Right and Wrong about Declining U.S. Economic Freedom

The Fraser Institute in Vancouver, Canada has released its annual Economic Freedom of the World report. One of the most striking findings of this year’s report, which is based on data from 2010, is that the United States now ranks 18th in the world! In the early 1970s the U.S. economy was in the top-three in the world in terms of freedom.

The plunge of the American economy is even more remarkable given that in 2007, only three years earlier, we ranked 5th.

So what happened? Did the Obama administration and its cronies in the Democrat-led Congress between the 2008 and 2010 elections really do that much damage to the U.S. economy in such a short period of time?

The Fraser Institute explains the U.S. decline as depending predominantly on growth in government spending. This is indeed true, but there are other nasty little secrets hidden in the report. Over the last three years reported, the U.S. economy has fallen more significantly behind the world leader, Hong Kong, in other areas than government spending. We are 7.1 percent worse off vs. Hong Kong when it comes to bloating the government budget, but we have fallen 10.7 percent in terms of regulations.

More specifically, again compared to Hong Kong:

  • Labor market regulations, 3.0 percent worse than in 2007;
  • Business regulations, 5.6 percent worse than in 2007; and
  • Credit market regulations, 22.3 percent worse than in 2007.

Access to credit is critical for business growth. This is now an area where the federal government, relying on the irresponsible Dodd-Frank act, has gotten its fingers deep into the cookie jar and is trying to decide who gets credit and who doesn’t. Mark Calabria at the Cato Institute makes this point well:

After two years of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a few of the landmines hidden in its hundreds of pages are starting to come to the surface. Under Section 1071, Subtitle G, labeled “Regulatory Improvements” (who says Congress doesn’t have a sense of humor?), the act establishes a system of small business loan data collection. The claimed purpose is to “facilitate enforcement of fair lending laws and enable communities, governmental entities and creditors to identify business and community development needs and opportunities of women-owned, minority-owned, and small business.” Translation: Push affirmative action in small-business lending. Recall that the same scheme of statutory social engineering contributed to the boom in subprime lending that eventually imploded the mortgage market. It appears Dodd-Frank is determined to drive small business lending down the same path.

Politics, not people, decide who gets to start a business and who has to sit on the sidelines.

Curiously, noting the expansion of government in this area and in other regulatory areas, it is interesting that the Fraser Institute also reports a deterioration of freedom in another category, namely “extra payments/bribes/favoritism”. Here, America was 12 percent worse off vs. Hong Kong in 2010 than we were in 2007. Is this a sign that a growing government bureaucracy is creating informal pathways through the regulatory jungle?

There is no doubt that the Economic Freedom of the World report is a wake-up call for American legislators to do something to put this great country back on its right track. But we should also keep in mind that while this report is methodologically impressive and published by the reputable Fraser Institute, its emphasis on regulations produces markedly different results than, e.g., the Index of Economic Freedom report by the equally reputable Heritage Foundation. In the latest IEF report, the United States ranks 10th, ahead of many countries that in the EFW report end up ahead of us.

One important reason for this difference is that the Heritage Foundation has designed its study to put more emphasis on taxes than regulations. This does not mean that they consider regulations unimportant, but Heritage takes a more cautionary approach to the impact of regulations such as Dodd-Frank:

The impact of the recently passed financial reform bills has yet to be measured, as detailed regulations are gradually emerging. However, they are likely to increase compliance costs, complicating the banking sector’s recovery.

In other words, we need to translate the cost of regulations into something that resembles a tax before we can measure its true economic impact.

It is also important to remember that taxes tend to impact private-sector economic activity on a continuous basis, while the impact of regulations is more discretionary (or structural, if you will). While taxes tend to affect daily economic activities, regulations pay their biggest role when entrepreneurs and consumers face decisions on whether or not to make significant changes to their economic activities, such as starting or expanding a business, making a new investment, buying or selling property, even getting a new job.

Over time, the costs of taxes and regulations obviously have a major impact on the economy, and long-term it really does not matter whether an economy taxes or regulates itself to death. But it is also important to keep in mind that both taxes and regulations are ultimately driven by the ideological notion that government has a role to play in the economy in the first place. That is of course not the case. If we truly want to restore economic freedom, we need to comprehensively, and with the long term in mind, redefine the role of government in our economy and our society.

Only then can we take a principled, sustainable approach to taxes and regulations.

One approach would be to pass an Economic Freedom Amendment to the U.S. Constitution.

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