The impact of economic inequality on economic freedom.

• Author: Murphy, Ryan H.

Contemporary economic policy debates are dominated by concerns regarding the rise in inequality (Stiglitz 2012, Piketty 2014). Primarily, this has led to a focus in re-invigorating redistribution. For instance, Robert Shiller (2014) has recently argued for indexing top marginal tax rates to inequality and using the revenues to fund transfer payments. Secondarily, there are the longstanding objections to "neoliberalism in general, which has encouraged globalization and the liberalization of markets. To the extent that liberal reforms have improved economic institutions, might today s inequality subsequently derail them?

It is often difficult to find firm evidence finking negative outcomes to inequality (Deaton 2003, Porter 2014). However, some economists have argued that inequality may harm the quality of institutions. For example, Acemoglu et al. (2013) have argued drat concentrations of wealth may subvert democracy. This argument is also present in political science (Bartels 2008), and Easterly (2001) has made similar points. Such arguments offer a more rigorous conception of the popular notion of inequality subverting politics, a concern that is especially salient following Citizens United v. Federal Election Commission, and more recently, McCutcheon v. Federal Election Commission. Acemoglu has made this point explicitly regarding Citizens United, saying, "Instead of trying to stem that tide, we've done the opposite and we've now opened the sluice gate and said you can use that money with no restrictions whatsoever" (Garofalo 2012). Generally, the debate has centered on the notion that inequality will weaken institutions by swinging policies toward favoring the economic interests of the rich.

The approach here will differ, looking at the effect of inequality on free economic institutions. The measure used will be the Economic Freedom of the World (EFW) index, published by the Fraser Institute (Gwartney, Lawson, and Hall 2013). The index runs from 0 to 10 using five components of economic freedom, with higher index values corresponding to greater economic freedom. This index has been used in a variety of academic journals to investigate a broad range of issues (Hall and Lawson 2014). Numerous studies using this index have investigated whether economic freedom worsens inequality (Berggren 1999, Scully 2002, Carter 2007, Clark and Lawson 2008), finding mixed results, but not whether inequality may worsen economic freedom. Also relatedly, recent research by Young and Lawson (2014) finds that economic freedom is associated with a higher share of labor income.

Using a similar index for the United States, Apergis, Dincer, and Payne (2014) argue that there is a bidirectional relationship between inequality and economic freedom, with the possibility that policies that are meant to reduce inequality will reduce economic freedom, which will then only make inequality worse. Bennett and Vedder (2013) investigate the relationship between the two variables, also using U.S. data, and find similar results. In this article, I do not seek to identify bidirectional effects; rather, I wish to investigate the long-run effects of inequality on economic freedom in an international context.

This article also fits with the growing literature that uses the EFW index as the dependent variable. While the index has been used a large number of times as an independent variable, far less work has gone into explaining economic freedom. Recent scholarly work has examined the impact of foreign aid (Bearce and Tirone 2010), personal characteristics of politicians (Dreher et al. 2009), and culture (Jing and Graham 2008) on economic freedom as measured by the EFW index. Inequality too may play a role in determining economic freedom.

The primary method this article employs is to control for economic freedom at the beginning period, in effect differencing the data, and then determine the impact of the Gini coefficient, (1) a common measure of income inequality, in the first period on the EFW index in the future period. We find that a one standard deviation increase in the Gini coefficient reduces (worsens) the EFW index by 0.18-0.26 standard deviations, depending on the specification. This magnitude persists across the other three specifications of the baseline model, though it loses significance upon the inclusion of fixed effects. (2)

In addition, the same procedure was applied to each of the five subcomponents of the EFW index. Of the five subcomponents, inequality has the largest impact in the later period on the size of government. The most counterintuitive result is the mixed results regarding the impact of inequality on regulation. Upon inclusion of fixed effects, a one standard deviation increase in the Gini coefficient improves the regulation score by 0.46 standard deviations. While the effect is only significant with 90 percent confidence, the magnitude is very large. Besides the impact of inequality on regulation, its impact on the other components of the EFW index is generally intuitive.

Data and Method

Differencing (or controlling for levels in the first period) alleviates many concerns regarding endogeneity, but the tradeoff that arises is that there is often little variation from year to year. The approach used in this article avoids that problem by comparing periods 10 years apart. The most parsimonious specification employed is to use the Gini coefficient in year t to predict economic freedom in year t + 10...