EDESUS Proceeding 2019 (46 of 1531) Impacts of Economic Freedom on Economic Growth in Developing Countries Dao Thi Bich Thuy(1)* VNU University of Economics and Business, Vietnam National University, Hanoi, Vietnam (*) Correspondence: thuydaokt@vnu.edu.vn Abstract: The purpose of this study is to investigate the impact of economic freedom on economic growth The study is conducted with 65 developing countries worldwide in the period from 1995 to 2014 The Index of Economic Freedom published by the Heritage Foundation is employed at both overall level and dimensional level comprises of nine sub-indices The finding reveals that economic freedom is a growth stimulus factor as a higher degree of economic freedom results in a faster economic growth At the dimensional level, seven out of nine economic freedom sub-indices show statistically effects on economic growth, of which have positive and have negative growth effects Business freedom, government integrity, trade freedom, tax burden and government spending are among the positive growth effect factors Investment freedom and property rights show negative effects on economic growth while monetary freedom and financial freedom have statistically insignificant effects This finding suggests developing countries would experience higher economic growth when there is improvement in business freedom, higher government integrity and trade freedom, less tax burden and lower size of government spending, less freedom in investment outflows and weak property rights Keywords: Economic growth; economic freedom index; developing countries Introduction Economic growth has always been at the heart of economic policy discussions, especially for developing countries, as a higher growth performance results in greater national output, potentially higher living standards for people and an enhanced ability to attain various economic and social objectives Among the many determinants of economic growth, interest is focused on economic freedom As Friedman, foreword in Gwartney et al (1996), views “free societies have arisen and persisted only because economic freedom is so much more productive economically than other methods of controlling economic activity” Conceptually, economic freedom refers to the level of freedom that individuals, entrepreneurs and businesses have to use their time and money in the way that they feel is best for them and free from unnecessary government restrictions and predation Economic freedom is believed to foster economic growth by affecting incentives, productive effort and the effectiveness of resource use (Erdal 2004) There are various efforts to quantify economic freedom and among them the two most popular indexes are the Fraser Institute’s Economic Freedom Index and the Index of Economic Freedom produced by the Heritage Foundation The Fraser Institute defines EDESUS Proceeding 2019 (47 of 1531) economic freedom as composed of personal choice, voluntary exchange, freedom to compete and protection of person and property The Fraser Institute’s Economic Freedom Index is established under five main dimensions which are size of government, legal structure and security of property rights, access to sound money, freedom to trade internationally and regulation of credit, labor, and business The Heritage Foundation defines economic freedom as “the absence of government coercion or constraint on the production, distribution or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself” In other words, people are free to work, produce, consume and invest in the ways they feel are most productive The Heritage Foundation Index of Economic Freedom is constructed based on the four pillars with 12 categories including rule of law (property rights, judicial effectiveness and government integrity), government size (tax burden, government spending and fiscal health), regulatory efficiency (business freedom, labor freedom and monetary freedom) and market openness (trade freedom, investment freedom and financial freedom) The relation between economic freedom and economic growth has received a great attention in literature At the overall level of economic freedom, a positive relation between economic freedom and economic growth is found in many researches (Wu and Davis 1999; Gwartney et al 1999; De Haan and Sturm 2000; Hanson 2000; Heckelman 2000; Vega and Alvarez 2003; Razmi and Refaei 2013; Akin et at 2014; Gorlach and Roux 2015; Mehnatfar et al 2015; Nadeem et al 2019) At the disaggregated level of economic freedom, the outcome shows rather conflicting results Based on the Fraser Institute’s freedom index, Carlson and Lundström (2002) studied 74 countries for the period 1975-1995 and found a positive effect on economic growth of only legal structure and freedom to use alternative currencies while smaller government, in terms of consumption, transfers, and taxes, is harmful to economic growth Justesen (2008) found that a small size of government and less regulation of business are factors enhancing economic growth Using 17 Middle East and East Asian countries’ data during 2000-2009, Razmi and Refaei (2013) showed that legal structure and security of property rights, freedom to trade internationally, regulation of labor, credit and business are positively related to economic growth, however, government size and access to sound money show a negative growth effect The study by Akin et at (2014) for 94 different countries grouping into five different income groups to cover the period from 2000 to 2010 revealed that the size of government is found to have a positive and statistically significant impact in upper-middle and lowermiddle income groups while it is not significant in high and low income groups Legal system and property rights have a positive impact for all income groups Sound money is positively related to economic growth only in high income OECD and in lower-middle income groups Trade freedom has a negative effect in high income group but a positive effect in low income group And only in high income OECD and low income groups, there is a positive and significant relation between regulation freedom and economic growth EDESUS Proceeding 2019 (48 of 1531) Gorlach and Roux (2015) investigated the relationship between economic freedom and economic growth for 13 SADC countries from 2000 to 2009 and concluded that all five components which are size of government, legal structure and security of property rights, access to sound money, freedom to trade internationally, regulation of labor, credit and business are highly significant and positively related to economic growth but yet the magnitude of the coefficients varies Nadeem et al (2019) analyzed the relationship between economic freedom index and GDP per capita growth of South Asian countries over the period of 1990-2015 The study found a positive relation between GDP per capita growth and economic freedom However, while size of government, property rights protection, trade freedom and regulations positively affect economic growth, monetary freedom shows a negative effect Using the Heritage Foundation’s freedom index, in his study for OECD nations in the 2003- 2007 period, Cebula (2011) found a positive relation between the growth rate of per capita real GDP and six forms of economic freedom which are fiscal freedom, business freedom, monetary freedom, property rights freedom, labor freedom and investment freedom The research by Hussain and Haque (2016) for 186 countries over the period 20132015 revealed that trade freedom, financial freedom, business freedom, labor freedom and fiscal freedom all have a positive impact on economic growth The relationship between economic freedom and economic growth still deserves much of interest Our study focuses on this relationship in developing countries We seek to answer two main questions of whether economic freedom is growth stimulus factor and how each dimension of economic freedom affects economic growth in developing countries Answering to the second question is more of interest, for it would suggest appropriate policies that governments in developing countries can take in order to foster economic growth Methodology The theoretical framework of the study is set in the context of Solow growth model The economy’s production function takes the Cobb-Douglas form where total output depends on stocks of physical capital and labor Yt eEF K t Lt t (1) where Y is total output, K is stock of physical capital and L is labor α and β are the factor intensity The degree of economic freedom EF is incorporated into the production function as a size effect The sign of θ reveals the relation between economic freedom and total output When θ takes a positive (negative) value, economic freedom shows a positive (negative) effect on total output In the case of θ equal to zero, economic freedom has no effect on total output Take the natural logarithm both sides of the production function, we can derive the growth equation as follow EDESUS Proceeding 2019 (49 of 1531) LnYt LnK t LnLt EFt (2) The equation shows how growth in total output is determined by growth in stocks of physical capital and labor and the change in the degree of economic freedom In particular, 1% increase in the stock of physical capital and 1% increase in the stock of labor results in α% and β% increase in total output respectively Beside, unit change in the degree of economic freedom results in θ% change in total output The empirical study is conducted with 65 developing countries worldwide in the period from 1995 to 2014 to investigate the impact of economic freedom on economic growth Index of Economic Freedom published by the Heritage Foundation is used to measure economic freedom The study aims to examine the growth effect of economic freedom at both overall and individual component level Due to the availability of data, out of 12 dimensions of economic freedom index are considered including property rights (PRR), government integrity (GIN), tax burden (TAB), government spending (GSP), business freedom (BUF), monetary freedom (MOF), trade freedom (TRF), investment freedom (INF) and financial freedom (FIF) The regression equations for the models are written as: Model LNGDPi ,t c LNK i ,t LNL i ,t EFI i ,t ei ,t (3) Model LNGDPi ,t c LNK i ,t LNL i ,t PRR i ,t SGIN i ,t 5TAB i ,t GSPi ,t BUFi ,t MOFi ,t TRFi ,t INFi ,t FIFi ,t ei ,t (4) where subscript i denotes country and t denotes time in year The independent variable LNGDP is natural logarithm of GDP For the explanatory variables, LNK is natural logarithm of stock of physical capital, LNL is natural logarithm of stock of labor and EFI is economic freedom index Model studies the effect of overall economic freedom on economic growth whereas Model investigates the growth effect of each dimension of economic freedom Data for GDP, physical capital stock and labor are taken from the Penn World Table (Feenstra et al 2015) To adjust for the effect of inflation, GDP and physical capital stock are measured at a constant price level (in 2011 USD) The stock of labor is measured by the number of employed people Data for EFI and its sub-indices are taken from the Index of Economic Freedom published by The Heritage Foundation The EFI has scores ranging from to 100 with a higher score indicates a higher degree of economic freedom Similarly, the EDESUS Proceeding 2019 (50 of 1531) score for each sub-index ranges from to 100 The raise in the score value for each sub-index means the increase in economic freedom that it nominates Data for all countries is collected in the same period of time that provides a strongly balanced panel data Panel data analysis requires controlling for time invariant and unobserved factors affecting the independent variables Since each country is specific on its own then the unobserved factors are referred to as country heterogeneity Regression analysis on panel data is conducted with STATA statistical software program Various diagnostics tests are conducted which show there are problems of cross-sectional dependence, serial correlations and heteroskedasticity With the presence of these problems in data, Torres-Reyna 2007 suggests to use the generalized least square method Results The regression results are presented in Table Table Impact of economic freedom on economic growth in developing countries Dependent variable: LNGDP: Natural logarithm of GDP Explanatory variables Model Model Coefficient P - value Coefficient P - value LNK: Natural logarithm stock of capital 0.677 0.000 0.674 0.000 LNL: Natural logarithm stock of labor 0.318 0.000 0.315 0.000 EFI: Overall economic freedom index 0.043 0.000 0.000 PRR: Property Right -0.024 0.004 GIN: Government Integrity 0.031 0.001 TAB: Tax Burden 0.025 0.007 GSP: Government Spending 0.017 0.010 BUF: Business Freedom 0.050 0.000 MOF: Monetary Freedom 0.009 0.293 TRF: Trade Freedom 0.019 0.003 INF: Investment Freedom -0.024 0.001 FIF: Financial Freedom -0.011 0.120 1.855 0.000 CONSTANT 2.199 0.000 Source: The author’s own calculations (see Appendix) As can be seen from the result table of Model 1, overall economic freedom index has a statistically positive effect on the growth of GDP, that is, economic freedom promotes economic growth A higher degree of economic freedom in terms of better rule of law, lower government size, more regulatory efficiency and larger degree of market openness would results in a faster economic growth In order to gain a better understanding of how economic freedom affect economic growth, Model reveals the outcome At the dimensional level, out of sub-indices of economic freedom show statistical effects on economic growth, of which have positive and have negative growth effects EDESUS Proceeding 2019 (51 of 1531) Among the growth stimulus factor, business freedom has the strongest impact Business freedom reflects the extent to which the regulatory and infrastructure environments constrain the efficient operation of businesses Many regulations hinder business productivity and profitability and likely distort competition Burdensome and redundant regulations are the most common barriers to the free conduct of entrepreneurial activity Increase in business freedom by reducing burdensome barriers to conducting business including regulatory red tape and high transaction costs will decrease the cost of production to business firms that leads to an increase in aggregate supply and finally a higher total output Government integrity has the second largest positive effect on economic growth Corruption erodes economic freedom by introducing insecurity and coercion into economic relations Systemic corruption of government institutions and decision-making is found with various practices such as bribery, extortion, nepotism, cronyism, patronage, embezzlement, and graft Improvement in government integrity with more transparency in government policymaking and governmental and civil service would increase public trust and economic vitality by reducing the transaction costs of economic activity and promoting fair competition Higher government integrity encourages economic activity and fosters economic growth Next is the growth effect of tax burden In the Index of Economic Freedom, a higher score for tax burden sub-index means less tax burden imposed on economic activity With a positive coefficient for tax burden variable, this suggests the lower the tax burden, the higher the economic growth Government taxes are imposed at individuals as well as business firms Lower tax burden increase the reward for individuals and businesses for their economic activity For individuals, lower income tax results in a higher personal income after tax that provides more incentive to undertake work Beside, higher income after tax induces people to consume more that stimulates aggregate demand and thus higher total output produced At the business firms, lower tax rates raise returns to business operation and increase firms’ incentives to pursue their goals in the marketplace and therefore increase the level of overall private-sector activity Come fourth is trade freedom In many countries, government place restrictions on trade in the various form of tariffs, export taxes, trade quotas, outright trade bans or in the form of regulatory barriers related to health or safety Trade freedom allows the free flow of foreign commerce, direct production incentives for local producers to the goods in which they have a comparative advantage and enjoy the benefit of economies of scale from mass production Trade freedom also put advanced-technology products and services to the reach of local entrepreneurs and expand their own productive development This raises overall economic efficiency and economic growth Finally, the size of government spending affects economic growth in different channels In a positive channel, government spending provides infrastructure, fund research for technology improvement, or human capital investment which increases productivity and thus faster economic growth In a negative channel, excessive government EDESUS Proceeding 2019 (52 of 1531) spending crowds out private economic activity Government spending which is financed by taxes and borrowing will distort the market allocation of resources and decrease private investment incentives Even worse, the growth of public sector may lead to bureaucracy, lower productivity, inefficiency, and mounting public debt that hinders economic growth The effect of government spending on economic growth depends very much on which channel will dominate the other In the Index of Economic Freedom, a higher score for government spending sub-index means a lower size of government spending A positive coefficient for government spending variable reveals that lower size of government spending leads to higher economic growth When the burden of government spending is less private sector has more chance to develop as more economic resources are allocated to this sector and since private sector is more efficient than public sector, this would contribute positively to economic growth The two economic freedom sub-indices including investment freedom and property rights are found to have negative effects on economic growth Firstly, a higher degree of investment freedom impedes economic growth This is not a surprise finding Investment freedom measures the free flows of capital across the borders, both inflows of international capital and outflows of domestic capital in the search for higher rates of return In the developing countries, economic growth relies very much on capital accumulation As shown in the result table, percent increase in capital stock leads to 0.67 percent increase in GDP, more than double compared to that of labor of 0.31 In many countries, governments while encourage the inflows of foreign capital often place restrictions on the movement of domestic capital to limit the outflows of capital Therefore, a lower degree of investment freedom in terms of higher restrictions on capital outflows can increase the stock of domestic capital in the countries and help to faster economic growth Property rights unexpectedly show a negative growth effect Property rights refer to the extent to which a country’s legal framework allows individuals to acquire, hold, and utilize private property, secured by clear laws that can be enforced effectively Secure property rights give citizens the confidence to undertake economic activity and make longterm plans because they know that their property are safe from unfair expropriation or theft One possible explanation for the negative growth effect of property rights in the developing countries would be that in many developing countries, private property rights, especially intellectual property rights are often violated Lack of or inadequate legal framework to protect intellectual property rights for foreign technology or new ideas would facilitate local businesses to expropriate advanced technology or new ideas that help to increase the production of goods and thus higher economic growth Conclusions Achievement of high and sustainable economic growth is considered a major objective for developing countries to increase their people’s living standards and in the hope to close the income gap with developed countries The empirical study on growth effect of economic freedom for 65 developing countries worldwide in the 1995-2014 period provides EDESUS Proceeding 2019 (53 of 1531) a robust evidence to support the idea that economic freedom indeed plays an important role in stimulating economic growth Several policy implications can be withdrawn from the study’s finding Developing countries would experience higher economic growth if governments are ready to improve the level of economic freedom To it, government should facilitate the development of private sector which seems to be more effective than public sector by creating a conducive business environment Efforts needed to lessen excessive business regulations, reduce burdensome barriers to conducting business and raise the degree of market friendliness for investors Government should improve government integrity as it helps to raise transparency, lower transaction costs of economic activity, increase public trust and confidence and promote fair competition Besides, there is the need to lessen tax burden on business firms and provide more room for private sector to grow via reducing the size of government spending For this, government should be ready to narrow its share in the nation’s economic activity Encouraging the inflow of foreign investment together with restrictions in the outflow of capital seems to be an effective policy as developing countries rely very much on capital contribution to economic growth Finally, while property rights show to have a negative effect on economic growth, government in developing countries must still pay attention to improve property rights because in the long run economic growth cannot be sustainable if property rights are seriously violated References Akin, C., Aytun, C., Aktakas, B (2014) The impact of economic freedom upon economic growth: an application on different income groups Asian Economic and Financial Review, 4(8): 1024-1039 Carlsson, F., Lundström, S (2002) Economic freedom and growth: decomposing the effects Public Choice, 112(3-4): 335-344 Cebula, R (2011) Economic growth, ten forms of economic freedom, and political stability: an empirical study using panel data, 2003–2007 Private Enterprise, 26(2): 61-81 De Haan, J., Sturm, J (2000) On the relationship between economic freedom and economic growth European Journal of Political Economy, 16(2): 215-241 Erdal, F (2004) Economic freedom and economic growth: a time series evidence from Italian economy Dostupno na: http://www etsg org/ETSG2004/Papers/erdal.pdf Feenstra R., Inklaar R., Timmer M (2015) The next generation of the Penn World Table American Economic Review, 105(10): 3150–3182 Gorlach, V., Roux, P (2015) The impact of economic freedom on economic growth in the SADC: An individual component analysis Studies in Economics and Econometrics, 39(2): 41-61 Gwartney, J., Lawson R., Holcombe R (1999) Economic freedom and the environment for economic growth Institutional and Theoretical Economics, 155(4): 643-663 EDESUS Proceeding 2019 (54 of 1531) Gwartney, J D, Lawson, R., Block, W (1996) Economic freedom of the world, 19751995 The Fraser Institute Hanson, J R (2000) Prosperity and economic freedom: a virtuous cycle The Independent Review, 4(4): 525-531 Heckelman, J (2000) Economic freedom and economic growth: a short-run causal investigation Journal of Applied Economics 3(1): 71–91 Heritage Foundation (Washington, D.C) and Wall Street Journal (1995) The index of economic Freedom Hussain, M., Haque, M (2016) Impact of economic freedom on the growth rate: a panel data analysis Economies, 4(2): Justesen, M (2008) The effect of economic freedom on growth revisited: New evidence on causality from a panel of countries 1970–1999 European Journal of Political Economy, 24(3): 642-660 Mehnatfar, Y., Zare , M., Hossini, S (2015) Analyzing the relationship between economic freedom and economic growth: the case study of South-West Asian countries Economics, Management and Trade, 9(4): 1-9 Nadeem, M., Jun, Y., Akhtar, T Dong, W and Niazi, M (2019) Does really economic freedom matter for growth in South Asia? Empirical evidences from pre-economic crises and post-economic crises period Asian Economic and Financial Review, 9(1): 52-63 Razmi, M., Refaei, R (2013) The effect of trade openness and economic freedom on economic growth: the case of Middle East and East Asian countries International Economics and Financial Issues, 3(2): 376-385 Torres-Reyna, O (2007) Panel data analysis fixed and random effects using Stata, from Vega, G.M., L Alvarez 2003 Economic growth and freedom: a causality study Cato Journal, 23(2): 199-215 Wu, W., Davis O (1999) The two freedoms, economic growth and development: an empirical study Public Choice, 100(1-2): 39-64 Appendix Model EDESUS Proceeding 2019 (55 of 1531) Cross-sectional time-series FGLS regression Coefficients: Panels: Correlation: generalized least squares homoskedastic no autocorrelation Estimated covariances = Estimated autocorrelations = Estimated coefficients = lngdp Coef lnk lnl efi _cons 6774394 3188659 0432437 2.199405 Number of obs Number of groups Obs per group: avg max Wald chi2(3) Prob > chi2 Std Err .0119651 0118577 0113521 1182935 z 56.62 26.89 3.81 18.59 = = = = = = = 1263 65 16 19.43077 20 38718.47 0.0000 P>|z| [95% Conf Interval] 0.000 0.000 0.000 0.000 6539882 2956252 020994 1.967554 7008905 3421066 0654934 2.431256 Model Cross-sectional time-series FGLS regression Coefficients: Panels: Correlation: generalized least squares homoskedastic no autocorrelation Estimated covariances = Estimated autocorrelations = Estimated coefficients = lngdp Coef lnk lnl prr goi tab gsp buf mof trf inf fif _cons 6742133 3156273 -.0239522 0312328 0247616 0169165 0501158 0098186 0191851 -.024131 -.0114806 1.85563 12 Std Err .0127111 0131435 0082739 0096825 0092481 006555 0093357 0093347 0064908 0070603 0073906 1440753 Number of obs Number of groups Obs per group: avg max Wald chi2(11) Prob > chi2 z 53.04 24.01 -2.89 3.23 2.68 2.58 5.37 1.05 2.96 -3.42 -1.55 12.88 P>|z| 0.000 0.000 0.004 0.001 0.007 0.010 0.000 0.293 0.003 0.001 0.120 0.000 = = = = = = = 1225 65 12 18.84615 20 41041.83 0.0000 [95% Conf Interval] 6493 2898665 -.0401688 0122555 0066357 0040689 0318182 -.008477 0064634 -.0379689 -.025966 1.573247 6991266 3413882 -.0077357 0502102 0428875 029764 0684134 0281143 0319069 -.0102931 0030048 2.138012 ... effect on economic growth Corruption erodes economic freedom by introducing insecurity and coercion into economic relations Systemic corruption of government institutions and decision-making is... examine the growth effect of economic freedom at both overall and individual component level Due to the availability of data, out of 12 dimensions of economic freedom index are considered including... table of Model 1, overall economic freedom index has a statistically positive effect on the growth of GDP, that is, economic freedom promotes economic growth A higher degree of economic freedom in