are associated with economic and social benefits such as stronger economic performance (Vedder 1981, 1990), lower unemployment (Vedder and Gallaway 1996, 1997), and poverty alleviation (Vedder and Gallaway 2002). Vedder has also examined the impact of government policy on income inequality (Vedder 2006; Vedder and Gallaway 1986, 1999; Vedder, Gallaway, and Sollars 1988), an area that he and I have collaborated to study (Bennett and Vedder 2013, 2015). Thus, Vedder's scholarship has contributed to our understanding of the impact that economic freedom exerts on economic outcomes.

Vedder's research has primarily examined the effects of individual policies such as the structure of taxation and barriers in the labor market, but a mounting body of academic research links aggregate measures of economic freedom to a variety of positive economic, political, and social outcomes. Hall and Lawson (2014) and Hall, Stansel, and Tarabar (2016) provide recent surveys of this literature. This article builds on my previous work with Vedder and contributes to the growing body of research on the effects of economic freedom by examining the relationship between subnational economic freedom and various measures of economic performance for a panel of U.S. states and Canadian provinces over the period 1980-2010.

Existing theory and empirical evidence suggest that economic freedom is positively associated with economic development and labor market outcomes, which the evidence presented here further corroborates, but the relationship between economic freedom and inequality is not well understood. It is important to examine how economic freedom affects inequality because income inequality has been heralded as the "defining challenge of our time" by influential public figures and economists. Free-market capitalism is often blamed for rising inequality, and the prescribed solution is typically freedom-reducing government interventions. Pope Francis (2013: 48), for instance, describes market capitalism as a system of exclusion and inequality that is "unjust at its roots." Paul Krugman (2013) points to U.S. financial deregulation and entitlement reform as factors in driving higher U.S. income disparities. President Barack Obama has repeatedly expressed a desire to raise the federal minimum wage and increase the progressivity of the income tax structure as means to stem the tide of rising inequality. Thomas Piketty (2014: 1) argues that without corrective political intervention, capitalist economies inevitably produce rates of return on capital that exceed the growth rates of income and output, a process that "automatically generates arbitrary and unsustainable inequalities."

While free-market capitalism is heralded as the villainous perpetrator of inequality, existing theory and evidence on the relationship between economic freedom and inequality is largely inconclusive (Bennett and Nikolaev 2015b). By necessity, institutional and policy reforms intended to reduce inequality through government intervention reduce economic freedom, potentially undermining the other positive effects associated with economic freedom such as economic development and improved employment opportunities, both of which enhance economic well-being. The results presented here suggest that subnational economic freedom is associated with higher levels of income per capita, lower rates of unemployment, and higher income inequality across subnational economies in the United States and Canada.

Methodology and Data

This article utilizes panel data from the 50 U.S. states and 10 Canadian provinces over the period 1980-2010 to estimate (lie partial effects of subnational economic freedom on measures of macroeconomic performance, including income per capita, the unemployment rate, and relative income inequality. It does so using the fixed effects specifications given by equation (1):

(1) [PERFORM.sub.rt] = [[alpha].sub.0] + [[alpha].sub.1] [EF.sub.rt] + [X.sub.r,t] [beta]' + [[delta].sub.r] + [[epsilon].sub.r,t],

where [PERFORM.sub.rt], [X.sub.rt] and [[delta].sub.r] represent economic performance, economic freedom, a vector of control variables, and a time-invariant state/province unobserved effect, respectively, for state/province r in period t. (1) It is the first study on subnational economic freedom and economic performance that I am aware of that pools subnational data for these two North American countries. Because it does so, the number of variables available to control for is limited because of data availability and comparability.

Economic Freedom Data

Subnational economic freedom measures for the U.S. states and Canadian provinces are from the Fraser Institute's Economic Freedom of North America (EFNA) annual report (Stansel and McMahon 2013). The EFNA composite index is comprised of three area indices: size of government (EFNA1); distortionary taxation and takings (EFNA2); and labor market freedom (EFNA3). (2) The data are available annually over the period 1980-2010. The data used in this study reflect a five-year average within two years of each period ending in zero and five to minimize short-run fluctuations associated with business cycles. Although the EFNA provides both all-government and subnational government measures, this article utilizes the all-government EFNA data only because it is assumed that incentives created or destroyed by policy interventions are invariant to the level of government instituting policy.

Economic Performance Data

Three measures of economic performance are utilized in this study. First, gross income Gini coefficients are used as the measure of relative income inequality. The Gini coefficient was chosen primarily because of data availability but also because it is widely used in empirical studies. The Gini coefficient is a measure of relative inequality that ranges from 0 (perfect equality) to 1 (perfect inequality). The Gini coefficient data for the United States come from Galbraith and Hale (2008), who estimate family gross income inequality measures annually using between-industry pay inequality data for each state over the period 1978-2004. (3) Although the data are available annually, quinquennial data are utilized in this article. Each quinquennial observation reflects the five-year (+/-2 years of periods ending in 0 and 5) Gini value over the period 1980-2005. (4) These data are supplemented with the five-year average gross household income Gini values over the period 2008-12 to extend the panel to 2010. The latter data are from the American Community Survey five-year estimates. (5)

Gross family income Gini measures for the Canadian provinces are from the Income Statistics Division of Statistics Canada and are available annually over the period 1980-2011. As with the U.S. measures, a five-year average for the period +/- 2 years of each quinquennial period are used. The resulting panel of data includes quinquennial measures for each of die 50 U.S. states and 10 Canadian provinces spanning the period 1980-2010 and are referred to in the results as GINI.

Next is the natural log of real income per capita, in constant 2011 U.S. dollars (LRGDPL). Nominal state-level GDP data and population data for the United States are from the Census Bureau. Canadian province-level nominal income and population data are from Statistics Canada. (6) Third is the unemployment rate, or the number of unemployed persons as a share of the total labor force (UNEMPLOY). These data are from Statistics Canada and the Statistical Abstract of the United States.

Data for Control Variables

Because this article pools subnational data for the United States and Canada, the selection of control variables is limited by data that is relatively comparable across die two countries. Several variables are controlled for that potentially influence economic performance, including the adult four-year college attainment rate (COLLEGE), the share of the labor force employed in the manufacturing sector (MEG), the dependency ratio (DEP2LAB), the female share of the population (FEMALE), and the natural log of population density (LPOPDEN). (7) The source for the Canadian data is Statistics Canada. Wifli the exception of the MFG data, which is from the Bureau of Economic Analysis, all of the state-level data are from the U.S. Census Bureau. Table 1 provides summary statistics for all of the variables used.

Economic Freedom and Income Per Capita

Institutions and policies consistent with economic freedom promote competition, incentivize investment, and encourage entrepreneurism, providing an efficient economic environment for growth and prosperity. Although much of the empirical literature has focused on the positive relationship between economic freedom and economic growth (De Haan, Lundstrom, and Sturm 2006; Doucouliagos...

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