Freedom & growth

It should come as no surprise that some of the states that top the Debroy-Bhandari Composite Economic Freedom Index are also the ones with the highest per capita incomes.

For, the parameters chosen to judge levels of economic freedom are precisely those that determine whether a state is an attractive destination for investment or not. For instance, states which have a low government expenditure-to-GDP ratio are more likely to be offering a larger role for private investment and appear higher on the index.

Similarly, those that have a high ratio of mandays lost due to strikes are clearly bad for investment and it is only appropriate that they appear low on the economic freedom index compiled for the Friedrich-Naumann-Stiftung Foundation by Bibek Debroy of the Rajiv Gandhi Institute for Contemporary Studies and Laveesh Bhandari of Indicus Analytics.

High stamp duties tend to restrict property registrations and a high proportion of vacant judicial posts tend to imply poorer quality of justice, once again justifying the fact that such states appear low on the index.

Overall, a total of 26 such variables have been used to determine the index, but several anomalies need closer examination and explanation. Kerala, at number three on the overall index, shows no signs of any investment boom, though there is no doubting its high-quality social infrastructure.

Despite being one of India’s richest states, Punjab is ranked at the same level as Jharkhand on the economic freedom index and is fourth from the bottom. While that may look like a paradox, the fact is there is little fresh private investment taking place in the state, and that is precisely what the index indicates would be happening in the state. It should be a matter of concern for the state as its future prosperity will depend on this. Another interesting case is that of the fledgling Chhattisgarh state, which tops the “size of government” sub-index by virtue of having a very small government. It does well on the “legal structure” sub-index as well.

The state is, however, second from the bottom on the last sub-index, with very high licence fees being charged to traders and with very few industrial entrepreneurs’ memoranda (IEMs) actually getting implemented.

Overall, the state is number four on the index, and that’s something that is borne out by the large number of investment commitments it has managed to get since it was carved out of Madhya Pradesh some years ago. The lesson for the government is that it has to concentrate on getting a lot more IEMs implemented.

While the study does not indicate the causal nature of the link between economic freedom and per capita incomes—perhaps it’s a chicken-or-egg question—it seems pretty obvious that states with low levels of economic freedom misallocate resources between factors of production since it is governments and not markets that are making such decisions. Sub-optimal returns may be the norm in such cases. It’s equally true that, along with per capita incomes, states with higher economic freedom indices have higher wage rates and lower inflation.