Does economic freedom increase income inequality? Evidence from the EU countries

Abstract

This paper examines the relationship between economic liberalization and income inequality in the EU using panel data for the 2000s. The empirical evidence suggests that economic freedom is strongly related to income inequality. However, not all areas of economic freedom affect income distribution similarly. Government size is robustly associated with inequality, and also when controlling for potential endogeneity in a dynamic panel data analysis. Regulation is linked to income inequality as well, whereas legal system and sound money have no significant effects on income distribution. In the case of freedom to trade internationally, the relationship differs between old (EU-15) and new (former socialist) EU countries.

Keywords:

• economic freedom
• income inequality
• European Union

JEL Classifications:

• C82
• D31
• E02
• O52

Acknowledgements

The authors are grateful for the helpful suggestions from seminar participants at the University of Malaga and the University of Florence, and from discussions at the XII Economic Policy International Conference and the 6th Meeting of the Society for the Study of Economic Inequality (ECINEQ). In addition, we thank Giovanni Andrea Cornia, Stephen Jenkins, María E. Rochina-Barrachina, and two anonymous referees for their useful comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Although relative poverty is a different concept, relative income poverty and income inequality are closely related. In order to check the robustness of the results in our panel data analysis, we additionally take into consideration the at-risk-of-poverty rate (cut-off point: 70% of median equalized income) from Eurostat as a dependent variable in the sensitivity analysis.

2. Income must be understood as equalized disposable income after taxes and social transfers. It is the total income of a household, after tax and other deductions, that is available for spending or saving, divided by the number of household members converted into equalized adults; household members are made equivalent by weighting each according to their age, using the so-called modified OECD equivalence scale (Eurostat 2014).

3. All the data and other information are available at http://www.freetheworld.com.

4. Berggren (2003, 193) reminds that, in econometric analysis, economic freedom is usually an independent variable. However, economic freedom may also be affected by other variables and thereby constitute a dependent variable, possibly influenced by factors such as political freedom, wealth, or democracy. In any event, economic freedom also may have an intrinsic value; if so, the consideration of economic freedom as a dependent variable may likewise become more accurate.

5. The HFI measures 10 specific components of economic freedom that are classified in four categories: (i) rule of law (property rights, freedom from corruption), (ii) government size (fiscal freedom, government spending), (iii) regulatory efficiency (business freedom, labor freedom, monetary freedom) and (iv) market openness (trade freedom, investment freedom, financial freedom). As can be understood, the components of the HFI relatively differ from those of the EFI and there is not a direct correspondence, making complex an accurate comparison between them.

6. Let us recall that in the fixed effects model ζ_i is allowed to be correlated with the regressors, while continuing to assume that such regressors are uncorrelated with the idiosyncratic error ω_it.

7. To express both indices in the same scale, the original HFI data have been divided by 10.

8. Basically, this hypothesis claims that growth and inequality are related in an inverted U-shaped curve: inequality would increase over the initial stages of development as an economy transforms from rural to urban and from agricultural to industrial and, subsequently, inequality would decrease as the labor force in the industrial sector expands and that of the agricultural sector falls (Kuznets 1955).

9. In order to consider possible unobservable time effects additionally to unobservable individual effects, we also estimate fixed effects regressions with Driscoll–Kraay standard errors including time dummies for all specifications. The results remain robust. They are available upon request.

10. Let us recall in this context that over half of the EU countries are members of the euro area and share a common monetary policy. In particular, in 2010, 16 out of 27 EU countries were part of this economic and monetary union.

11. We should also take into account that the EU countries follow a common policy on international trade.

12. Theoretically, one of the channels linking economic freedom and income inequality is through economic growth, as economic freedom encourages growth. Given that GDP per capita seems to lead to increased income inequality in the EU countries, our empirical evidence would not support that economic freedom reduces inequality through economic growth.

13. Note that when using inequality measures provided by the OECD, we only take into account 21 EU countries, excluding Bulgaria, Croatia, Cyprus, Latvia, Lithuania, Malta, and Romania. In these cases, EFI4 (Freedom to trade internationally) is negatively and significantly related to inequality.

14. Another concept related to some extent to income inequality is income mobility, which takes into account that people can change their position on the income distribution scale over time and can belong to different income deciles. Using data from Eurostat (2006–2010), for transitions from the previous year’s situation to more than one income decile up/down, we find that EFI1 and EFI2 are positively associated with income mobility, while EFI3 and EFI4 are negatively associated. Results available upon request.

15. There are 11 countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia.

16. The last enlargement of the EU-15 was in 1995, when Austria, Finland and Sweden joined.

17. The maximum lag of instruments is set as three to avoid using too many instruments.