Most economists now agree that “economic freedom”, “institutional quality”, or “market institutions” matter greatly for economic growth. However, there is still much debate around how these factors matter for the share of income distribution across society. Essentially, there are questions as to whether that economic growth is shared broadly amongst society. While economic growth is typically associated with “good” outcomes, there are concerns that if those income shares only go to those at the top, there may not be a society-wide benefit to economic freedom.
Two recently published scholarly articles of mine seek to empirically test these concerns about the role of “capitalism” in determining income inequality and economic mobility. One, with Vincent Geloso at George Mason University, examines the role of economic freedom in determining intergenerational income mobility. Another, with Andrew Young at Texas Tech University, looks at how economic freedom changes incomes, income shares, and income inequality at each decile (as well as for the top 5% and 1% of the income distribution).
Theoretically, the relationship between economic freedom and inequality could go in either direction (in fact, the empirical results are quite scattered). Economic freedom might drive people to put their effort toward productive uses, as contended by economist Arthur Okun. This productive activity, while making an economy better off, might not be taken advantage of by everyone in a society, necessarily creating inequalities. Furthermore, greater economic freedom usually means lower government spending, inevitably meaning that less money is being given to the poor, increasing inequality almost tautologically. However, economic freedom may decrease inequality if property right protections and lax regulatory policies create opportunities for the poor. Of course, this “economic freedom” must be available to all of a society, and not just those who are politically connected or in the majority, if such policies are to ever have the chance to decrease inequality.
A similar theoretical relationship exists between economic freedom and income and social mobility. Governments could theoretically spend scarce funds and improve the welfare of those at the very bottom, helping them to escape the poverty trap. However, there are surely diminishing marginal returns to such a strategy, insofar as “too much” support can fixate one in their own economic position, thereby removing the opportunity and incentive to improve one’s economic standing. However, the removal of government-induced barriers (occupational licensing, starting business regulations, and the protection of property rights) are also ways in which governments (by “getting out of the way” and providing stable rules, regulations, and protections) can allow one to increase their chances of raising the income ladder.
To that end, I find in a report for the Archbridge Institute strong protections of property rights and high quality legal systems, particularly the control of corruption and independent court systems are important for intergenerational mobility both within the United States and across countries. Similarly, in another Archbridge Institute report, I show that the “environment for entrepreneurship” (lax business regulations, impartial bureaucratic institutions, and business dynamism) can improve mobility.
Economists have recently been focused on the inequality of outcomes. Notably, Nobel Prize-winning economists Amartya Sen and Gary Becker, have discussed how income inequality is tied to income mobility and, in turn, to inequality of opportunity. They propose a simple mechanism whereby inequality of outcomes in previous periods reduces the real choice set for poor people. While in free societies, one is of course “free” to do what they see as best, the existing inequality in an area greatly influences the actual opportunities afforded to the poor. The rich, on the other hand, gain access to even more opportunities. This relationship has been coined the “Great Gatsby curve”, meaning that there is a negative relationship between society’s inequality and their intergenerational income mobility.
The role of economic freedom, though, has long been ignored with respect to intergenerational economic mobility. This casting aside of economic freedom is problematic. Unequal societies might be unequal precisely because they are economically unfree—the lack of economic freedom locks the poor in their initial position. But there’s also an indirect impact of economic freedom, mainly through economic growth. Again, it is widely accepted that these institutional structures make society richer. Whether or not economic growth is perfectly distributed across a population, if the poor receive any of the benefits of economic growth (via economic freedom), then they are made better off. If they are better off, they are more likely to be able to escape their initial conditions.
In both of these studies, I (along with my co-authors) use the measurements of economic freedom from the Fraser Institute’s Economic Freedom of the World index. This index measures the state’s influence on the size and scope of government, legal system and protection of property rights, monetary policy, freedom to trade internationally, and regulatory policies.
Typically utilized measures of income inequality, Gini coefficients, can mask a lot of valuable information about the distribution of income. This is not to suggest that the Gini coefficient is unimportant; but, trying to assess income inequality by using one single measurement hides data about the actual inequality of income. To address this, Andrew Young and I use income shares at all ten deciles, as well as for the top 5% and top 1% income earners. We also look at the average income of someone in each decile. Casual observations suggest that more “capitalistic” societies have more of their income going towards the bottom 10% of income earners and less going to the top, with few exceptions. For example, Slovenia (who scores in the second quartile of countries in economic freedom) had the largest share of income received by the bottom 10 percent (4%) and the lowest share going towards the top 10 percent (20.7%). Countries like Zambia, Sierra Leone, and Jamaica (which all have below average economic freedom scores) consistently have the lowest shares of income going towards the bottom 10% (less than 0.3%). South Africa and Zambia have the largest share of income going to the top 1% (each over 37%).
Our empirical results, which examine large increases in economic freedom and the subsequent impact on changing income shares and average incomes at each level, find that incomes at all deciles increase substantially following a shift toward greater economic freedom. Over five years, incomes increase 15-20% higher than expected, which is quite substantial. The income increases are highest for the top 20% and bottom 30%. This is of course to not say that the “middle class” is not benefitting, but just by a marginally lower magnitude. There is very little evidence that income shares change, but there is a slight increase in Gini coefficients, suggesting a rise in income inequality. However, this increase in Gini coefficients is less than 1 point (out of a possible 100). So while income inequality slightly increases, the effect is small compared to the broader income growth experienced throughout society. When looking at which components of economic freedom matter for income growth, we find that good monetary policy and lax regulatory policy are the biggest contributors. This coincides with previous studies that show how inflation harms the poorest the most. Regulatory policies, which limit one’s ability to start their own business or enter certain fields without the proper licensing and state approval, mainly help the middle class according to our findings.
The results here suggest that average incomes grow substantially following a move toward greater economic freedom. While there is some evidence that income inequality (as measured by Gini coefficients) does increase, this effect is mild relative to the vast gains seen in income growth at all levels of the income distribution. This does not speak, though, to one’s ability to move across different income deciles.
If incomes grow at each decile, what then happens to one’s ability to improve on the income “group” that they were originally in? Here, I explain my work with Vincent Geloso on intergenerational income mobility. By intergenerational income mobility, we mean the relationship between someone’s income and the incomes of their parents. If this relationship is high, then the country is said to have a great deal of income persistence; however, if this relationship is low, then one’s early family income is not determinative of their economic lot in life.
Again, the institutional environment matters greatly. To illustrate this case, I’ll briefly describe an article by my co-author, Vincent Geloso and Vadim Kufenko. They look at the impact of income inequality in the Olympics, and if this effect is different for economically free countries. The main idea is that intrinsic talent is unattached from one’s income and upbringing. However, the development of that talent is costly and does have to do with one’s income and upbringing. Their research finds that countries with highly unequal societies win fewer medals, likely because they were unable to send the truly “best” athletes needed to compete. This is because their skillsets were never actually fostered due to the level of income inequality. In places with high levels of economic freedom, though, this effect goes away. This suggests that free areas can alleviate the inequality effect by providing the incentives needed to invest in athletes’ own skillsets.
If we think of this in terms of the broader economy, this suggests that innate entrepreneurial talent is evenly distributed across society. However, the actual opportunities are lower in very unequal areas, but can be realized better (and have the income inequality effect mitigated) in economically free areas. This certainly does not ignore the “Great Gatsby” curve argument, where income inequality can harm mobility. However, such an argument does not tell the full story. Where property rights are secure, the appropriation of monetary gains from entrepreneurship is present and there to be realized. Secure property rights and broad economic freedom mean that the lure of gains provides an incentive to invest in skills needed to succeed, whether that be in the Olympics or in the broader economic sphere.
Vincent and I argue that there is a direct effect of economic freedom on mobility, but also an indirect one (via economic growth). We first start by showing, as the vast majority of studies do, that economic freedom (and each of its components) greatly increase incomes. We also find evidence of the “Great Gatsby” curve, or a negative relationship between income inequality and mobility. Furthermore, we find that income per capita is related to less income persistence (or greater income mobility). In this indirect channel, economic freedom and its areas improve mobility, but only through higher incomes.
We further this analysis by showing that economic freedom has an independent effect on economic mobility that is unrelated to incomes. We still find that economic freedom influences mobility. In fact, it often has a stronger effect than income inequality! This speaks back to the Olympics example given— economic freedom can mitigate the effect of income inequality in determining one’s chances at improving their life.
The results from these two studies suggest at least one very strong conclusion. First and perhaps most interesting is that economic freedom has a positive influence on both one’s ability to increase their standing in life (and be less dependent on who their parents were) and can increase the incomes of those in a given income decile position. This suggests that economic freedom can help increase one’s opportunities for being able to “move up” in society, but also increase the incomes of those who stay in the same relative position.