Economic freedom and income mobility

A few weeks ago, my friend James Dean (see his website here, he will soon be a job market candidate and James is good) and I received news that the Journal of Institutional Economics had accepted our paper tying economic freedom to income mobility. I think its worth spending a few lines explaining that paper.

In the last two decades, there has been a flurry of papers testing the relationship between economic freedom (i.e. property rights, regulation, free trade, government size, monetary stability) and income inequality. The results are mixed. Some papers find that economic freedom reduces inequality. Some find that it reduces it up to a point (the relationship is not linear but quadratic). Some find that there are reverse causality problems (places that are unequal are less economically free but that economic freedom does not cause inequality). Making heads or tails of this is further complicated by the fact that some studies look at cross-country evidence whereas others use sub-national (e.g. US states, Canadian provinces, Indian states, Mexican states) evidence.

But probably the thing that causes the most confusion in attempts to measure inequality and economic freedom is the reason why inequality is picked as the variable of interest. Inequality is often (but not always) used as a proxy for social mobility. If inequality rises, it is argued, the rich are enjoying greater gains than the poor. Sometimes, researchers will try to track the income growth of the different income deciles to go at this differently. The idea, in all cases, is to see whether economic freedom helps the poor more than the rich. The reason why this is a problem is that inequality measures suffer from well-known composition biases (some people enter the dataset and some people leave). If the biases are non-constant (they drift), you can make incorrect inferences.

Consider the following example: a population of 10 people with incomes ranging from 100$ to 1000$ (going up in increments of 100$). Now, imagine that each of these 10 people enjoy a 10% increase in income but that a person with an income of 20$ migrates to (i.e. enters) that society (and that he earned 10$ in his previous group). The result will be that this population of now 11 people will be more unequal. However, there is no change in inequality for the original 10 people. The entry of the 11th person causes a composition bias and gives us the impression of rising inequality (which is then made synonymous with falling income mobility — the rich get more of the gains). Composition biases are the biggest problem.

Yet, they are easy to circumvent and that is what James Dean and I did. We used data from the Longitudinal Administrative Database (LAD) in Canada which produces measures of income mobility for a panel of people. This means that the same people are tracked over time (a five-year period). This totally eliminates the composition bias and we can assess how people within that panel evolve over time. This includes the evolution of income and relative income status (which decile of overall Canadian society they were in).

Using the evolution of income and relative income status by province and income decile, we tested whether economic freedom allowed the poor to gain more than the rich from high levels of economic freedom. The dataset was essentially the level of economic freedom in each five-year window matching the LAD panels for income mobility. The period covered is 1982-87 to 2013-18.

What we found is in the table below which illustrates only our results for the bottom 10% of the population. What we find is that economic freedom in each province heavily affects income mobility.

Image

More importantly, the results we find for the bottom decile are greater than the results “on average” (for all the panel) or than for the top deciles. In other words, economic freedom matters more for the poor than the rich. I hope you will this summary here to be enticing enough to consult the paper or the public policy summary we did for the Montreal Economic Institute (here)

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