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Chapter 1 The 10 Economic

The existence of a does not of course eliminate the need for government. On the con- trary, government is essential both as a forum for determining the “rules of the game” and as an umpire to interpret and enforce the rules decided on. What the market does is to reduce greatly the range of issues that must be decided through political means, and thereby to minimize the extent to which government need participate directly in the game. , and

conomic freedom is that aspect of human the ravages of nature or the predations of one that is concerned with the material citizen over another so that positive economic Eautonomy of the individual in relation such as property and contract are given to the and other organized groups. Indi- social as well as individual defense against the viduals are economically free if they can fully destructive tendencies of others. control their own labor and property. Economic A comprehensive definition of is related to—and is perhaps a neces- freedom should encompass all and rights sary condition for—political freedom, but it is of production, distribution, or consumption of also valuable as an end in itself.1 and services. The highest form of economic freedom should provide an absolute right of property owner- Defining Economic Freedom ship; fully realized freedoms of movement for labor, The authors of the Index of Economic Free- capital, and goods; and an absolute absence of coer- dom perceive economic freedom as a positive cion or constraint of economic liberty beyond the concept, recognizing that its traditional defini- extent necessary for citizens to protect and main- tion as an absence of government coercion or tain liberty itself. In other words, individuals constraint must also include a sense of liberty in an economically free society would be free as distinct from anarchy. Governments are and entitled to work, produce, consume, and instituted to create basic protections against invest in any way they please under a , with their freedom at once both protected and respected by the state. 1. Milton Friedman, (Chicago: University of Chicago Press, 1962), All government action involves coercion. esp. Chapter 1, “The Relation Between Economic Some minimal coercion is necessary for the citi- Freedom and Political Freedom,” pp. 7–17. zens of a community or nation to defend them-

11 selves, promote the evolution of civil society, nomic freedom are external in nature, mea- and enjoy the fruits of their labor. This Lockean suring the extent of an economy’s openness idea is embodied in the U.S. Constitution. For to investment or trade. Most are internal in example, citizens are taxed to provide revenue nature, assessing the liberty of individuals to for the protection of person and property as well use their labor or finances without restraint as for the common defense. Most political theo- and government interference. Each is vital to rists also accept that certain goods—what econo- the development of personal and national pros- mists call “public goods”—can be supplied more perity. The fundamental right of property, for efficiently by government than through private example, has been recognized for centuries by means. Of particular interest are those economic the great philosophers of liberty, such as Locke freedoms that are also public goods, such as the and , as a bulwark of free people. maintenance of a police force to protect prop- Over time, scholars and practitioners have rec- erty rights, a monetary authority to maintain a ognized many other pillars of economic liberty, sound currency, and an impartial judiciary to including , stable money, the right to enforce contracts among parties. work, control of government spending, and When government coercion rises beyond lower taxation. Over the past 15 years, the Index the minimal level, however, it becomes corro- has grown and improved its measurement of sive to freedom—and the first freedom affected countries’ capacity to create environments that is economic freedom. Logically, an expansion allow economic opportunity to flourish. of state power requires enforcement and there- The 10 specific economic freedoms mea- fore funding, which is extracted from the peo- sured in the Index of Economic Freedom are ple. Exactly where that line is crossed is open to discussed below. Each of the freedoms is indi- reasoned debate. vidually scored. A country’s overall economic Throughout history, governments have freedom score is a simple average of its scores imposed a wide array of constraints on eco- on the 10 individual freedoms. Detailed infor- nomic activity. Constraining economic choice mation about the used to score distorts and diminishes the production, distri- each component is contained in the appendix. bution, and consumption of goods and services (including, of course, labor services).2 The estab- Freedom #1: Business Freedom lishment of price controls is perhaps the clear- Business freedom is about an individual’s est example of the distortionary effect of state right to create, operate, and close an enterprise coercion because of its well-known disruption without interference from the state. Burden- of the equilibrium of supply and demand. some, redundant regulatory rules are the most common barriers to the free conduct of entre- Measuring Economic Freedom preneurial activities. As the first comprehensive study of eco- Regulations are a form of taxation that nomic freedom ever published, the 1995 Index makes it difficult for entrepreneurs to cre- of Economic Freedom defined a method of mea- ate . Although many regulations hinder suring and ranking freedom in such vastly dif- businesses, the most important are associated ferent places as Hong Kong and . with licensing new companies and businesses. The Index looks at economic freedom from In some countries, as well as many states in 10 different viewpoints. Some aspects of eco- the United States, the procedure for obtaining a business license can be as simple as mailing 2. “The property which every man has in his in a registration form with a minimal fee. In own labour, as it is the original foundation of Hong Kong, for example, obtaining a business all other property, so it is the most sacred and license requires filling out a single form, and inviolable.” , An Inquiry into the Nature the process can be completed in a few hours. In and Causes of the Wealth of Nations (New York: The Modern Library, 1937), pp. 121–122; first published other countries, such as India and countries in in 1776. parts of South America, the process involved

12 2009 Index of Economic Freedom in obtaining a business license requires endless debt that ultimately must be paid off through trips to government offices and can take a year taxation. or more. The marginal tax rate confronting an indi- Once a business is open, government regu- vidual is, in effect, the government’s cut of lation does not always subside; in some cases, it the profit from his or her next unit of work or increases. Interestingly, two countries with the engagement in a new entrepreneurial venture; same of regulations can impose different whatever remains after the tax is subtracted is regulatory burdens. If one country, for instance, the individual’s actual reward for this effort. applies its regulations evenly and transparent- The higher the government’s cut, the lower ly, it lowers the regulatory burden by enabling the individual’s reward—and the lower the businesses to make long-term plans more eas- incentive to undertake the work at all. Higher ily. If the other applies regulations inconsistent- tax rates both interfere with the ability of indi- ly, it raises the regulatory burden by creating an viduals and firms to pursue their goals in the unpredictable business environment. Finally, marketplace and reduce, on average, their will- regulations that make it difficult and expensive ingness to work or invest. to close business are disincentives for entrepre- While individual and corporate income neurs to start them in the first place. tax rates are important to economic freedom, they are not a comprehensive measure of the Freedom #2: Trade Freedom tax burden. Governments impose many other Trade freedom reflects the openness of an taxes, including payroll, sales, and excise taxes, economy to imports of goods and services from tariffs, and the value-added tax (VAT). One way around the world and the ability of citizens to to capture all taxation is to measure total gov- interact freely as buyers and sellers in the inter- ernment revenues from all forms of taxation as national marketplace. a percentage of total GDP. Trade restrictions can take the form of taxes on imports and exports, quotas or outright bans Freedom #4: Government Size on trade, and regulatory barriers. The degree to The burden of excessive government is a which government hinders the free flow of for- central issue in economic freedom, both in eign commerce has a direct bearing on the ability terms of generating revenue (see fiscal free- of individuals to pursue their economic goals. dom) and in terms of expenditure. Tariffs directly increase the prices that local Government expenditures are often justified consumers pay for foreign imports, but they in terms of “public goods” that are provided also distort production incentives for local pro- efficiently by the state rather than by the mar- ducers, causing them to produce either a ket. There is also a justification for correcting in which they lack a comparative advantage market failures through government action. or more of a protected good than is economi- Unfortunately, a government’s insulation from cally efficient. This impedes economic growth. market discipline leads to inefficiency, bureau- In many cases, trade limitations also put cracy, and lowered productivity. Government advanced-technology products and services expenditures necessarily compete with private beyond the reach of local people, limiting their agents and interfere in market prices by over- own productive development. stimulating demand and potentially diverting resources through a crowding-out effect. In Freedom #3: Fiscal Freedom extreme cases, governments can coerce goods Fiscal freedom is the freedom of individu- and capital out of markets altogether, driving als and businesses to keep and control their up interest rates and inflation. income and wealth for their own benefit and The government’s appetite for private use. A government can impose fiscal burdens resources affects both economic freedom and on economic activity by generating revenue for economic growth. Even if a state-managed itself, primarily through taxation but also from economy achieves fast growth through heavy

Chapter 1 13 expenditure, it diminishes freedom in the pro- financial services. This supervision serves two cess and can create long-term damage to a major purposes: ensuring the safety and sound- country’s growth potential. ness of the financial system and ensuring that financial services firms meet basic fiduciary Freedom #5: Monetary Freedom responsibilities. Monetary freedom, reflected in a stable cur- Excessive banking and financial regula- rency and market-determined prices, is to an tion by the state, however, limits competition, economy what free speech is to . impedes efficiency, and increases the costs of Free people need a steady and reliable currency financing entrepreneurial activity. In a free as a medium of exchange and store of value. banking environment, the marketplace should Without monetary freedom, it is difficult to cre- be the primary source of protection through ate long-term value. such institutions as independent auditors and The value of a country’s currency is con- services. Such oversight is distin- trolled largely by the monetary policy of its gov- guished from burdensome or intrusive govern- ernment. With a monetary policy that endeavors ment regulation or government ownership of to maintain stability, people can rely on market banks, both of which interfere with market pro- prices for the foreseeable future. Investment, vision of financial services to consumers. savings, and other longer-term plans are easier Increasingly, the central role played by to make, and individuals enjoy greater econom- banks is being complemented by other finan- ic freedom. Inflation not only confiscates wealth cial services that offer alternative means for like an invisible tax, but also distorts pricing, raising capital or diversifying risk. As with the misallocates resources, raises the cost of doing banking system, aside from basic provisions business, and undermines a free society. to enforce contractual obligations and prevent There is no singularly accepted theory of the fraud, increased government intervention in right monetary institutions for a free society. these areas undermines economic freedom and At one time, the gold standard enjoyed wide- inhibits the ability of non-banking financial ser- spread support, but this is no longer the case. vices to contribute to economic growth. If the What characterizes almost all monetary theo- government intervenes in the stock market, it ries today, however, is support for low inflation contravenes the choices of millions of individu- and an independent central bank. There is also als by interfering with the pricing of capital— now widespread recognition that price controls the most critical function of a . corrupt market efficiency and lead to shortages Equity markets measure, on a continual basis, or surpluses. the expected profits and losses in publicly held companies. This measurement is essential in Freedom #6: Investment Freedom allocating capital resources to their highest- Restrictions on foreign investment can limit valued uses and thereby satisfying consumers’ both inflows and outflows of capital. In a free most urgent requirements. Similarly, govern- environment, capital will flow to its best use ment ownership or intervention in the insur- where it is most needed and the returns are ance sector undermines the ability of providers greatest. State action to redirect the flow of to make available those services at prices that capital is an imposition on both the freedom are based on risk and market conditions. of the investor and the freedom of the people seeking capital. The more restrictions a country Freedom #8: Property Rights imposes on investment, the lower its level of The ability to accumulate is entrepreneurial activity and economic growth. the main motivating force in a market economy, and the rule of law is vital to a fully functioning Freedom #7: Financial Freedom free-market economy. Secure property rights Virtually all countries provide some type give citizens the confidence to undertake com- of prudential supervision of banks and other mercial activities, save their income, and make

14 2009 Index of Economic Freedom long-term plans because they know that their ety and workers, just as the free market has income and savings are safe from expropria- proven superior for virtually all other fields. tion or theft. The protection of private property Furthermore, state intervention generates the requires an effective and honest judicial sys- same problems in the labor market that it pro- tem that is available to all, equally and without duces in any other markets. discrimination. Government regulations take a variety of forms, including wage controls, hiring Freedom #9: Freedom from Corruption and firing restrictions, and health and safety Corruption is defined as dishonesty or restrictions. In many countries, unions play decay. In the context of governance, it can be an important role in regulating labor freedom defined as the failure of integrity in the system, and, depending on the nature of their activity, a distortion by which individuals are able to may be either a force for greater freedom or an gain personally at the expense of the whole. impediment to the efficient functioning of labor Political corruption is a sad part of human his- markets. In general, the greater the degree of tory and manifests itself in many forms such as labor freedom, the lower the rate of unemploy- bribery, extortion, nepotism, cronyism, patron- ment in an economy. age, embezzlement, and (most commonly) graft, whereby public officials steal or profit Equal Weight. In the Index of Economic Free- illegitimately from public funds. dom, the 10 components of economic freedom Many societies, of course, outlaw such are equally weighted so that the overall score activities as the traffic in illicit drugs, but oth- will not be biased toward any one component or ers frequently limit individual liberty by out- policy direction. It is clear that the 10 economic lawing such activities as private transportation freedoms interact, but the exact mechanisms and construction services. Corruption infects of this interaction are not easily definable. Is all parts of an economy unless the market is a minimum threshold for each one essential? allowed to develop transparency and effective Is it possible for one to maximize if others are policing. A government regulation or restric- minimized? Are they dependent or exclusive, tion in one area may create an informal market complements or supplements? in another. For example, a country with high These are valid questions, but they are barriers to trade may have laws that protect its beyond the scope of our fundamental mis- domestic market and prevent the import of for- sion. The purpose of the Index is to reflect the eign goods, but these barriers create incentives economic environment in every country sur- for smuggling and an informal market for the veyed in as balanced a way as possible. The barred products. Index has never been designed specifically to explain economic growth or any other depen- Freedom #10: Labor Freedom dent variable; that is ably done by empirical The ability of individuals to work as much econometricians elsewhere. The raw data for as they want and wherever they want is a key each component are provided so that others component of economic freedom. By the same can study and weight and integrate as they token, the ability of businesses to contract freely see fit. for labor and to fire workers when they are no The Grading Scale. Each one of the 10 longer needed is a vital mechanism for increas- economic freedoms is graded using a scale ing productivity and sustaining economic from 0 to 100, with 100 representing the maxi- growth. The core of any market is free, mum freedom. A score of 100 signifies an eco- voluntary exchange. That principle has several nomic environment or set of policies that is components such as voluntary choice and free most conducive to economic freedom. The competition. The labor market is no exception. grading scale is continuous, meaning that The free market is also an efficient institu- scores with decimals are possible. For example, tion for labor, yielding the best results for soci- a country could have a trade freedom score of

Chapter 1 15 50.3. Many of the 10 freedoms are based on 2008. It is important to understand, however, quantitative data that are converted directly that some component scores are based on his- into a score. In the case of trade, a country torical information. For example, the monetary with zero tariffs and zero non-tariff barriers freedom component is a three-year weighted will have a trade freedom score of 100.3 average rate of inflation from January 1, 2005, Period of Study. For the current Index of to December 31, 2007. Economic Freedom, the authors generally exam- Sources. In evaluating the criteria for each ined data for the period covering the second component, the authors have used a range of half of 2007 through the first half of 2008. To authoritative sources that are internationally the extent possible, the information consid- recognized. All sources are indicated in the ered for each factor was current as of June 30, narrative where appropriate. Because it would be unnecessarily cumbersome to cite all of the sources used in scoring every single variable of 3. For detailed guidance on how the data in the each factor, unless otherwise noted, the major Index can be used in statistical research, see http:// www.heritage.org/research/features/index/downloads. sources used in preparing the country summa- cfm#methodology. ries may be found in the appendix.

16 2009 Index of Economic Freedom