The Impact of Economic Freedom on Inequality
Abstract :
The cornerstones of economic freedom (EF) are: personal choice, voluntary exchange, open markets and clearly defined and enforced property rights (de Haan et al., 2006). Although greater economic freedom is generally associated with higher levels of output (a larger pie), it is widely believed that more market-based economies also have a more unequal distribution of gross income (the distribution of the pie). Government redistribution can redress this inequality, leading to a more equal distribution of net income. At the same time, such policies are likely to reduce the level of EF (which includes the size of government and the level of taxes). This, of course, means that the causality between EF and inequality can run in both directions. Nevertheless, most empirical studies focus on the unidirectional causality between EF and inequality, using a variety of econometric methods, measures of inequality and economic freedom, country samples and time periods. The results of these studies are very mixed. Moreover, it is noteworthy that most studies simply ignore that some of the other drivers of inequality, such as GDP per capita and human capital, may also be affected by EF.
This paper uses local projection methods to shed new light on the relationship between economic freedom or market reforms and inequality for a large panel of countries and years. The local projections (LP) approach is a flexible alternative to vector autoregression models as it does not impose dynamic restrictions. It is also better suited to estimating non-linear or state-dependent effects, such as the stance of fiscal or monetary policy. In estimating our models, we follow de Haan and Wiese (2020) and include the leads of the market reform dummies. This approach reduces the bias introduced by overlapping forecast horizons. When calculating the forecast horizon, the results for observations prior to a treatment by construction overlap with the treatment in the future, but this is not captured in the data for the affected observation when using a standard LP setup.
References
de Haan, J., Lundström, S. & Sturm, J.-E. (2006). Market-oriented Institutions and Policies and Economic Growth: A Critical Survey. Journal of Economic Surveys, 20(2), 157-191. https://doi.org/10.1111/j.0950-0804.2006.00278.x
de Haan, J., & Wiese, R. (2022). The impact of product and labour market reform on growth: Evidence for OECD countries based on local projections. Journal of Applied Econometrics, 37(4), 746–770. https://doi.org/10.1002/jae.2890