Chapter 3
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Methodology: Measuring the 10 Economic Freedoms

William W. Beach and Tim Kane, Ph.D.

The Index of Economic Freedom is a simple average of 10 individual freedoms, each of which is vital to the development of personal and national prosperity. The fundamental right of property, for example, has been recognized for centuries by the great philosophers of liberty such as Locke and Montesquieu as a bulwark of free people. Over time, scholars and practitioners have recognized many other freedoms as essential to economic liberty, including free trade, investment rights, and labor freedom.

As the first comprehensive study of economic freedom ever published, the 1995 Index of Economic Freedom defined a method by which economic freedom could be rated and ranked in such vastly different places as Hong Kong and North Korea. It did so by identifying 10 measurable freedoms for each country that in concert seem to matter most for the creation of wealth. Some of these freedoms are international in nature, measuring the extent of an economy’s openness to investment or trade. Most are internal in nature, assessing the liberty of individuals to use their labor or finances without restraint.

Since 1995, the Index has grown and improved; other, similar studies have added to the effort. Each cross-country study offers a unique and profound contribution that has helped to shape the world being measured.1

Defining Economic Freedom

Economic freedom is that part of freedom that is concerned with the material autonomy of the individual in relation to the state and other organized groups. An individual is economically free who can fully control his or her labor and property. This economic component of human liberty is related to—and perhaps a necessary condition for—political freedom, but it is also valuable as an end in itself.

The authors of the Index perceive economic freedom as a positive concept, recognizing that its traditional definition as an absence of government coercion or constraint must also include a sense of liberty as distinct from anarchy. Governments are instituted to create basic protections against the ravages of nature, so that positive economic rights such as property and contract are given social as well as individ-ual defense against the destructive tendencies of others. The definition of economic freedom therefore en-compasses all liberties and rights of production, distribution, or consumption of goods and services. The highest form of economic freedom provides an absolute right of property ownership, fully realized freedoms of movement for labor, capital, and goods, and an absolute absence of coercion or constraint of economic liberty beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, individuals are free to work, produce, consume, and invest in any way they please, and that freedom is both protected by the state and unconstrained by the state.

All government action involves coercion. Some minimal coercion is necessary for the citizens of a community or nation to defend themselves, promote the evolution of civil society, and enjoy the fruits of their labor. This Lockean idea is embodied in the U.S. Constitution. For example, citizens are taxed to provide revenue for the protection of person and property as well as for a common defense. Most political theorists also accept that certain goods—what economists call “public goods”—can be supplied more conveniently by government than through private means. Of particular interest are those economic freedoms that are also public goods, such as the maintenance of a police force to protect property rights, a monetary authority to maintain a sound currency, and an impartial judiciary to enforce contracts among parties.

When government coercion rises beyond the minimal level, however, it becomes corrosive to freedom—and the first freedom affected is economic freedom. Logically, an expansion of state power requires enforcement and therefore funding, which is extracted from the people. Exactly where that line is crossed is open to reasoned debate.

Throughout history, governments have imposed a wide array of constraints on economic activity.

Constraining economic choice distorts and diminishes the production, distribution, and consumption of goods and services (including, of course, labor services).2 The establishment of a price control is perhaps the clearest example of the distortionary effect of state coercion because of its well-known disruption of the equilibrium of supply and demand.

The 10 Economic Freedoms. Overall economic freedom, defined by multiple rights and liberties, can be quantified as an index of less abstract components. The index we conceive uses 10 specific freedoms, some as composites of even further detailed and quantifiable components. A detailed discussion of each of these factors and their component variables follows this overview.

Equal Weight. In the Index of Economic Freedom, all 10 factors are equally weighted in order not to bias the overall score toward any one factor or policy direction. As described earlier, economic freedom is an end in itself. The ability of economic freedom to establish a foundation for the rapid development of wealth for the average citizen explains contemporary interest, but it is not a valid rationale to weight some components over others. Nor would it be proper to weight the Index in a manner that caused the relation between democracy and economic freedom to be statistically stronger.

This is a common-sense approach. It is also consistent with the purpose of the Index: to reflect the balanced economic environment in every country surveyed. The Index has never been designed specifically to explain economic growth or any other dependent variable; that is ably done by empirical econometricians elsewhere.

Nor is it clear how the 10 economic freedoms interact. Is a minimum threshold for each one essential? Is it possible for one to maximize if others are minimized? Are they dependent or exclusive, complements or supplements? These are valid questions, and they are beyond the scope of our more fundamental mission. The Index, then, offers a simple composite based on an average of the 10 freedoms. It also offers the raw data for each factor so that others can study and weight and integrate as they see fit.

The Grading Scale. Each one of the 10 freedoms is graded using a scale from 0 to 100, where 100 represents the maximum freedom. A score of 100 signifies an economic environment or set of policies that is most conducive to economic freedom. The grading scale is continuous, meaning that scores with decimals are possible. For example, a country could have a trade freedom score of 50.33. Many of the 10 freedoms are based on quantitative data that are converted directly into a score. In the case of trade, a country with zero tariffs and zero non-tariff barriers will have a trade freedom score of 100. This will often be described using percent terminology.

In previous years, the Index used a scale of 1 to 5, in which 1 represented the best score. All of the old scores have been converted seamlessly to the new scale. If a country had an overall score of 3.00 and a trade freedom score of 2.00 in the year 1997, for example, those have been converted to 50 percent and 75 percent, respectively. 3

Period of Study. For the current Index of Economic Freedom, the authors generally examined data for the period covering the second half of 2005 through the first half of 2006. To the extent possible, the in-formation considered for each factor was current as of June 30, 2006. It is important to understand, how-ever, that some factors are based on historical information. For example, the monetary freedom factor is a three-year weighted average rate of inflation from January 1, 2003, to December 31, 2005.

Sources. In evaluating the criteria for each factor, the authors have used a range of authoritative sources. Because it would be unnecessarily cumbersome to cite all the sources used in scoring every single variable of each factor, unless otherwise noted, the major sources used in preparing the country summaries may be found below, in the introduction to Chapter 5, and in the list of Major Works Cited.

Methodology for the 10 Economic Freedoms

Freedom #1: Business Freedom

Business freedom is a quantitative measure of the ability to start, operate, and close a business that represents the overall burden as well as the efficiency of government regulations. Regulations are a form of taxation that make it difficult for entrepreneurs to create value. Although many regulations hinder businesses, the most important are associated with licensing new companies and businesses. In some countries, as well as many states in the United States, the procedure for obtaining a business license can be as simple as mailing in a registration form with a minimal fee. In Hong Kong, for example, obtaining a business license requires filling out a single form, and the process can be completed in a few hours. In other countries, such as India and countries in parts of South America, the process involved in obtaining a business license requires endless trips to government offices and can take a year or more.

Once a business is open, government regulation does not always subside; in some cases, it increases.

Interestingly, two countries with the same set of regulations can impose different regulatory burdens. If one country, for instance, applies its regulations evenly and transparently, it lowers the regulatory burden because it enables businesses to make long-term plans more easily. If the other applies regulations inconsistently, it raises the regulatory burden by creating an unpredictable business environment.

Finally, regulations that make it difficult and expensive to close businesses are disincentives for entrepreneurs to start them in the first place.

Methodology. The business freedom score for each country is a number between 0 and 100 percent, with 100 equaling the freest business environment. The score is based on 10 components, all weighted equally, based on objective data from the World Bank’s Doing Business study:

Each of these raw components is converted to a 0 to 100 scale, after which the average of the converted values is computed. The result represents the country’s business freedom score. For example, even if a country requires the highest number of procedures for starting a business, which yields a score of zero in that component, it could still receive a score as high as 90 based on scores in the other nine components. Norway, for example, has the world’s highest business freedom score (97 percent), even though it is ranked 30th in overall freedom worldwide. Indeed, Norway receives scores of 100 in nine of the 10 components, the exception being the 13 procedures required by the government for closing a business, which equates to a score of 69.8 percent for that component.

Each component is converted to a 100 percent scale using the following equation:

which is based on the ratio of the country data for each component relative to the world average, multiplied by 50. For example, on average worldwide, there are 18.16 procedures to close a business. Norway’s 13 procedures is a component value better than the average, resulting in a ratio of 1.397. That ratio multiplied by 50 equals the final component score of 69.8 percent. The average country will receive a component score of 50 percent, whereas a country’s maximum component score is limited to 100 percent.

For the 12 countries that are not covered by the World Bank’s Doing Business study, the business freedom factor is scored by looking into business regulations based on qualitative information from reliable and internationally recognized sources.5

Sources. Unless otherwise noted, the authors used the following sources in determining business freedom scores, in order of priority: World Bank, Doing Business 2007: How to Reform; Economist Intelligence Unit, Country Report and Country Profile, 2004–2006; U.S. Department of Commerce, Country Commercial Guide, 2003, 2004, 2005, and 2006.

Freedom #2: Trade Freedom

Trade restrictions can take the form of taxes on imports and exports (known as tariffs), quotas or outright bans on trade, and regulatory barriers. The degree to which government hinders access to and the free flow of foreign commerce can have a direct bearing on the ability of individuals to pursue their economic goals.

Tariffs immediately and directly increase the prices that local consumers pay for foreign imports, and these price distortions change incentives, often indirectly pulling producers away from specializing in some goods and toward the blocked goods. By interfering with comparative advantage, trade restrictions impede economic growth. Also, tariffs make local citizens poorer by raising prices. In many cases, trade limitations put advanced technology products and services beyond the reach of local people, limiting their own pro-ductive development.

Methodology. The trade freedom score is based two inputs:

Weighted average tariffs are a purely quantitative measure and account for the basic calculation of the score using an equation that is described below. The presence of NTBs in a country affects its trade freedom score by incurring a penalty of up to 20 percentage points, or one-fifth of the maximum score.

Different imports entering a country can, and often do, face different tariffs. The weighted average tariff uses weights for each tariff based on the share of imports for each good. This can be calculated by dividing the country’s total tariff revenue by the total value of imports. This weighted measure may understate the level of tariff protection because goods with high tariffs will have low trade weights. Furthermore, a tariff is counted toward the average level of protection only if an import actually occurred; thus, tariffs that are so high as to fully prevent imports are not captured. In contrast, the simple average tariff makes no distinction as to how much of each product is actually imported.

The weighted average tariff rate is converted to the base trade freedom score using this equation:

where TFi represents the trade freedom in country i, Tariffmax and Tariffmin represent the upper and lower bounds for tariff rates, and Tariffi represents the weighted average tariff rate in country i. The minimum tariff is naturally zero, and the upper bound was set as 50 percent. If applicable to country i, the NTB penalty of 20 percentage points is then subtracted from the base score. The equation simplifies to:

As an example, France received a trade freedom score of 76.6 percent, as did over 20 other European Union countries that share a unified trade policy. The weighted average tariff of 1.7 percent yields a base score 96.6 percent. The existence of significant NTBs, however, reduces the score by 20 percentage points.

Gathering data on tariffs to make a consistent cross-country comparison can be a challenging task. Unlike data on inflation, for instance, countries do not report their weighted average tariff rate or simple average tariff rate every year; in some cases, the most recent time a country reported its tariff data could have been as far back as 1993. To preserve consistency in grading the trade policy factor, the authors have decided to use the most recently reported weighted average tariff rate for a country from our primary source. If another reliable source reports more updated information on the country’s tariff rate, the authors note this fact and may review the grading of this factor if there is strong evidence that the most recently reported weighted average tariff rate is outdated.

The World Bank produces the world’s most comprehensive and consistent information on weighted aver-age applied tariff rates. When the weighted average applied tariff rate is not available, the authors use the country’s average applied tariff rate; and when the country’s average applied tariff rate is not available, the authors use the weighted average or the simple average of most favored nation (MFN) tariff rates.6 The data for customs revenues and total imports may not be consolidated in just one source. In addition, in the very few cases in which data on duties and customs revenues are not available, the authors use data on international trade taxes instead. In all cases, the authors clarify the type of data used and the different sources for those data in the corresponding write-up for the trade policy factor. Sometimes, when none of this information is available, the authors simply analyze the overall tariff structure and estimate an effective tariff rate.

Sources. Unless otherwise noted, the authors used the following sources to determine scores for trade policy, in order of priority: World Bank, World Development Indicators 2005 and Data on Trade and Import Barriers: Trends in Average Tariff Rates for Developing and Industrial Countries 1981–2003; World Trade Organization, Trade Policy Reviews, 1995 to March 2005; Office of the U.S. Trade Representative, 2005 National Trade Estimate Report on Foreign Trade Barriers; U.S. Department of Commerce, Country Commercial Guide, 2004 and 2005; Economist Intelligence Unit, Country Report, Country Profile, and Country Commerce, 2004–2005 and 2005–2006; and official government publications of each country.

Freedom #3: Fiscal Freedom

A government can impose fiscal burdens on economic activity by generating revenue for itself, primarily through taxation but also from debt that ultimately must be paid off through taxation. Fiscal freedom is a quantitative measure of these burdens in which lower taxation translates as a higher level of fiscal freedom. The Index methodology includes the top marginal tax rates on individual and corporate income, as well as a measure of total tax revenue as a portion of gross domestic product (GDP).

The marginal tax rate confronting an individual is, in effect, the price paid for supplying the next economic effort or engagement in an entrepreneurial venture. What remains after the tax is subtracted are the rewards of the effort. The higher the price of effort or entrepreneurship, the lower the rewards—and the less often such effort will be undertaken. Higher tax rates interfere with the ability of individuals to pursue their goals in the marketplace.

While individual and corporate income tax rates are important to economic freedom, they are not a comprehensive measure of the tax burden. First, they do not include the many other taxes such as payroll, sales, and excise taxes, tariffs, and the value-added tax (VAT). One way to capture all taxation is to measure total government revenues from all forms of taxation as a percentage of total GDP.

Methodology. Fiscal freedom is composed of three quantitative components in equal measure:

In scoring the fiscal freedom factor, each of these numerical variables is weighted equally as one-third of the factor. This equal weighting allows a country to achieve a score as high as 67 percent based on two of the components even if it receives a score of 0 percent on the third.

The economics of public finance are unambiguous on the effect of taxation, using simple supply and demand. A doubling of the tax rate quadruples the economic cost to society of lost market activity. This is known as deadweight loss because it is not value gained by government, but simply prosperity that is de-stroyed. This happens because the price wedge created by taxation separates optimal supply and demand and diminishes the quantity of goods exchanged. In the extreme, raising tax rates will decrease tax revenue itself, as famously demonstrated by the Laffer curve. Therefore, the scoring of fiscal freedom is calculated with a quadratic cost function. Each of the component pieces of data is converted to a 100-point scale using this quadratic equation:

where FFij represents the fiscal freedom in country i for component j and Componentij represents the raw percentage value (a number between 0 and 1) in country i for component j. The minimum score for each component 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 components irrelevant.

As an example, in the 2007 Index, the Bahamas has no tax on individual or corporate income, so two of the components equal 100. However, overall tax revenue as a portion of GDP in the Bahamas is 16 percent, or 0.16, yielding a revenue component score of 94.9. When the three component freedoms are averaged together, you get the Bahamas’ overall fiscal freedom score of 98.3 percent, which is the world’s 7th best fiscal freedom score.

Sources. Unless otherwise noted, the authors used the following sources for information on taxation, in order of priority: Ernst & Young, The Global Executive and Worldwide Corporate Tax Guide 2005–2006; Deloitte, Country Snapshot, 2005–2006, and Corporate Tax Rates at a Glance; International Monetary Fund (IMF), Staff Country Report, Selected Issues and Statistical Appendix, 2002 to 2006; investment agencies; and other governmental authorities (i.e., embassy confirmations and/or the country’s treasury or tax authority). For information on tax revenue as a percentage of GDP, the authors’ primary sources were Organisation for Economic Co-operation and Development data (for member countries); African Development Bank; International Monetary Fund, Staff Country Report, Selected Issues and Statistical Appendix, 2002 to 2006; Asian Development Bank, Key Indicators of Developing Asian and Pacific Coun-tries 2005; official government publications of each country; and individual contacts from government agencies and multinational organizations such as the IMF and World Bank.

Freedom #4: Freedom from Government

The burden of excessive government is a central issue in economic freedom, both in terms of generating revenue (see fiscal freedom) and in terms of expenditure. After a major methodology review, the 2007

Index is adopting the newly named freedom from government factor to measure the level of government spending and control in one place.7 The revised factor considers both the level of government expenditures as a percentage of GDP and the share of government revenue from state-owned enterprises and property. Government expenditures—including consumption and transfers—account for two-thirds of the score, and revenue from state-owned enterprises and properties accounts for the remainder.

Government expenditures are often justified in terms of “public goods” that are provided efficiently by the state rather than by the market. There is also a justification for correcting market failures through government action. Economists recognize another kind of systemic failure as well: a tendency for government failure whereby the state becomes inefficient, bureaucratic, and even harmful to productivity. Government expenditures necessarily compete with private agents and interfere in market prices by overstimulating demand and potentially diverting resources through a crowding-out effect. In extreme cases, governments can coerce goods and capital out of markets altogether, driving up interest rates and inflation. Distortions in markets occur whenever the purpose of the government’s expenditure is to acquire resources for its own purposes (government consumption) or for transfer payments.

For these reasons, the new methodology treats zero government spending as the ideal level. Since some level of government expenditures represents public goods, setting the ideal level greater than zero, where anything more or less than this ideal level of government expenditures (e.g., 10 percent) would receive a lower score, was considered. Ultimately, choosing a non-zero ideal level seems too arbitrary, static, and difficult to apply universally. Moreover, governments with no public goods will be penalized by lower scores in the other factors (such as property rights and financial freedom) that measure public goods institutions. As a compromise, the new scale for scoring government spending is non-linear, which means that government spending that is close to zero is not significantly penalized, while levels of government exceeding 30 percent of GDP receive much worse scores in a quadratic fashion (e.g., doubling spending yields four times less freedom), so that only really large governments receive very negative scores.

The government’s appetite for private resources affects both economic freedom and economic growth. Even if a state-managed economy achieves fast growth through heavy expenditure, it diminishes freedom in the process and can create long-term damage to a country’s growth potential.

Methodology. Scoring of the freedom from government factor is based on two components:

Government expenditure as a percentage of GDP is weighted as two-thirds of the freedom from government factor score, and revenue from SOEs is weighted as one-third. In cases where SOE data do not exist, the data are excluded from the factor score.

A non-linear quadratic cost function is used to calculate the expenditures score, and a simple subtraction function is used for the SOE score. The expenditure equation is:

where GEi represents the government expenditure score in country i, Expendituresi represents the total amount of government spending at all levels as a portion of GDP (between 0 and 1), and C is a constant to control for variation among scores (set at 3500). The minimum component score is zero.

For example, Israel has a freedom from government score of 60.0 percent, which is driven largely by high government expenditures that equal 40.8 percent of GDP, yielding a component score of 41.7. The other component for SOE has a score of 96.5, which is 100 minus the 3.5 percent of SOE revenue collected. In contrast, Hong Kong has an expenditure level of 18.3 percent of GDP, for a component score of 88.3, but its SOE is so low that its overall freedom from government score is 91.6 percent—the 8th highest in the world.

In most cases, general government expenditure data include all levels of government such as federal, state, and local. In cases where general government spending data are not available, data on central government expenditure are used instead. Often, data for the share of total revenues from state-owned enter-prises and government ownership of property are not readily available. In these cases, the authors look both for data on total revenues from state-owned enterprises and property and for data on total government revenues and then calculate the percentage of total revenues that is attributable to revenues from state-owned enterprises and property.

Sources. Unless otherwise noted, the authors used the following sources for information on government intervention in the economy, in order of priority: World Bank, World Development Indicators 2006 and Country at a Glance tables; official government publications of each country; Economist Intelligence Unit, Country Report and Country Profile, 2004–2006; International Monetary Fund, Government Finance Statistics April 2006 on CD–ROM; Organisation for Economic Co-operation and Development data (for member countries); African Development Bank; International Monetary Fund, Staff Country Report, Selected Issues and Statistical Appendix, 2002 to 2006; Asian Development Bank, Key Indicators 2005; and U.S. Department of Commerce, Country Commercial Guide, 2003, 2004, 2005, and 2006.

Freedom #5: Monetary Freedom

Monetary freedom is to market economics what free speech is to democracy. Free people need a steady and reliable currency as a medium of exchange and store of value. Without monetary freedom, it is difficult to create long-term value. A country’s currency is controlled largely by the monetary policy of its government. With a monetary policy that endeavors to maintain stability, people can rely on market prices for the foreseeable future.

Investment, savings, and other longer-term plans are easier to make, and individuals enjoy greater economic freedom. Inflation not only confiscates wealth like an invisible tax, but also distorts pricing, misallocates resources, raises the cost of doing business, and undermines a free society.

There is no singularly accepted theory of the right monetary institutions for a free society. At one time, the gold standard enjoyed widespread support, but this is no longer the case. What characterizes almost all monetary theorists today, however, is support for low inflation and an independent central bank. There is a powerful consensus among economists that price controls corrupt market efficiency and that measured inflation in the face of widespread price controls is essentially impossible since the price signal can no longer equate supply and demand.

Methodology. The score for the monetary freedom factor is based on two components:

The weighted average inflation (WAI) rate for the most recent three years serves as the primary input into an equation that generates the base score for monetary freedom (MF). The extent of price controls is then assessed as a penalty of up to 20 percent subtracted from the base score. The two equations used to convert inflation into the policy score for a given year are:

where Θ1 through Θ3 (thetas 1–3) represent three numbers that sum to 1 and are exponentially smaller in sequence (in this case, values of 0.665, 0.245, and 0.090, respectively); Inflationit is the absolute value of the annual inflation rate in country i during year t as measured by the consumer price index; d represents a constant that stabilizes the variance of scores; and the PC penalty is an assigned value of 0–20 percentage points based on the extent of price controls. The convex (square root) functional form was chosen to create separation among countries with low inflation rates; 128 of 161 countries had weighted average inflation under 10 percent in absolute value. A concave functional form would essentially treat all hyperinflations as equally bad, whether they were 100 percent price increases annually or 100,000 percent, whereas the square root provides much more gradation. The constant d is set to equal 6.333, which converts a 10 percent inflation rate into a freedom score of 80.0 and a 2 percent inflation rate into a score of 91.0.

Sources. Unless otherwise noted, the authors used the following sources for data on monetary policy, in order of priority: International Monetary Fund, International Financial Statistics On-line; International Monetary Fund, 2006 World Economic Outlook; and Economist Intelligence Unit, Country Report, 1999 to 2006, and Country Profile, 2004–2006.

Freedom #6: Investment Freedom

Restrictions on foreign investment limit the inflow of capital and thus limit economic freedom. By contrast, little or no restriction of foreign investment enhances economic freedom because foreign in-vestment provides funds for economic expansion. By its nature, capital will flow to where it is most needed and the returns are greatest. State action to redirect the flow of capital is an imposition on both the freedom of the investor and the people seeking capital. For this factor, the more restrictions a country imposes on foreign and domestic investment, the lower its level of economic freedom.

Methodology. This factor scrutinizes each country’s policies toward foreign investment, as well as its policies toward capital flows internally, in order to determine its overall investment climate. The authors assess all countries using the same rubric.

Questions examined include whether there is a foreign investment code that defines the country’s investment laws and procedures; whether the government encourages foreign investment through fair and equitable treatment of investors; whether there are restrictions on access to foreign exchange; whether foreign firms are treated the same as domestic firms under the law; whether the government imposes restrictions on payments, transfers, and capital transactions; and whether specific industries are closed to foreign investment. The following criteria are used:

Sources. Unless otherwise noted, the authors used the following sources for data on capital flows and foreign investment, in order of priority: International Monetary Fund, Annual Report on Exchange

Arrangements and Exchange Restrictions 2005; official government publications of each country; Economist Intelligence Unit, Country Commerce, Country Profile, and Country Report, 2005 and 2006; Office of the U.S. Trade Representative, 2006 National Trade Estimate Report on Foreign Trade Barriers; and U.S. Department of Commerce, Country Commercial Guide, 2005 and 2006.

Freedom #7: Financial Freedom

In most countries, banks provide the essential financial services that facilitate economic growth; they lend money to start businesses, purchase homes, and secure credit for the purchase of durable consumer goods. Banks also furnish a safe place in which individuals can store their savings. Greater direct control of banks by government is a threat to these functions because government interference can introduce inefficiencies and outright corruption. Heavy bank regulation reduces opportunities and restricts economic freedom; therefore, the more a government restricts its banking sector, the lower its economic freedom score will be.

It should be noted that virtually all countries provide some type of prudential supervision of banks and other financial services. This supervision serves two major purposes: ensuring the safety and soundness of the financial system and ensuring that financial services firms meet basic fiduciary responsibilities.

Ultimately, this task falls under a government’s duty to enforce contracts and protect its citizens against fraud by requiring financial institutions to publish their financial statements and relevant data, verified by independent audit, so that borrowers, depositors, and other financial actors can make informed choices.

In a free banking environment, the marketplace should be the primary source of protection through such institutions as independent auditors and information services. Such oversight is distinguished from burdensome or intrusive government regulation or government ownership of banks, both of which interfere with market provision of financial services to consumers. It is such government intervention in the market, not the market itself, that limits economic freedom and causes a country’s grade for this factor to be worse than it might otherwise be.

Increasingly, the central role played by banks is being complemented by other financial services that offer alternative means for raising capital or diversifying risk. As a result, the authors take related non-banking financial services, such as insurance and securities, into consideration when grading this factor. As with the banking system, aside from basic provisions to enforce contractual obligations and prevent fraud, increased government intervention in these areas undermines economic freedom and inhibits the ability of non-banking financial services to contribute to economic growth. If the government intervenes in the stock market, it contravenes the choices of millions of individuals by interfering with the pricing of capital—the most critical function of a market economy. Equity markets measure, on a continual basis, the expected profits and losses in publicly held companies. This measurement is essential in allocating capital resources to their highest-valued uses and thereby satisfying consumers’ most urgent requirements. Similarly, government ownership or intervention in the insurance sector undermines the ability of providers to make available those services at prices based on risk and market conditions.

Methodology. The financial freedom factor measures the relative openness of each country’s banking and financial system. The authors score this factor by determining the extent of government regulation of financial services; the extent of state intervention in banks and other financial services; the difficulty of opening and operating financial services firms (for both domestic and foreign individuals); and government influence on the allocation of credit. The authors use this analysis to develop a description of the country’s financial climate and assign it an overall score between 0 percent and 100 percent. The following criteria are used in determining a country’s score for this factor:

Sources. Unless otherwise noted, the authors used the following sources for data on banking and finance, in order of priority: The Financial Sector Reform and Strengthening (FIRST) Initiative jointly undertaken by the Department for International Development of the United Kingdom (DFID), the International Development Agency of Canada, the State Secretariat for Economic Affairs of Switzerland, the Ministry of Foreign Affairs of the Netherlands, the International Bank for Reconstruction and Development (IBRD or World Bank), and the International Monetary Fund; Economist Intelligence Unit, Country Commerce, Country Profile, and Country Report, 2005 and 2006; official government publications of each country; U.S. Department of Commerce, Country Commercial Guide, 2005 and 2006; Office of the U.S. Trade Representative, 2006 National Trade Estimate Report on Foreign Trade Barriers; and World Bank, World Development Indicators 2006.

Freedom #8: Property Rights

The ability to accumulate private property is the main motivating force in a market economy, and the rule of law is vital to a fully functioning free-market economy. Secure property rights give citizens the confidence to undertake commercial activities, save their income, and make long-term plans because they know that their income and savings are safe from expropriation.

Methodology. This factor scores the degree to which a country’s laws protect private property rights and the degree to which its government enforces those laws. It also assesses the likelihood that private property will be expropriated and analyzes the independence of the judiciary, the existence of corruption within the judiciary, and the ability of individuals and businesses to enforce contracts.

The authors grade each country according to the following criteria:

Sources. Unless otherwise noted, the authors used the following sources for information on property rights, in order of priority: Economist Intelligence Unit, Country Commerce, Country Profile, and Country Report, 2005 and 2006; U.S. Department of Commerce, Country Commercial Guide, 2005 and 2006; and U.S. Department of State, Country Reports on Human Rights Practices, 2005 and 2006.

Freedom #9: Freedom from Corruption

Corruption is defined as dishonesty or decay. In the context of governance, it can be defined as the failure of integrity in the system, a distortion by which individuals are able to gain personally at the ex-pense of the whole. Political corruption is a sad part of human history and manifests itself in many forms such as bribery, extortion, nepotism, cronyism, patronage, embezzlement, and (most commonly) graft, whereby public officials steal or profit illegitimately from public funds.

Corruption infects all parts of an economy unless the market is allowed to develop transparency and effective policing. As a general rule, a higher level of corruption equates to a greater corrosion of eco-nomic freedom, although this may not hold in extreme cases. “In some circumstances,” notes Harvard economist Robert Barro, “corruption may be preferable to honest enforcement of bad rules. For example, outcomes may be worse if a regulation that prohibits some useful economic activity is thoroughly en-forced rather than circumvented through bribes.” 8

Many societies, of course, outlaw such activities as trafficking in illicit drugs, but others frequently limit individual liberty by outlawing such activities as private transportation and construction services. A government regulation or restriction in one area may create an informal market in another. For example, a country with high barriers to trade may have laws that protect its domestic market and prevent the import of foreign goods, but these barriers create incentives for smuggling and an informal market for the barred products.

Methodology. This factor relies on Transparency International’s Corruption Perceptions Index (CPI), which measures the level of corruption in 152 countries, to determine the freedom from corruption scores of countries that are also listed in the Index of Economic Freedom.

The CPI is based on a 10-point scale in which a score of 10 indicates very little corruption and a score of 1 indicates a very corrupt government. In scoring freedom from corruption, the authors convert each of these raw CPI data to a 0 to 100 scale by multiplying the CPI score by 10. For example, if a country’s raw CPI data score is 5.5, the country’s overall freedom from corruption score is 55.

For countries that are not covered in the CPI, the freedom from corruption score is determined by using the qualitative information from internationally recognized and reliable sources. This procedure considers the extent to which corruption prevails in a country.

Sources. Unless otherwise noted, the authors used the following sources for information on informal market activities, in order of priority: Transparency International, Corruption Perceptions Index, 2002, 2003, 2004, and 2005; U.S. Department of Commerce, Country Commercial Guide, 2004, 2005, and 2006; Economist Intelligence Unit, Country Commerce, Country Profile, and Country Report, 2004, 2005, and 2006; Office of the U.S. Trade Representative, 2006 National Trade Estimate Report on Foreign Trade Barriers; and official government publications of each country.

Freedom #10: Labor Freedom

Labor policy has been a key variable in the Index of Economic Freedom since its inception in 1995 as part of the wages and prices factor as well as the regulation factor. However, coverage on labor market flexibility in the previous methodology was limited by the lack of data on labor regulation that were available across countries in a consistent manner.

In light of the growing importance of labor market flexibility in today’s economy and the increased availability of consistent labor policy data across countries, the 2007 Index has adopted an independent labor freedom factor that is designed to measure countries’ labor market regulations more adequately.

Methodology. The new labor freedom factor is a quantitative factor based on objective data from the World Bank’s Doing Business study. It provides reliable cross-country data on regulations concerning minimum wages, laws inhibiting layoffs, severance requirements, and measurable regulatory burdens on hiring, hours, and so on.

Specifically, four quantitative components are equally weighted as 25 percent of the labor freedom factor:

The minimum wage component is basically a single quantitative measure: each country’s mandatory minimum wage as a percentage of the average value added per worker. A higher minimum wage makes hiring unskilled workers more difficult.

Rigidity of hours is an index measure, calculated by Doing Business, that includes five components:

(i) whether night work is unrestricted; (ii) whether weekend work is unrestricted; (iii) whether the workweek can consist of 5.5 days; (iv) whether the workweek can extend to 50 hours or more (in-cluding overtime) for 2 months a year; and (v) whether paid annual vacation is 21 working days or fewer.9

Difficulty of firing is also an index measure calculated by Doing Business. It represents a simple issue: whether employers have the legal authority to lay off workers efficiently, or whether that act has to be justified to the government or third parties. It has eight components:

(i) whether redundancy is disallowed as a basis for terminating workers; (ii) whether the em-ployer needs to notify a third party (such as a government agency) to terminate 1 redundant worker; (iii) whether the employer needs to notify a third party to terminate a group of more than 20 redun-dant workers; (iv) whether the employer needs approval from a third party to terminate 1 redundant worker; (v) whether the employer needs approval from a third party to terminate a group of more than 20 redundant workers; (vi) whether the law requires the employer to consider reassignment or retraining options before redundancy termination; (vii) whether priority rules apply for redundancies; and (viii) whether priority rules apply for reemployment.10

The cost of firing is a composite of three quantitative subcomponents related to dismissals: the legally mandated notice period, mandatory severance pay, and a penalty the employer must pay when dismissing a worker.

In constructing the labor freedom score, each of the four components is converted to a 0 to 100 scale, based on the following equation:

where country i data are calculated relative to the world average and then multiplied by 50. The average country will receive a component score of 50 percent, whereas a country’s maximum component score is limited to 100 percent. The four component scores are then averaged for each country, yielding a labor freedom score.

As an example, Turkey’s average minimum wage as a ratio of the average wage is 0.62, which is double the average of 0.32 globally, yielding a component score of 25.2 percent. Turkey’s overall score is 45.4 percent, which is higher because the other three components represent a higher level of freedom than its minimum wage represents.

The simple average of the converted values for these four variables is computed for the country’s labor freedom score. For example, even if a country has the worst rigidity of hours in the world, with a zero score for the component, it could still get a score as high as 75 based on the other three components.

For the 12 countries that are not covered by the World Bank’s Doing Business study, the labor freedom factor is scored by looking into labor market flexibility based on qualitative information from other reliable and internationally recognized sources.11

Sources. Unless otherwise noted, the authors relied on the following sources for data on labor freedom, in order of priority: World Bank, Doing Business 2007: How to Reform; Economist Intelligence Unit, Country Report and Country Profile, 2004–2006; U.S. Department of Commerce, Country Commercial Guide, 2004, 2005, and 2006.

Continuity and Change

With over a decade’s experience measuring freedom in over a hundred nations annually, two issues regularly challenge our methodology. The first challenge has to do with outdated data. Country data in the most up-to-date sources are often behind by years. A few months before this publication went to press, for example, the World Bank revised tariff data for numerous countries, and this affected their trade freedom scores as we incorporated the new tariff rates. But countries often make policy changes during the year of grading. Sometimes the policy changes are not reflected in official data, and sometimes the changes are proposed but not made law, or made law but not enforced. Additionally, a country can experience a violent conflict or catastrophe that interrupts all efforts to measure the economy.

The second challenge is the balance between quality and consistency of the Index itself. The authors aim for methodological consistency from one year to the next, balanced against opportunities to incorporate new data and methods that improve the quality of the current year’s scores.

Most Current Information. Analyzing economic freedom annually permits the authors of the Index to include the most recent information as it becomes available country by country. A cutoff date is utilized so that all countries are treated fairly. As described above, the period of study for the current year’s Index con-siders all information as of the last day of June of the previous year (June 30, 2006). Any changes in law effective after that date have no positive or negative impact; nor do new constitutions, election results, or democratic initiatives.

Occasionally, because the Index is published several months after the cutoff date for evaluation, major economic events occur that cannot be factored into the scores. In the past, such occurrences have been uncommon and isolated to one region of the world. The Asian financial crisis, for example, erupted at the end of 1997 just as the 1998 Index of Economic Freedom was going to print. The policy changes in response to that crisis therefore were not considered in that year’s scoring but were included in the next year’s scores.

Changes in government policy are occurring at a rapid rate in many less-developed countries. The Index of Economic Freedom, because it is published each year, enables readers around the world to see how recent changes in government policy affect economic freedom in any of 161 specific countries. Each country page includes a time series graph of the country’s overall score for each year from the present back to 1995.

In 2006, numerical grading was suspended for four countries: the Democratic Republic of Congo and Sudan, which are in a state of civil unrest or anarchy, and Iraq and Serbia–Montenegro, for which data necessary to grade the country are not available. Grading was resumed in 2006 for Angola and Burundi, which had been suspended since 2001 because of civil unrest or anarchy.

New Methodology. This year, every one of the 10 factors of freedom has been revised, and only a few—those that are purely quantitative—are 100 percent continuous back to 1995. Most have a discontinuity of some degree for one year in the overall series. For example, business freedom uses inputs from the World Bank’s Doing Business for the 2006 and 2007 Indices but uses graders’ assessments of the regulatory environment for the years 1995–2005. The correlation between these methods is high, but the methods themselves are clearly distinct.

The changes introduced in the 2007 Index include very minor discontinuities for comparisons between 2006 and 2007 scores because the 2006 scores have been revised as well. The following table defines how the Index time series changed over time.

The inclusion of labor freedom is the only radical departure from the old methodology. With the publication of the World Bank’s Doing Business report, there exists for the first time a way to compare the restrictions placed on labor freedom in a quantitative way. Regrettably, this information is new and extends back only to 2005.

The other discontinuities are really just changes in the method, not adoptions of new data that have no relation to the previous data. High correlations exist between old and new data sources for the business freedom and freedom from corruption factors.

The three qualitative freedoms (investment, financial, and property) present an interesting dilemma. Though the methodology for the qualitative freedoms is not changed, the scaling is changed, from a five-bracket scale to a 0–100 scale. Old 1–5 scores for 1995–2006 were converted using a simple equation—e.g., using 100, 75, 50, 25, and 0, respectively, for 1–5—but the new detail allowed for 2007 scores means that there will be a one-time adjustment in these four factor series. For example, a country that received a 2 for property rights in 2006—which is now transformed to 75—may get a score of 80 in 2007 even if its laws are unchanged.

An attempt to regrade qualitative factor scores in previous years is problematic given

their qualitative/subjective nature, and we think it is fairest to leave them as is. While the new level of detail is clearly superior, the breaks mean that overall score changes between 2006 and 2007 will partially be the result of methodological detail in the Index and partially due to policy changes in the country.

Continuity. Ideally, the methodology used for the Index of Economic Freedom should not change over time. Instead, the scores for various countries would improve as the institutions of freedom improved as measured against a constant standard of measurable liberty. However, the increased quality of data available allows researchers to create more detailed measures of institutions as well as economic performance. The happy consequence of progress is an enhanced ability to measure progress.

Over time, therefore, the Index of Economic Freedom has been continually revised and improved; but we also aim for continuity, so each time a methodology change is implemented, we also attempt to make the scores continuous back to 1995. In this way, country performance from one year to the next is comparable.

Nevertheless, there are still some cases for which new data are not available going back to the first year, at least not in the same level of detail. There is a natural tension between the quality of the Index and the continuity of the Index. It would be easy to maintain perfect continuity if no changes were ever made, or vice versa, but we are committed to incorporating innovations into the methodology to optimize both the quality and continuity of the Index rather than simply maximizing one at the expense of the other.

It is important to remember that the Index has been an effort to quantify subjective factors, not the measure of a singular, natural data-generating process (such as temperature), and has inevitably relied on the assessments of human beings. It is a policy tool with uses for current year analysis and time series analysis.

Discontinuities in any one of the 10 factors tend to be minor, with negligible impact on the overall score. For example, in 2002, the authors began to use a measure of corruption reflecting survey data rather than expert judgment. The change made sense, and the discontinuity of time series was justified by a high correlation between the methods. Another theoretical discontinuity is the fact that different human graders are used to judge the same factor in different years, although the graders make every effort to use the same standards.

In the end, both the addition of an academic advisory board and the effort to improve the methodology are intended to help people achieve greater personal freedom. As a tool to compare economic institutions across countries, the Index should therefore be better than ever.

  1. See, for example, James D. Gwartney and Robert A. Lawson with Erik Gartzke, Economic Freedom of the World, 2005 Annual Report (Vancouver, Canada: Fraser Institute, 2005), and Richard E. Messick, World Survey of Economic Freedom: 1995–1996 (New Brunswick, N.J.: Transaction Publishers, 1996).
  2. "The property which every man has in his own labour, as it is the original foundation of all other property, so it is the most sacred and inviolable." Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: The Modern Library, 1937), pp. 121–122; fi rst published in 1776.
  3. For detailed guidance on how the data in the Index can be used in statistical research, see www.heritage.org/research/features/index/downloads.cfm#methodology.
  4. The recovery rate is a function of time and cost. However, the business freedom factor uses all three subvariables to emphasize closing a business, starting a business, and dealing with licenses equally.
  5. Twelve countries are not covered by the World Bank’s Doing Business study: Bahamas, Bahrain, Barbados, Burma, Cuba, Cyprus, North Korea, Libya, Luxembourg, Malta, Qatar, and Turkmenistan.
  6. The most favored nation tariff rate is the "normal," non-discriminatory tariff charged on imports of a good. In commercial diplomacy, exporters seek MFN treatment; that is, the promise that they will be treated as well as the most favored exporter. The MFN rule requires that the concession be extended to all other members of the World Trade Organization. MFN is now referred to as permanent normal trade relations (PNTR).
  7. In previous years’ Index methodology, expenditure measures were considered in two different places: the fi scal burden of government factor and the government intervention factor
  8. Robert J. Barro, "Rule of Law, Democracy, and Economic Performance," Chapter 2 in Gerald P. O’Driscoll, Jr., Kim R. Holmes, and Melanie Kirkpatrick, 2000 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., 2000), p. 36.
  9. World Bank, Doing Business 2007: How to Reform, p. 81.
  10. Ibid.
  11. See note 5.