Fiscal freedom is a measure of the tax burden imposed by government. It includes direct taxes, in terms of the top marginal tax rates on individual and corporate incomes, and overall taxes, including all forms of direct and indirect taxation at all levels of government, as a percentage of GDP. Thus, the fiscal freedom component is composed of three quantitative factors:
- The top marginal tax rate on individual income,
- The top marginal tax rate on corporate income, and
- The total tax burden as a percentage of GDP.
In scoring fiscal freedom, each of these numerical variables is weighted equally as one-third of the component. This equal weighting allows a country to achieve a score as high as 67 based on two of the factors even if it receives a score of 0 on the third.
Fiscal freedom scores are calculated with a quadratic cost function to reflect the diminishing revenue returns from very high rates of taxation. The data for each factor are converted to a 100-point scale using the following equation:
Fiscal Freedomij= 100 – α (Factorij)2
where Fiscal Freedomij represents the fiscal freedom in country i for factor j; Factorij represents the value (based on a scale of 0 to 100) in country i for factor j; and α is a coefficient set equal to 0.03. The minimum score for each factor is zero, which is not represented in the printed equation but was utilized because it means that no single high tax burden will make the other two factors irrelevant.
As an example, in the 2013 Index, Mauritius has a flat rate of 15 percent for both individual and corporate tax rates, which yields a score of 93.3 for each of the two factors. Mauritius’s overall tax burden as a portion of GDP is 18.5 percent, yielding a tax burden factor score of 89.7. When the three factors are averaged together, Mauritius’s overall fiscal freedom score becomes 92.1.
Sources. Unless otherwise noted, the Index relies on the following sources for information on taxation, in order of priority: Deloitte, International Tax and Business Guide Highlights; International Monetary Fund, Staff Country Report, “Selected Issues and Statistical Appendix,” and Staff Country Report, “Article IV Consultation,” 2009–2012; PricewaterhouseCoopers, Worldwide Tax Summaries, 2009–2012; countries’ investment agencies; other government authorities (embassy confirmations and/or the country’s treasury or tax authority); and Economist Intelligence Unit, Country Commerce and Country Finance, 2009–2012.
For information on tax burden as a percentage of GDP, the primary sources (in order of priority) were Organisation for Economic Co-operation and Development data; Eurostat, Government Finance Statistics data; African Development Bank and Organisation for Economic Co-operation and Development, African Economic Outlook 2012; International Monetary Fund, Staff Country Report, “Selected Issues,” and Staff Country Report, “Article IV Consultation,” 2009–2012; Asian Development Bank, Key Indicators for Asia and the Pacific, 2009–2012; and individual contacts from government agencies and multinational organizations such as the IMF and World Bank.