Including U.S. State Government Regulation in the Economic Freedom of North America Index

Article excerpt

Abstract

The paper examines the Economic Freedom Index of North America (EFNA) and its ability to predict income in U.S. states. We show that including state government regulatory spending, using U.S. Census Bureau data on "Protective Inspection and Regulation, NEC" as the measure of regulation, improves the predictive power of our models. We conduct a number of robustness checks and construct a factor analysis model to show that the regulation spending variable contributes information that is currently not included in the EFNA. We argue that since regulation adds to the predictive power of EFNA, and is a theoretically essential component of economic freedom, it should be considered alongside the EFNA.

JEL Codes: H11, H70

Keywords: Economic freedom; Regulation; State government; Factor analysis

I. Introduction

Economic freedom, as defined by the Economic Freedom of North America Index (EFNA) (Karabegovic et al., 2003), is a measure of governmental impedance to economic activity. A high degree of economic freedom is necessary to insure and to help prolong robust economic activity and development (Karabegovic et al., 2003). The EFNA includes variables that measure the degree of protection for the property rights and whether individuals are coerced regarding economic transactions. The EFNA also measures the abiUty of individuals to make personal decisions. A high value of the EFNA impHes more economic freedom, which is to say, less governmental impedance to economic activity. The EFNA provides an index value for U.S. states and Canadian provinces that is comparable across time and location. Since its publication, the EFNA has sparked a small revolution in the academic Hterature and in pubUc discussions of policy, similar to the larger revolution created by the indices measuring economic freedom across nations (e.g., Gwartney, Lawson and Block, 1996; Gwartney, Lawson and Norton, 2008). So long as a poHcy or academic institution continues to pubUsh updated values of the EFNA, it will continue to have a substantial academic and public policy impact. We believe the EFNA to be the best established, most widely known, and most significant economic freedom index of U.S. states and Canadian provinces. Accordingly, in the remainder of this paper, we use the EFNA as our "straw man" to discuss economic freedom measures of the U.S. states in general. By doing so, we mean no particular criticism of the EFNA. Indeed, it was our appreciation of the significance and usefulness of the EFNA which motivated this paper.

Given the ongoing policy and academic significance of the EFNA, we believe the research community would benefit from periodic review of the components of any index measuring economic freedom. As researchers frequently use indices like the EFNA to explain various aspects of economies, such indices should include aU theoretically justified factors that influence the accuracy and robustness of the index. Any economic freedom index - international or subnational - can always be improved by inclusion of pertinent variables that wiU expand its explanatory power (Gwartney, Lawson, and Park, 2001). Gwartney, Lawson and Clark (2002) suggest that as the usefulness of economic freedom indices expand, so does the necessity to improve them by incorporating other variables that may improve their functionality. The goal of this research is to investigate whether regulation, which is theoretically linked to economic freedom, could improve the predictive power of an economic freedom index for U.S. states. We argue that economic freedom indices could be improved by including an essential component of government intrusion into the economy, state regulation expenditure.

The impetus of both the EFNA and the international indices was Friedman's Capitalism and Freedom (1962), in which he argues that economic freedom is required for human development and serves as a channel to political freedom. Friedman goes on to discuss how differences in nations' monetary policies and international trading and financial arrangements affect economic freedom. …