- freely available
Economies 2017, 5(2), 18; https://doi.org/10.3390/economies5020018
2. Review of Literature on Income Inequality Links to Liberalization and Democracy
2.1. Inequality and Economic Liberalization
- Size of government: This component measures government size via indicators like government consumption and transfers as a share of GDP, state-owned enterprises, and top marginal tax-rates. It is coded in a way that larger size of government received less freedom score. Thus, a positive relationship to income inequality is expected since larger government normally leads to lower inequality. In other words, larger government size as a result of greater welfare spending and increased public sector transfers is expected to reduce income gap as such spending and transfers are meant for various income-equalizing policies like child benefits, free education and healthcare etc.
- Legal system and property rights: This component focuses on the protection of property rights via rule of law, independent and unbiased judiciary, and impartial and effective enforcement of the law. Intuitively, protection of property rights is thought to mainly benefit those with properties which are normally the high income earners. Protection increases the value of the properties leading to rising earnings of this group, and consequently creating a larger gap with the low income earners in the country. Thus, we may expect a positive relationship of this component to inequality.
- Access to sound money: Economic exchanges require money. This component receives low scores when the value of money is volatile due to inflationary pressure and unpredictable monetary policy. Thus, a negative association with income inequality is expected since the cost of inflation in term of returns to capital and lending rates are expected to be relatively more detrimental to low income earners whose assets are less protected against inflation. This leads to wider gap between the top and bottom earners within a population.
- Freedom to trade internationally: This component captures various protectionist measures like trade taxes, tariff rates and trade barriers and capital market controls. According to Heckscher-Ohlin theory, openness to international trade is expected to reduce (increase) income inequality in developing (developed) countries. This is because increased demand for low skilled workers that are abundant in developing countries is expected to exert a downward pressure on the wage gap between skilled-unskilled labors. Nevertheless, this proposition is still debatable due to differing theoretical approximations taking into account degrees of openness, different assumptions in term of factors supply and mobility, and unequal level of technology between the trading countries.
- Regulation of credit, labor and business: The final component of EFW focuses on the regulatory constraints that limit the freedom of exchange in credit, labor and product markets. Deregulation provides greater access to credit to all population segments including the low income earners to support their economic ventures and this subsequently may improve their incomes. Nevertheless, positive distributive effect of deregulation may not be realized in a situation when political elites can influence the deregulation policy. Therefore, there is no clear indication in the direction of inequality-effect of this component.
2.2. Inequality and Democracy
- Median voter theory: This theory argues that, based on rational choice of redistribution, the median voters would choose redistribution and higher taxation for rich people if the median income lies below the mean income. This theory thus predicts that income inequality is lower in a democracy than an autocracy.
- Political participation mechanism: Via this mechanism, democracy is expected to lower the costs of political participation, giving rise to strong and organized labor unions, political parties and interest groups representing the low and middle income groups. These groups would then push for more welfare-augmenting policies such as minimum wage that reduce wage dispersion.
- Political competition mechanism: This mechanism highlights the importance of electoral connection. Reelection-oriented democratic leaders would compete for citizen support, and consequently invest more in meeting the needs of the larger segments of suffrage who are normally the low and middle income earners. To win the voters’ support, they would adopt various redistributive measures such as welfare spendings and benefits, greater access to education and healthcare, price subsidies, and other public services provisions.
3. Data, Econometric Specification and Empirical Strategy
- size of government (henceforth denoted EFW1),
- legal system and property rights (EFW2),
- access to sound money (EFW3),
- freedom to trade internationally (EFW4), and
- regulation of credit, labor, and business (EFW5).
3.2. Econometric Specification
3.3. Empirical Strategy
4. Results and Discussion
4.1. Baseline Results
4.2. Summary of Baseline Results
4.3. Sensitivity Analysis
4.4. Economic Freedom-Inequality Relationship in Different Regimes
5. Conclusions and Policy Implications
Conflicts of Interest
|Variable||Mean||Std. Dev.||Min||Max||Total no. of obs.||No. of Countries||No. of Periods (avg)||Data Sources|
|Gini net||36.93||9.58||16.11||65.72||789||115||6.9||SWIID5.0 (Solt 2014)|
|Gini gross||45.26||7.96||20.13||75.29||789||115||6.9||SWIID5.0 (Solt 2014)|
|EHII Gini||41.44||6.97||22.34||56.38||531||104||5.1||UTIP (Galbraith et al. 2014)|
in The World
(Gwartney et al. 2010)
|IP2||0.74||0.44||0||1||769||115||6.7||Hadenius and Teorell (2007)|
|ANRR||0.74||0.44||0||1||769||115||6.7||Acemoglu et al. (2015)|
|BMR||0.66||0.47||0||1||769||115||6.7||Boix et al. (2013)|
|CGV||0.67||0.47||0||1||769||115||6.7||Cheibub et al. (2010)|
|Real GDP per capita||13,597.06||13,313.61||436.55||90,604.64||762||113||6.7||PWT9.0, Feenstra et al. (2015)|
|Education||6.99||6.26||0||30.9||750||109||6.9||Barro and Lee (2013)|
|Age dependency ratio||64.91||18.18||34.96||112.84||747||113||6.6||World Development Indicator (WDI) World Bank (2016)|
|Emp. in industry||23.90||8.29||2.2||45.6||544||110||4.9|
|Emp. in service||53.47||16.78||5.6||83.6||544||110||4.9|
|Gini Net||Gini Gross||EHII Gini||Real GDPpc||Education||Agedep||Urbanpop||Empind||Empserve|
|Real GDP pc||−0.556||−0.130||−0.706|
|High Income (42 Countries)||Upper Middle Income (31 Countries)||Lower Middle Income (26 Countries)||Lower Income (16 Countries)|
|Austria||Algeria||Bangladesh||Central African Republic|
|Czech Republic||Costa Rica||Guatemala||Nepal|
|Israel||Malaysia||Papua New Guinea|
|Korea, Republic of||Namibia||Syria|
|New Zealand||South Africa|
|Trinidad and Tobago|
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A necessary caveat is required when interpreting the inequality-effect of democracy, and it is discussed more in the results section.
See https://www.fraserinstitute.org for more information on the economic freedom index definition, areas and methodology to compute the index. For a more detailed discussion on the theoretical links and empirical evidence of five areas of economic freedom to inequality, see Bergh and Nilsson (2010).
For more details, see https://freedomhouse.org/report/methodology-freedom-world-2017.
See Bergh and Nilsson (2010) for discussion on the superiority of Gini coefficient from SWIID as compared to World Income Inequality Database (WIID) of UNU-WIDER, Standardized Income Distribution Database (SIDD) created by Babones and Alvarez-Rivadulla (2007) or Luxembourg Income Study (LIS) etc. On the other hand, Jenkins (2015) recommends the use of WIID over SWIID although his recommendation is conditional. It is noteworthy that Jenkins, in discussing his concern regarding SWIID imputation exercise that may lead to the risk of bias estimates, refers to SWIID version 4.0, and this paper uses the latest SWIID version 5.0.
EHII dataset is downloadable at http://utip.gov.utexas.edu and available up until to 2008 only.
Specifically, the average score of political rights and civil liberties is transformed to a scale 0–10, as is Polity2 score of −10 to 10. Subsequently these transformed scores are averaged into an imputed version of Polity 2 with final score between 0–10. In the event that data on Polity 2 is missing, this imputed version generate imputed values for countries by regressing Polity 2 scores on the average Freedom House measure.
Venezuela status as a “partly free” country is remarked as trending down after the election of new president following the death of Chavez in 2012—see the country’s detailed report especially in year 2014 onwards on the Freedom House website here: https://freedomhouse.org/report/freedom-world/2014/venezuela. In the latest 2017 report, Venezuela however is now classed as “not free.” Meanwhile Russia has been classed as “not free” since 2005, prior to that year was classed “partly free.”
The other partial derivative is when we take which examines the inequality-effect of democratization for a given level of economic freedom in the country under study. Nevertheless, our interpretation on the effect of democratization always assume economic freedom to be constant. This is since the focus of the study is to examine the role of democracy in the economic freedom-inequality nexus, which is captured by Equation (2).
Ordinary Least Square (OLS) estimation therefore is straightforward biased since the estimation does not allow for the presence of fixed effects in the model. Furthermore, we follow Acemoglu et al. (2015) in not using Arellano and Bover (1995) and Blundell and Bond (1998) System GMM estimation. System GMM is an estimation that combines the difference equation with a level equation. Lagged levels are used as instruments for the endogenous variables in the differenced equation, whereas in level equation lagged first differences of the endogenous regressors are used as instruments. For consistency, System GMM estimator requires that the initial value of democracy and economic freedom variables to be uncorrelated with the fixed effects, however this is unlikely to be a good assumption given the historically determined nature of democracy and free market-oriented institutions.
By construction, the differenced error term is probably serially correlated at first-order even if the original error is not. While most studies employing GMM estimation report the test for first order serial correlation, some do not.
Note that one-period lag of the variable of interests in Equation (1) always means a 5-year lag, since the data are 5-year average across the sample year 1970–2014. The practice to predate endogenous regressors as a way to handle endogeneity has also been done by Berggren (1999), Bergh and Nilsson (2010), and Acemoglu et al. (2015).
Various instrument lags are experimented and the decision to set this lag restriction is made because the estimation results fulfill the necessary requirements i.e., successfully pass the instrument’s exogeneity (Hansen) and second order serial correlation (AR2) tests.
Specifically, the calculations are as follows: (1) to determine the size of effect of economic freedom on inequality, we first set the baseline Gini value using this equation: (based on the partial derivative and holding other factors constant), then we raise 1 standard deviation in the efw variable above its mean, and recalculate the new Gini value to see the size of change in Gini from its baseline value, (2) to determine the size of effect of democracy on inequality, we set the baseline Gini value using this equation: (based on the partial derivative and holding another factors constant), then we raise dem variable by 1 standard deviation above its mean, and recalculate the new Gini value to see the size of change in Gini from its baseline value, and finally (3) to determine the size of effect of economic freedom in a democratic regime, we set the baseline Gini value using this formula: (based on the partial derivative setting dem = 1 and holding other factors including individual dem constant), then we concurrently raise efw and dem by 1 standard deviation above their means, and recalculate the new Gini value to see the size of change in Gini from its baseline value. Please see also discussion on the partial effect the of variables of interest in Equation (2) in econometric specification section.
To obtain the long term effect, we first need to set giniit = giniit−1 so that the dynamics in the dependent variable would converge to a new steady state level. Consequently, the long run effect of freedom to international trade EFW4 is given by: , long run effect of democracy is , and the long run effect of the interaction between EFW4*Democracy is , holding other variables constant.
According to the latest classification by the World Bank, a middle income country is an economy whose Gross National Income (GNI) between $1026–12475 threshold; with lower middle income GNI between $1026–$4035, and upper middle income GNI between $4036–$12,475. Note the skewed range of GNI for the upper middle income group. The range of GNI between $0–$1025 for low income group is thus naturally closer to the lower middle income group GNI range.
By omitting dem variable we are assuming the effect of regime types are fully captured by the country fixed effects term.
This is an average effect, since the average values for the coefficient, the mean, and the standard deviation of EFW4 variable are used since there are four sources for democracy classification. Specifically, for each regime type, the average of the four means and standard deviations are obtained from the variable’s summary statistics according to four difference democracy sources. Similarly, the average of the EFW4 coefficients used is the one reported in Table 6 according to regime classification based on the four different democracy sources.
|Country Sample||Mean||Std. Dev.||Minimum||Maximum||Obs.||No. of Countries|
|Gini of Net Income|
|Overall sample||36.93||9.58||16.11 (Bulgaria)||65.72 (Namibia)||789||115|
|Always democracy||34.29||10.26||17.29 (Slovakia)||65.72 (Namibia)||376||55|
|In-transition||39.00||8.60||16.11 (Bulgaria)||61.47 (Sierra Leone)||326||46|
|Always non-democracy||40.57||6.45||25.35 (Rwanda)||58.21 (Egypt)||87||14|
|High income||30.02||6.51||17.29 (Slovakia)||51.07 (Chile)||323||42|
|Upper middle income||42.12||9.11||16.11 (Bulgaria)||65.72 (Namibia)||216||31|
|Lower middle income||40.97||7.79||19.99 (Ukraine)||61.25 (Kenya)||170||26|
|Low income||42.19||7.35||25.35 (Rwanda)||61.47 (Sierra Leone)||80||16|
|Economic Freedom Overall Index, EFW|
|Overall sample||6.26||1.25||2.5 (Peru)||8.9 (Singapore)||726||115|
|Always democracy||6.78||1.04||2.9 (Nicaragua)||8.8 (New Zealand)||340||55|
|In-transition||5.82||1.19||2.5 (Peru)||7.9 (Chile)||305||46|
|Always non-democracy||5.70||1.39||2.8 (Uganda)||8.9 (Singapore)||81||14|
|High income||7.00||1.00||3.5 (Poland)||8.9 (Singapore)||300||42|
|Upper middle income||5.93||1.16||2.5 (Peru)||7.8 (Jordan)||195||31|
|Lower middle income||5.73||1.12||2.9 (Nicaragua)||7.7 (Armenia)||154||26|
|Low income||5.26||1.01||2.8 (Uganda)||7.4 (Rwanda)||77||16|
|Lagged Gini||0.473 ***|
|EFW||0.006||0.006||0.036 *||0.005||0.027 *|
|Democracy||0.041||0.025||0.209 **||0.225 **||0.130 *|
|EFW*Democracy||−0.035 *||−0.038 *||−0.024 *|
|Number of countries||103||104||103||103||103||103|
|Estimation Method||Fixed Effect Estimation||Difference GMM Estimation|
|Lagged Gini||0.473 ***||0.480 ***||0.438 ***||0.472 ***||0.460 ***||0.458 ***||0.152||0.251 **||0.370 ***||0.239 **||0.178 *||0.122|
|Democracy||0.130 *||0.093||0.053||−0.005||0.053||0.190 ***||0.419 *||0.104||−0.037||0.168||0.237 ***||0.358 **|
|EFW||0.027 *||0.088 *|
|EFW4||0.011 *||0.055 ***|
|EFW4*Democracy||−0.011 *||−0.029 *|
|EFW5||0.034 ***||0.081 ***|
|EFW5*Democracy||−0.034 ***||−0.054 *|
|No. of observations||463||467||458||473||463||464||368||369||368||372||368||370|
|No. of countries||103||103||103||103||103||103||95||95||95||95||94||95|
|No. of instruments||82||82||82||82||82||82|
|1. Alternative Gini||2. Alternative Democracy Variable||3.Control Variables||4. Level of Development|
|Gini Net (Bounded)||Gini Gross||EHII Gini||ANRR||BMR||CGV||Set 1||Set 2||High Income||Middle Income||HI & Upper MI||LI & Lower MI|
|A||EFW||0.058 **||0.115 *||0.006||0.162 **||0.100 ***||0.072 ***||0.095 **||0.108 ***||0.074||−0.001||0.120 ***||0.020|
|Democracy||0.266 *||0.561 *||0.173||0.717 **||0.434 ***||0.270 *||0.427 *||0.433 **||0.278||0.000||0.541 ***||−0.142|
|EFW*Democracy||−0.037||−0.083||−0.018||−0.124 *||−0.073 **||−0.040||−0.076*||−0.084 **||−0.047||0.018||−0.095 ***||0.028|
|B||EFW 1||−0.010||0.031||−0.005||0.008||0.033 **||0.031 *||0.045 *||0.050 **||−0.012||−0.001||−0.016||−0.030|
|Democracy||0.016||0.310 *||0.137*||0.075||0.202 *||0.162||0.362 **||0.390 ***||0.045||0.056||0.010||−0.141|
|EFW1*Democracy||0.015||−0.031||−0.011||0.005||−0.021||−0.013||−0.053 **||−0.060 **||0.007||0.003||0.022||0.028|
|EFW2*Democracy||0.024 *||0.064 *||0.025 *||0.019||0.012||0.014||0.038 *||0.030||0.037||−0.005||0.066 **||0.028|
|Democracy||0.035||0.089||0.096||0.228 **||0.099||0.076||0.103||0.086||−0.084||0.067 **||0.163 *||−0.021|
|E||EFW4||0.036 *||0.081 ***||0.021 *||0.067 ***||0.062 ***||0.063 ***||0.060 ***||0.080 ***||0.098 *||0.032 **||0.057 **||0.038|
|Democracy||0.163 ***||0.352 ***||0.166 ***||0.252 ***||0.252 ***||0.242 ***||0.175 *||0.224 ***||0.264||0.128 *||0.230 ***||−0.024|
|EFW4*Democracy||−0.021||−0.050 *||−0.019 *||−0.042 **||−0.039 ***||−0.038 ***||−0.039 *||−0.054 ***||−0.076||−0.008||−0.038 *||0.012|
|F||EFW5||0.047 **||0.150 ***||0.028||0.113 ***||0.094 ***||0.079 ***||0.063 **||0.061 **||0.002||0.019||0.050 *||−0.053|
|Democracy||0.236 **||0.715 ***||0.207 ***||0.469 ***||0.419 **||0.328 **||0.297 *||0.264||0.080||0.124||0.263 **||−0.040|
|EFW5*Democracy||−0.035 *||−0.125 ***||−0.031 *||−0.084 **||−0.075 **||−0.054 *||−0.054||−0.050||0.008||−0.012||−0.038||0.012|
|No. of observations||368–372||368–372||226–227||368–372||368–372||368–372||466–483||456–473||184–187||172–173||288–292||79–80|
|No. of countries||95||95||73||95||95||95||107||106||39||48||66||29|
|No. of instruments||82||82||69||82||82||82||85||87||80||79||82||61|
|1. Always Democracy||2. In Transition||3. Always Non-Democracy|
|A||EFW||0.035 *||0.038 *||0.030||0.026||0.006||−0.003||0.013||0.001||−0.064||0.065||0.036||0.032|
|C||EFW2||0.028 *||0.026 *||0.013||0.015||0.023||0.022||0.028 *||0.026 *||−0.047||−0.012||0.009||0.009|
|E||EFW4||0.036 ***||0.039 ***||0.028 ***||0.028 ***||0.039 ***||0.040 ***||0.037 ***||0.035 **||−0.011||0.022||0.017||0.049|
|No. of observations||198–201||200–203||178–180||188–191||141–143||137–140||145–148||130–132||27||29||43||47–49|
|No. of countries||49||50||44||47||35||33||34||29||11||12||17||19|
|No. of instruments||58||58||58||58||58||58||58||58||27||29||40||42|
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