Academic journal article Contemporary Economic Policy

The Relationship between Economic Freedom and Economic Dynamism

Academic journal article Contemporary Economic Policy

The Relationship between Economic Freedom and Economic Dynamism

Article excerpt

We analyze the consequences of economic freedom on economic dynamism across U.S. states and over time. Using data from the Economic Freedom of North America index, we show that states with greater economic freedom have higher rates of gross and net job creation and establishment entry. The results are robust to the inclusion of many different control variables and alternative specifications, suggesting a connection between freedom and dynamism. This evidence supports theories in which government policies may impede business dynamism. (JEL 043, P16, R5)

I. INTRODUCTION

Economic dynamism--changes in an economic system over time--plays a major role in modern economies. New products are created, old ones are destroyed. New businesses open their doors, old ones close up shop. Firms continually hire and fire workers. In this paper, we show that constructed economic freedom indexes are strongly correlated with the pace of economic dynamism across states over time.

We merge the "Economic Freedom of North America," originally constructed by Karabegovic et al. (2003), with U.S. Census data on entry and exit rates of establishments and rates of job creation and destruction to form a 33-year panel. We measure economic dynamism by following Davis and Haltiwanger's (1992, 1999) definition of "gross reallocation" and "net creation." Gross reallocation is defined as the sum of jobs (establishments) created and jobs (establishments) destroyed. Net creation is defined as the difference between jobs (establishments) created and jobs (establishments) destroyed. Underlying these definitions is the notion that dynamic economies feature substantial creation and destruction. As new establishments are created, inefficient ones exit and their factors of production are reallocated to the entering and existing establishments. Even after controlling for differences across states and over time, the level of a state's economic freedom is positively correlated with all four measures of economic dynamism. All else equal, a one standard deviation increase in the freedom index is associated with a 0.71 percentage point increase in the net establishment entry rate and a 1.02 percentage point increase in the net job creation rate. Most of these results are estimated precisely using standard levels of statistical significance and are robust to a range of alternative specifications. Moreover, breaking the freedom index into its subindexes shows that labor market freedom--in the form of the percent of the workforce unionized, minimum wage, and the share of government employment--and, to a lesser extent, the size of government are the primary drivers of these results. Discriminatory taxation, on the other hand, is actually negatively correlated with economic dynamism.

The results suggest that various policy reforms may increase the rate of economic dynamism. However, without having a model that prescribes an optimal rate of establishment and job creation and destruction, there is no way to know whether such reforms would be desirable. For all the benefits of greater turnover, namely the creation of innovative businesses and the reallocation of factors of production to more efficient establishments, such innovation and reallocation are costly. A social planner would equate marginal benefits and costs, but this imaginative planner's problem is not presented in this paper. However, conditional on having such a model, the results suggest ways to increase or decrease the pace of dynamism.

II. LITERATURE REVIEW

Our paper is most closely related to the literature which examines the relationship between economic freedom and a variety of economic outcomes. There has been a substantial number of papers written on an international scale since the Economic Freedom of the World index was published by Gwartney, Lawson, and Block (1996). (1) From an American perspective, many authors have used Karabegovic et al. 's (2003) Economic Freedom of North America index, now published annually by the Fraser Institute. …

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