Economic Freedom and Inequality in Latin America

Can improvements in income inequality be attributed to economic freedom?

he positive influence of greater levels of economic freedom on growth, development, democracy, and other indicators of human progress has been well-documented. Nations in the top quartile of economic freedom outperform those in the bottom quartile on a wide range of well-being indicators. Economically free countries have higher levels of incomes per capita and life expectancy, enjoy higher levels of political and civil liberties, and tend to fare better in terms of gender equality. However, studies that look at the relationship between economic freedom and inequality produce conflicting or ambiguous results. Can improvements in income inequality be attributed to economic freedom? Let’s explore the link between economic freedom and income inequality from 1970 to 2016 across selected countries in Latin America, the most unequal region in the world.

Introduction

During the current era of globalization, the world has increased its level of economic freedom notably. According to the Economic Freedom of the World: 2018 Annual Report (EFW) national economies have become more open to trade and investment, currencies have become more stable, regulations less burdensome, and the protection of property and respect for contracts have improved in countries around the world. Other studies — available here, here, and here — find that economic freedom exerts a strong, positive impact on growth and the level of income. It also leads to lower gender wage gaps across countries and time periods and is associated with a lower risk of civil war.

The relationship between economic freedom and inequality is less clear, however. If a greater reliance on market economics inevitably tends to produce greater inequality, as some assert, the increase in economic freedom may not be so welcome after all. That is especially so if inequality exerts a negative impact on indicators of progress, such as poverty reduction or economic growth, as some have claimed. What does the evidence say about the link between economic freedom and inequality?

Latin America offers a rich case study to examine that question. It is the most unequal region in the world, using the Gini coefficient as a measure, and it has long been so. However, it is also the only region in the world that has seen a notable decline in its levels of inequality in recent decades. Although Latin America as a region has increased its level of economic freedom in the past few decades, countries in the region exhibit a diverse set of reform experiences. Some countries, such as Peru or Chile, moved swiftly toward, or achieved relatively high levels of, economic freedom, while other countries, such as Argentina or Venezuela, saw dramatic declines. The fact that inequality fell in almost all Latin American countries allows us to reach tentative conclusions about the link between economic freedom and inequality, or at least to reject certain claims.

Key Findings

Overall Trends in Inequality and Economic Freedom

Gini Index over Time, 1980–2016 | Source: World Bank, World Development Indicators.

From 2000 onwards, almost all Latin American countries experienced a decline in the Gini coefficient. Costa Rica, however, increased its Gini score from 45.3 in 1990 and to 48.7 in 2016. Before 2000, countries for which there is data available, showed an increase in their levels of inequality. These countries are Argentina, Bolivia, Costa Rica, and Brazil.

Latin America has increased its level of economic freedom in the past few decades. This trend became more pronounced after 1985 when some Latin American countries undertook major economic reforms.

Three distinct periods can be identified from 1970 to 2016. During the first period that goes from 1970 to 1985, some countries show an increase in their levels of freedom, while others follow the opposite path. A second period between 1985 and 2000, reveals a positive trend towards higher levels of economic freedom for most Latin American countries. Lastly, from 2000 to 2016, countries either maintained their levels of freedom or increased them but in a much slower pace and magnitude in comparison to the previous period.

Economic Freedom over Time, 1970–2016 | Source: James Gwartney et al., Economic Freedom of the World: 2018 Annual Report (Vancouver: Fraser Institute, 2018).

Two countries stand out: Chile and Venezuela. In the 1970s Chile, one of the least free countries in Latin America at that time, began major economic reforms. It implemented free-market policies that led to economic takeoff, which in 2016 ultimately landed Chile in the top 20 nations among the 162 countries the EFW analyzes. Venezuela is the polar opposite of Chile. Once the freest country in Latin America, “Venezuela has experienced a lengthy decline in economic freedom that started long before Hugo Chavez assumed the presidency in 1999. But Chavez, his United Socialist Party of Venezuela, and successor, Nicolás Maduro, have presided over a continued stunning slide in economic freedom”. As a result, Venezuela fell to last place from 2010 to 2016 in the EFW index. On its scale from 0 to 10, where 0 is less freedom, Venezuela lost more than 3 points from 1970 to 2016.

Gini Index and Economic Freedom over Time, 1970–2016 | Source: James Gwartney et al., Economic Freedom of the World: 2018 Annual Report (Vancouver: Fraser Institute, 2018) and World Bank, World Development Indicators.

As a region, Latin America saw a steady decline in its economic freedom from 1970 to 1985. During the following 15 years, economic freedom noticeably increased, moving from almost 4.5 in 1985 to 6.7 in 2000 on the 10-point scale. Meanwhile, inequality declined from 56 on the Gini scale in 1985 to 54 in 2000. From 2000 to 2016, economic freedom has remained almost the same while inequality has dropped by almost 20 percentage points.

Reductions in inequality have taken place while or immediately after economic freedom has increased. Do all Latin American countries follow this same pattern?

A Case-by-case Analysis

The largest decline in inequality took place in Ecuador. The Gini Index fell by 20.21 percentage points from 2000 to 2016 at the same time economic freedom increased by 3.41 percentage points. By contrast, Costa Rica experienced an increase in both inequality and economic freedom between 1990 and 2016 of 7.51 and 8.17 percentage points respectively.

The largest increase in economic freedom (94.26 percentage points) occurred in Brazil between 1985 and 2015. The Gini Index decreased by 7.73 percentage points during the same time period. El Salvador saw the largest decline in economic freedom. Its economic freedom score decreased by 6.41 percentage points while inequality fell 19.84 percentage points between 1995 and 2016.

Percentage Changes in Economic Freedom and Inequality | Source: Author’s calculations.

Countries can be classified into four distinct areas based on whether economic freedom and inequality either increased or decreased (see table below). Three countries — El Salvador, Panama, and Peru — show a decrease both in inequality and economic freedom. By contrast, Argentina, Bolivia, and Costa Rica exhibit an increase in both indicators. A third, and largest, group of 11 countries shows increases in economic freedom and decreases in inequality. None of the countries studied present increases in inequality and decreases in economic freedom. The next section will look into the evolution of economic freedom and inequality over time for each country.

Classification of Latin American Countries | Source: Author’s calculations.

Economic Freedom and Inequality in Latin American Countries over Time

The following figures tell a more complete story of the evolution of economic freedom and inequality over a more complete time period. They reveal when changes in the Gini Index took place and if those changes were accompanied to some degree by changes in economic freedom.

Three main groups of countries can be identified: countries that report declines in the Gini Index at the same time that they attain higher levels of economic freedom; countries that experience a fall in the Gini Index only after economic freedom increases; and outlier countries for which no pattern could be identified.

Brazil, Chile, Colombia, Dominican Republic, Ecuador, Guatemala, Honduras, Mexico, Nicaragua, and Uruguay belong to the group of countries that increased their levels of economic freedom while inequality declined. The Brazilian, Chilean, Colombian, Dominican, Mexican, and Uruguayan cases are the most outstanding. For these countries the largest declines in inequality took place at the same time that economic freedom levels were increasing at a faster pace. For the rest of the countries in this group, the gains in equality happen while economic freedom is increasing but a slower pace than the other countries in the group.

For other countries, the declines in the Gini Index began at least 10 years after increases in economic freedom. These countries are Bolivia, Peru, El Salvador, Panama, and Argentina. Bolivia’s increase in economic freedom started in 1985 at 3.52 and climbed to 6.97 in 2000. In this same year inequality started decreasing until 2016. While inequality was declining, economic freedom decreased at a much slower pace and smaller magnitude. Peru and Panama follow Bolivia’s pattern with inequality declining some 10 to 15 years after economic freedom began increasing. Argentina saw its score in the Gini Index decrease 15 years after economic freedom started climbing. It is also worth noting that Argentina’s rating in economic freedom saw a dramatic reduction beginning in 2000. 14 years after economic freedom started declining, Argentina showed a rise in inequality. El Salvador, however, demonstrated the first decline in the Gini Index almost 25 years after economic freedom started climbing.

Only two countries do not seem to follow any pattern while or immediately after economic freedom increases. Venezuela’s economic freedom rating decreased from 7.18 points in 1970 to 2.88 in 2016. Its Gini Index increased from 48 in 2000 to almost 53 in 2005; it then declined abruptly to almost 46 in 2006. Costa Rica also showed increases and decreases in the Gini Index at the same time economic freedom marked a positive trend. For example, as economic freedom increased from 6.98 in 1990 to 7.76 in 2006, the Gini Index jumped from 45.3 in 1990 to 51.9 in 2002, and fell to 47.5 in 2005. The Gini Index demonstrated similar behavior with ups and downs through the rest of the period, although with vicissitudes of smaller magnitude.

Conclusions

While some academics have found that economic freedom substantially increases inequality, others report that economic freedom is associated with decreases in inequality. The aim of this study was to explore the relationship between income inequality and economic freedom in Latin America between 1970 and 2016.

Almost all Latin American countries have increased their levels of economic freedom in the late 1980s and early 1990s, and showed a decline in inequality beginning in 2000. Overall trends indicate that there might be a negative correlation between economic freedom and inequality. 15 out of the 17 countries analyzed report increases in economic freedom and declines in inequality. These changes in inequality, however, do not necessarily take place at the same time as the changes in economic freedom. For some countries, for example, the decline in inequality occurs more than a decade after there is an increase in economic freedom.

Based on the Latin American data and this analysis, we can conclude that an increase in economic freedom does not necessarily result in an increase in inequality, and more often than not results in its decrease.

The full study and data mining analysis can be found in this GitHub repo.

Special thanks to Ian Vásquez for providing comments and suggestions on an earlier draft.

Data Scientist interested in deep learning and data visualization

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