Index of Economic Freedom

What Is an Index of Economic Freedom?

An index of economic freedom measures jurisdictions against each other in terms of parameters such as trade freedom, tax burden, judicial effectiveness, and more. These factors may be weighted according to their influence on economic freedom and compiled into a single score that allows for a ranking. The ranking can be done on a country basis or can look at wider regions or smaller subnational units like states.

The most widely referenced index of economic freedom is produced by the Heritage Foundation, a conservative American think tank. The Fraser Institute, a Canadian think tank, also publishes a well-known index of economic freedom.

Understanding Economic Freedom Indexes

Indexes of economic freedom arose in the discipline of economics as part of New Institutional Economics, specifically from the study of the relationship between political-economic institutions and economic development. Going back at least as far as the ideas of classical economists, such as Adam Smith, there had been a strong streak of free-market-oriented thought in economics. Based on their observations of how economies function, economists developed theories about how political-economic institutions like free trade and the consistent enforcement of private property rights were essential to promoting economic development and general prosperity.

In the late 20th century some New Institutional economists sought to quantify the concept of "economic freedom" that these institutions embody, so that they could use it in rigorous empirical studies to test and demonstrate the link between institutions and economic growth. A major motivation of these studies was to remedy apparent failures by major contemporary theories of economic development to explain variation in the rate of development across different countries.

The indexes of economic freedom that these economists developed combine qualitative and quantitative data about the laws, regulations, taxes, and general economic policies of different countries (or subnational political entities) into a composite score for each country and an overall ranking across countries.

These scores and ranks can then be compared statistically with metrics of economic performance or other variables by researchers. In general, these studies have found that more economically free countries tend to also experience greater rates of investment, faster economic growth, and higher per capita incomes.

A major issue with the construction of indexes of economic freedom is the definition of the term "economic freedom," as well as how any specific policy or institution should be counted as either promoting or detracting from economic freedom. It should be noted that some of these categories are ideologically loaded.

For example, the absence of binding minimum wage laws appeals to a laissez-faire economist as a high degree of labor freedom, but might strike a liberal economist as a policy that limits the economic freedom of the workers. Even among free-market-oriented economists there are sometimes fierce differences of opinion regarding whether specific policies and institutions should be considered economically free or not.

Overall, however, despite these disagreements, the advent and application of indexes of economic freedom were influential in the 1990s and 2000s in driving economic development and public policy. The demonstrated economic benefits of economic freedom helped lead to increased openness to trade and other market-oriented reforms across developing countries, in post-Soviet Eastern Europe, and even in advanced economies.

The Heritage Index of Economic Freedom

The Heritage Foundation's Index of Economic Freedom is one of the most popular of these indexes. It scores countries based on 12 factors:

A country's scores in each area are then compiled into a single score, according to which countries are ranked from most (highest score) to least free.

The Heritage Foundation's Index of Economic Freedom has pointed out some important correlations that should encourage nations to try to improve their scores over time. The most important is the observation that people living in countries categorized as free or mostly free enjoy higher incomes than those living in lower-scoring nations.

The disparity between the best and worst nations is almost 10 times, meaning that on average someone in an economically free nation makes nearly 10 times more money than someone in an economically nonfree nation. Related to this income gap, there is also a correlation between economic freedom and GDP growth, as well as a higher standard of living and a general rule of law for citizens.

Countries with a high degree of economic freedom tend to have more productive economies. Countries ranked "free" or "mostly free" had six times the average per-capita GDP of "repressed" countries.

Recent Index of Economic Freedom Rankings

In recent years, the top countries for economic freedom have been fairly consistent. Singapore ranked number one in 2021 with an overall score of 89.7. It was followed by New Zealand (83.9), Australia (82.4), Switzerland (81.9), and Ireland (81.4) to round out the economies rated as free. Countries on the opposite end of the freedom spectrum include North Korea (5.2), Venezuela (24.7), Cuba (28.1), Sudan (39.1), and Zimbabwe (39.1). The United States ranked 20th with an overall score of 74.8, dropping by 1.8 points from 2020 mostly due to increased trade restrictions.

As mentioned, the higher the score in the economic freedom index, the higher the income and vice versa. Countries ranked as "free" or "mostly free" had an average per-capita GDP that was double the overall average, and more than six times higher than the average per-capita incomes of "repressed" countries.

There is also a regional phenomenon where similarly ranking countries can be clustered. In 2021, Sub-Saharan Africa scored below the world average of 61.6 with a regional score of 55.7. Europe scored above the world average as a region with 70.1. Of course, there are outliers in every region. North Korea, with the overall worst score of 5.2, is in the Asia Pacific region along with two of the highest scorers — Singapore and Taiwan.

Top 10 Countries By Economic Freedom

New Zealand

Switzerland

United Kingdom

Ranked According to 2021 Heritage Index of Economic Freedom

How the Index of Economic Freedom Is Used for Investing

The Heritage Foundation's Index of Economic Freedom website features a heat map that allows you to view the changes in the world over time. In addition to being academically interesting, the change to economic freedom over time can be a significant data source for investors, particularly those interested in emerging markets.

The index of economic freedom can provide a guide as to whether the potential for hot emerging market picks like the BRIC nations (Brazil, Russia, India, and China) are actually seeing the policy changes necessary for that growth to benefit international investors. On the opposite end, negative changes in the index can be a signal to investors to trim their direct and indirect exposure to nations that are experiencing a decline.

Special Considerations

The latest edition of the heritage index omitted two regions that had previously ranked close to the top by economic freedom: Hong Kong and Macau. Hong Kong had previously held the number one spot for 25 years, before being bumped by Singapore in 2020 due to perceptions of tightening control by the mainland Chinese government.

In a note accompanying the 2021 Index, the Heritage Foundation explained that Hong Kong was left out, so that the index would only cover places "where governments exercise sovereign control of economic policies." Although both regions continue to enjoy advantageous policies, the Foundation explained, "those policies are ultimately controlled from Beijing."

Hong Kong officials objected to the omission, calling the assertion of Beijing's control "ill-conceived and untrue."

Index of Economic Freedom FAQs

How Does Political Freedom Determine Economic Growth?

Although there is a correlative relationship between political freedom and economic growth, establishing causation is less certain. One study found that countries that transitioned to a democratic government enjoyed a 20% average gain over 25 years, compared to those that retained authoritarian forms of government.

An MIT economist who co-authored the study suggested that democracies "get rid of special favors" that might inhibit economic growth. They are also more likely to invest in health and human capital, generating long-term economic gains.

How Is a Free Enterprise System Linked to Economic Freedom?

Economic freedom is a key element of free enterprise, a market-based economic system in which business decisions are made with minimal government interference. Economic freedom, by giving individuals the ability to work, do business, and enter into voluntary contracts with one another, is a key element of the free enterprise system.

What Is the Human Freedom Index?

Similar to the economic freedom index, a human freedom index is a composite measure of personal, civil, and economic freedoms in different countries. The most famous human freedom index is jointly published by the right-wing Cato Institute and the Fraser Institute. Unlike the economic freedom index, the human freedom index also measures the freedom of noneconomic areas, such as religion, movement, and association in civil society.

What Is the Corruption Perceptions Index?

The corruption perceptions index is a composite measure of the perception of corruption in public institutions, based on expert assessments and opinion surveys. It is published by Transparency International, a nonprofit association founded by former employees of the World Bank.

The Bottom Line

The index of economic freedom is one of several metrics for comparing different economic regimes. Although the Heritage Foundation publishes the most widely-used economic freedom index, there are several institutions that publish their own versions. Each of them seeks to quantify elements such as regulation, taxation, government interference, and price controls, which represent constraints on free enterprise and market activity.