The effect of economic freedom on income inequality

Every now and then we seem to hear about the failings of capitalism. Disregard for the environment, negligence of workers’ welfare, overemphasis on profits, and especially a widening wealth gap have all been pinned on our new favourite scapegoat.

It would be worth noting that while capitalist economies and free markets have overlapping qualities, and are often used interchangeably, they are not exactly identical. Features of capitalism include personal ownership of property, open competition, and individual incentives, whereas a free market is ruled by supply and demand, with little or no government intervention. I would argue that both go hand-in-hand in promoting economic freedom, which in a liberal viewpoint is the freedom to trade with minimal government regulations and without deception or coercion.

Free market capitalism has long been associated with wealth creation. Things like innovation, entrepreneurship, business investment, all attracted by incentives, have led to huge growth in economies. As of 2018, over half of the world population live in households that are considered to be ‘middle class’ or ‘rich’. Considering that in 1800, 81% of the people lived in poverty, our current economic system has done us a great service.

A study published by the American think tank NCPA states that ‘freer economies enjoy higher rates of economic growth than less free ones’, and that ‘they are more equal economies; economic freedom reduces inequality by increasing the share of market income going to the poor and lowering the share going to the rich’. Sounds good, right? Well, by avoiding taxes, influencing politics, and pushing down wages, big corporations and the rich have fueled the inequality crisis instead. Moreover, an Oxfam report has found that eight men own just as much wealth as (the poorest) half of the human population. Might it be a possibility that although income inequality is rampant nowadays, it used to be worse? Unfortunately, between 1988 and 2011, incomes of the poorest 10% grew by just $65 per person, while the incomes of the richest 1% rose by $11,800 per person – 182 times as much. This only shows that the economic model most of the world is running on is flawed in practice and desperately needs reform.

As the economic freedom score increases, economic inequality, as measured by the Gini coefficient, decreases.

However, the NCPA study has found that ‘nations that have more economic freedom have a more equal income distribution’. According to the author’s calculations, ‘the effect of a one-unit increase in economic freedom, holding the economic growth variable constant, is to lower the Gini coefficient by 0.012 points’. This means that economic freedom (marginally) decreases income inequality. The Gini coefficient expresses income inequality with an index, with 0 being perfectly equal and 1 meaning maximum inequality.

We are therefore presented with very mixed results. On one hand, economic freedom has promoted economic growth, which indisputably has raised standards of living in the past century, allowing us to live in a more equal society. On the other hand, there is evidence that income inequality has increased drastically instead. Economics differs from hard sciences in that it is difficult to carry out research and draw conclusions from experiments in a controlled environment. In ‘On the ambiguous economic freedom–inequality relationship’ (the name says it all) by Bennett and Nikolaev, we are told that results vary with samples, time periods and methods of measuring inequality, due to empirical heterogeneity. Thus conclusive results are hard to find.

So the truth is, we don’t know. If someone had figured out how to maintain the perfect balance of economic growth, freedom, and equality, you wouldn’t be reading this article right now, and the studies cited above would not be necessary, or show contradictory findings. What we do agree on is that income inequality is harmful – a section of society is disproportionately affected. If they are not presented with the appropriate resources, resource inequality becomes a problem, and some people will not be able to access quality education, healthcare, and equal opportunities, which are beneficial to improving human capital, and making it easier for people to break out of the cycle of poverty.

(Cover image taken from the American Economic Association)