Chapter 1 Principles of Economic

Ambassador Terry Miller and Anthony B. Kim

[A] society that puts freedom first will, as a individual merit. Government decision-making happy by-product, end up with both great- is characterized by openness and transparency, er freedom and greater equality. Though which illuminates the shadows where dis- a by-product of freedom, greater equality crimination might flourish and promotes equal is not an accident. A free society releases opportunity for all. the energies and abilities of people to pur- In an economically free society, the power of sue their own objectives. It prevents some economic decision-making is widely dispersed, people from arbitrarily suppressing others. and the allocation of resources for production and consumption is on the basis of open compe- —Milton and Rose Friedman1 tition so that every individual or firm gets a fair chance to succeed. n an economically free society, each person These three fundamental principles of controls the fruits of his or her own labor economic freedom—empowerment of the I and initiative. Individuals are empowered— individual, non-discrimination, and open compe- indeed, entitled—to pursue their dreams by tition—underpin every measurement and policy means of their own free choice. idea presented in the Index of Economic Freedom. In an economically free society, individu- als succeed or fail based on their individual ECONOMIC FREEDOM: effort and ability. The institutions of a free and THE ROLE OF GOVERNMENT open market society do not discriminate either As once observed, “To be against or in favor of individuals based on their controlled in our economic pursuits means to be race, ethnic background, gender, class, family controlled in everything.”2 Hayek’s keen insights connections, or any other factor unrelated to into economic freedom are based on the moral

11 truth that each person is, as a matter of natural and enjoy the fruits of their labor. For example, right, a free and responsible being with inalien- citizens are taxed to provide revenue for public able dignity and fundamental that safety, the protection of , and the com- righteous and effective political systems should mon defense. Other goods—what call regard as unassailable. Governments that are “public goods”—may be supplied more efficiently just, according to the U.S. Declaration of Inde- by government than through private means. pendence, are instituted precisely to secure Some public goods, such as the maintenance of these . a police force to protect property rights, a mon- Any discussion of economic freedom thus has etary authority to maintain a sound currency, and at its heart reflection on the critical relationship an impartial to enforce contracts among between individuals and the government. In parties, are themselves vital ingredients of an eco- general, state action or government control that nomically free society. When government action interferes with individual autonomy limits eco- rises beyond the minimal necessary level, how- nomic freedom. ever, it leads inevitably and quickly to the loss of However, the goal of economic freedom is freedom—and the first freedom affected is often not simply an absence of government coercion economic freedom.3 or constraint, but the creation and maintenance Throughout history, governments have of a mutual sense of for all. As individuals imposed a wide array of constraints on econom- enjoy the blessings of economic freedom, they ic activity. Such constraints, though sometimes in turn have a responsibility to respect the eco- imposed in the name of equality or some other nomic rights and of others within the noble societal purpose, are in reality imposed . Governments are instituted to ensure most often for the benefit of societal elites or spe- basic protections against the ravages of nature cial interests, and they come with a high cost to or the predations of one citizen against another. society as a whole. By substituting political judg- Positive economic rights such as property and ments for those of the marketplace, government contracts are given societal as well as individ- diverts entrepreneurial resources and energy ual defense against the destructive tendencies from productive activities to rent-seeking, the of others. quest for economically unearned benefits. The A comprehensive view of economic freedom result is lower , economic stagna- should encompass all liberties and rights of pro- tion, and declining prosperity. duction, distribution, or consumption of goods Government provision of goods and services and services. The highest forms of economic beyond those that are clearly considered pub- freedom should provide an absolute right of lic goods also imposes a separate constraint on property ownership; full economic activity, crowding out private-sector for labor, capital, and goods; and an absolute activity and usurping resources that otherwise absence of coercion or constraint of economic might have been available for private investment activity beyond that which is necessary for the or consumption. Constraining economic choice protection and maintenance of liberty itself. An distorts and diminishes the production, distri- economically free society encourages the han- bution, and consumption of goods and services dling of economic decisions in a decentralized (including, of course, labor services). The fashion. Individuals are free to work, produce, of a nation inevitably declines as a result. consume, and invest in any way they choose under the even-handed application of laws, with MEASURING ECONOMIC FREEDOM their economic freedoms at once both protected The Index of Economic Freedom takes a broad and respected by the state. and comprehensive view of economic freedom, Some government action is necessary for measuring country performance in 10 separate the citizens of a nation to defend themselves, areas. Some of the aspects of economic freedom promote the peaceful evolution of civil society, that are evaluated are concerned with a coun-

12 2015 Index of Economic Freedom try’s interactions with the rest of the world—for prospects for long-term . Such example, the extent of an economy’s openness to a system is also vital to the maintenance of peace global investment or trade. Most, however, focus and security and the protection of human rights. on policies within a country, assessing the liberty A key aspect of property rights protection is of individuals to use their labor or finances with- the enforcement of contracts. The voluntary out undue restraint and government interference. undertaking of contractual obligations is the Each of the measured aspects of economic foundation of the market system and the basis freedom plays a vital role in developing and for economic specialization, gains from com- sustaining personal and national prosperity. mercial exchange, and trade among nations. All are complementary in their impact, howev- Even-handed government enforcement of pri- er, and progress in one area is often likely to vate contracts is essential to ensuring equity and reinforce or even inspire progress in another. integrity in the marketplace. Similarly, repressed economic freedom in one Freedom from Corruption. In the context area—respect for property rights, for example— of economic freedom, corruption can best be may make it much more difficult to achieve high understood as the failure of integrity in the eco- levels of freedom in other categories. nomic system, a distortion by which individu- The 10 measured aspects of economic free- als or special-interest groups are able to gain at dom may be grouped into four broad categories: the expense of the whole. Often a direct result of the government’s concentration of economic • Rule of law (property rights, freedom or political power, corruption manifests itself in from corruption); many forms such as bribery, extortion, nepotism, • Government size (fiscal freedom, govern- cronyism, patronage, embezzlement, and graft. ment spending); Corruption can infect all parts of an economy • Regulatory efficiency (business freedom, in systematic ways. There is a direct relationship labor freedom, monetary freedom); and between the extent of government intervention • Market openness (trade freedom, invest- in economic activity and the prevalence of cor- ment freedom, financial freedom). ruption. In particular, excessive and redundant government provide opportunities Rule of Law for bribery or graft. In addition, government Property Rights. The ability to accumulate regulations or restrictions in one area may cre- and wealth is understood to ate informal markets in another. For example, be a central motivating force for workers and by imposing numerous burdensome barriers on investors in a . The recognition conducting business, including regulatory red of private property rights and an effective rule of tape and high transaction costs, a government law to protect them are vital features of a fully can incentivize bribery and encourage illegiti- functioning market economy. Secure property mate market interactions. rights give citizens the confidence to undertake Ensuring transparency is crucial to dealing entrepreneurial activity, save their income, and effectively with corruption. Openness in regu- make long-term plans because they know that latory procedures and processes can promote their income, savings, and property (both real equitable treatment and greater efficiency. and intellectual) are safe from unfair expropria- tion or theft. Government Size The protection of private property requires Fiscal Freedom. Fiscal freedom is a direct an autonomous and accountable judicial system measure of the extent to which government that is available to all equally and without dis- permits individuals and businesses to keep and crimination. The independence, transparency, manage their income and wealth for their own and effectiveness of the judicial system have benefit and use. A government can impose fiscal proven to be key determinants of a country’s burdens on economic activity through taxation,

Chapter 1 13 but it also does so when it incurs public debt that and private investment incentives. Even worse, ultimately must be paid off through taxation. a government’s insulation from market dis- The marginal tax rate confronting an indi- cipline often leads to bureaucracy, lower pro- vidual is, in effect, the government’s cut of the ductivity, inefficiency, and mounting public from that individual’s next unit of work or debt that imposes an even greater burden on engagement in a new entrepreneurial venture; future generations. whatever remains after the tax is the individu- As many economies have experienced in al’s actual reward for the effort. Therefore, the recent years, high levels of public debt accumu- higher the government’s cut, the lower the indi- lated through irresponsible government spend- vidual’s reward—and the lower the incentive to ing undermine economic freedom and prevent undertake the work at all. Higher tax rates inter- dynamic entrepreneurial growth. fere with the ability of individuals and firms to pursue their goals in the marketplace and there- Regulatory Efficiency by reduce overall private-sector activity. Business Freedom. Business freedom is While individual and corporate income tax about an individual’s right to establish and run rates are important to economic freedom, they an enterprise without undue interference from are not a comprehensive measure of the tax bur- the state. Burdensome and redundant regula- den. Governments impose many other indirect tions are the most common barriers to the free taxes, including payroll, sales, and excise taxes, conduct of entrepreneurial activity. as well as tariffs and the value-added tax (VAT). By increasing the costs of production, regula- In the Index of Economic Freedom, the burden of tions can make it difficult for entrepreneurs to these taxes is captured by measuring the overall succeed in the marketplace. Although many reg- tax burden from all forms of taxation as a per- ulations hinder business productivity and profit- centage of total GDP. ability, the most inhibiting to Government Spending. The cost of exces- are those that are associated with licensing sive government is a central issue in economic new businesses. freedom, both in terms of generating revenue In some countries, as well as many states in (see fiscal freedom) and in terms of spending. the , the procedure for obtaining Government spending comes in many forms. a business license can be as simple as mailing in Some government spending—for example, a registration form with a minimal fee. In Hong to provide infrastructure, fund research, or Kong, for example, obtaining a business license improve human capital—may be considered requires filling out a single form, and the process investments. Government also spends on can be completed in a few hours. In other econo- public goods, the benefits of which accrue mies, such as India and parts of South America, broadly to society in ways that markets cannot the process of obtaining a business license can price appropriately. take much longer, involving endless trips to gov- All government spending that must eventu- ernment offices and repeated encounters with ally be financed by higher taxation, however, officious and sometimes corrupt bureaucrats. entails an opportunity cost. This cost is the value Once a business is open, government regu- of the private consumption or investment that lation may interfere with the normal decision- would have occurred had the resources involved making or price-setting process. Interestingly, been left in the private sector. two countries with the same set of regulations Excessive government spending runs a great can impose different regulatory burdens. If one risk of crowding out private economic activ- country applies its regulations evenly and trans- ity. Even if an economy achieves faster growth parently, this can lower the regulatory burden by through more government spending, such eco- facilitating long-term business planning. If the nomic expansion tends to be only temporary, other applies regulations inconsistently, it raises distorting the market allocation of resources the regulatory burden by creating an unpredict-

14 2015 Index of Economic Freedom able business environment. Rigid and onerous term plans can be made more confidently. An bankruptcy procedures are also distortionary, inflationary policy, by contrast, confiscates providing a disincentive for entrepreneurs to wealth like an invisible tax and also distorts pric- start businesses in the first place. es, misallocates resources, and raises the cost of Labor Freedom. The ability of individuals doing business. to work as much as they want and wherever they There is no single accepted theory of the right want is a key component of economic freedom. monetary policy for a free society. At one time, By the same token, the ability of businesses to the enjoyed widespread support. contract freely for labor and dismiss redun- What characterizes almost all monetary theo- dant workers when they are no longer needed is ries today, however, is support for low inflation essential to enhancing productivity and sustain- and an independent central bank. There is also ing overall economic growth. The core principle widespread recognition that price controls cor- of any market is free, voluntary exchange. That rupt market efficiency and lead to shortages is just as true in the labor market as it is in the or surpluses. market for goods. State intervention generates the same prob- Market Openness lems in the labor market that it produces in any Trade Freedom. Trade freedom reflects an other market. Government regulations take a economy’s openness to the flow of goods and variety of forms, including wage controls, restric- services from around the world and the citizen’s tions on hiring and firing, and other constraints. ability to interact freely as buyer or seller in the In many countries, unions play an important international marketplace. Trade restrictions role in regulating labor freedom and, depending can manifest themselves in the form of tariffs, on the nature of their activity, may be either a export taxes, trade quotas, or outright trade bans. force for greater freedom or an impediment to However, trade restrictions also appear in more the efficient functioning of labor markets. subtle ways, particularly in the form of regula- Onerous labor laws penalize businesses and tory barriers. workers alike. Rigid labor regulations prevent The degree to which government hinders the employers and employees from freely negoti- free flow of foreign commerce has a direct bear- ating changes in terms and conditions of work, ing on the ability of individuals to pursue their resulting often in a chronic mismatch of labor economic goals and maximize their productiv- supply and demand. In general, the greater the ity and well-being. Tariffs, for example, directly degree of labor freedom, the lower the rate of increase the prices that local consumers pay for in an economy. foreign imports, but they also distort production Monetary Freedom. Monetary freedom incentives for local producers, causing them to requires a stable currency and market-deter- produce either a good in which they lack a com- mined prices. Whether acting as entrepreneurs parative advantage or more of a protected good or as consumers, free people need a steady and than is economically efficient. This impedes reliable currency as a medium of exchange, unit overall economic efficiency and growth. of account, and store of value. Without monetary In many cases, trade limitations also put freedom, it is difficult to create long-term value advanced-technology products and services or amass capital. beyond the reach of local entrepreneurs, limit- The value of a country’s currency can be ing their own productive development. influenced significantly by the monetary policy Investment Freedom. A free and open of its government. With a monetary policy that investment environment provides maximum endeavors to fight inflation, maintain price sta- entrepreneurial opportunities and incentives bility, and preserve the nation’s wealth, people for expanded economic activity, greater pro- can rely on market prices for the foreseeable ductivity, and job creation. The benefits of such future. Investments, savings, and other longer- an environment flow not only to the individual

Chapter 1 15 that take the entrepreneurial risk in es that offer alternative means for raising capital expectation of greater return, but also to society or diversifying risk. As with the banking system, as a whole. An effective investment framework the useful role for government in regulating will be characterized by transparency and equi- these institutions lies in ensuring transparency ty, supporting all types of firms rather than just and integrity and promoting disclosure of assets, large or strategically important companies, and liabilities, and risks. will encourage rather than discourage innova- Banking and financial by the state tion and . that goes beyond the assurance of transparency Restrictions on the movement of capital, both and honesty in financial markets can impede domestic and international, undermine the effi- efficiency, increase the costs of financing entre- cient allocation of resources and reduce pro- preneurial activity, and limit competition. If the ductivity, distorting economic decision-making. government intervenes in the stock market, for Restrictions on cross-border investment can instance, it contravenes the choices of millions limit both inflows and outflows of capital, there- of individuals by interfering with the pricing of by shrinking markets and reducing opportuni- capital—the most critical function of a market ties for growth. economy. Equity markets measure on a con- In an environment in which individuals and tinual basis the expected profits and losses in companies are where and how to publicly held companies. This measurement is invest, capital will flow to its best use: to the sec- essential in allocating capital resources to their tors and activities where it is most needed and highest-valued uses and thereby satisfying con- the returns are greatest. State action to redirect sumers’ most urgent requirements. the flow of capital and limit choice is an imposi- tion on the freedom of both the investor and the ECONOMIC FREEDOM: AN END IN person seeking capital. The more restrictions ITSELF, A MEANS FOR PROGRESS a country imposes on investment, the lower its As a vital element of human dignity, auton- level of entrepreneurial activity. omy, and personal empowerment, economic Financial Freedom. An accessible and effi- freedom is valuable as an end itself. But just as ciently functioning formal financial system important is the fact that economic freedom is ensures the availability of diversified savings, the key to achieving the broad-based economic credit, payment, and investment services to dynamism that ensures lasting inclusive growth individuals. By expanding financing opportuni- and increased prosperity for society as a whole. ties and promoting entrepreneurship, an open As Hayek foresaw decades ago, “the guiding prin- banking environment encourages competition ciple in any attempt to create a world of free men in order to provide the most efficient financial must be this: a policy of freedom for the individ- intermediation between households and firms ual is the only truly progressive policy.”4 as well as between investors and entrepreneurs. As editions of this Index have documented Through a process driven by supply and over the past two decades, the link between demand, markets provide real-time information economic freedom and long-term development on prices and immediate discipline for those who is clear and strong. Countries that allow their have made bad decisions. This process depends citizens more economic freedom reach higher on transparency in the market and the integrity incomes and better standards of life. People in of the information being made available. A pru- economically free societies live longer. They dent and effective regulatory system, through have better health. They are able to be better disclosure requirements and independent audit- stewards of the environment, and they push for- ing, ensures both. ward the frontiers of human achievement in sci- Increasingly, the central role played by banks ence and technology through greater innovation. is being complemented by other financial servic-

16 2015 Index of Economic Freedom ENDNOTES 1. and Rose D. Friedman, Free to Choose: A Personal Statement (New York: Harcourt Brace Jovanovich, 1979). 2. Friedrich A. Hayek, The Road to Serfdom (Chicago: University of Chicago Press, 1944). 3. “The property which every man has in his own labor, as it is the original foundation of all other property, so it is the most sacred and inviolable.” , An Inquiry into the Nature and Causes of the Wealth of Nations (New York: The Modern Library, 1937), pp. 121–122; first published in 1776. 4. Hayek, The Road to Serfdom.

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