ECONOMIC FREEDOM AND STATE BOND RATINGS

I. INTRODUCTION AND REVIEW The purpose of this paper is to test for a link between economic freedom and bond ratings at the state level. Our work extends a growing literature by testing for the effects that differences in economic freedom might have on financial markets. As noted by Roychoudhury and Lawson (2010), economic freedom "measures [of] the quality of institutions and policies" and allows researchers "to examine the impact of the institutional environment" (p. 150) on the general economic performance of an economy (i.e., economic growth) but also, thus far to a much more limited extent, on macro-finance issues, such as investment (Gwartney et al. 2006) and capital flows (Lothian 2006). This study, in the spirit of Roychoudhury and Lawson (2008; 2010), examines whether such institutional differences across states affect a more micro-level financial market phenomenon; the assignment of state bond ratings. This paper thus extends a growing literature that investigates the role that such institutional factors play in financial markets. For example, D'Souza et al. (2005) find that economic freedom is a positive and statistically important factor explaining performance improvements in newly privatized firms across 23 Organization of Economic Cooperation and Development countries. Smimou and Karabegovic (2010) report that improvements in economic freedom have a positive effect on equity market returns. Peyton and Belasen (2012), for example, show that higher levels of corruption are associated with lower levels of economic freedom, and together these factors reduce a country's ability to secure foreign investment. Hafer (2012) presents evidence supporting the idea that greater economic freedom is associated with more financial development across countries. Two recent studies have explored the role of economic freedom in a manner most closely related to the present study. Roychoudhury and Lawson (2010) find that countries with higher levels of economic freedom have significantly higher sovereign credit ratings than countries with lower levels of economic freedom. Jones and Stroup (2013) report that the pricing of single-state municipal bond closed-end funds is related to a state's economic freedom. This study also extends a broad literature that has attempted to explain bond ratings at the state level. In answering the question "What factors influence a state's bond rating?", the list of potential candidates is long. Liu and Thakor's (1984) early analysis pointed to the role that state economic characteristics play in explaining state bond ratings. Poterba and Rueben (1999; 2001) consider the effect of fiscal rules on the market for state bonds, concluding that "state fiscal institutions affect the required return that lenders demand when states enter the market for tax-exempt bonds" (p. 204). Johnson and Kriz (2005) find that states with more restricted abilities to increase expenditures and indebtedness and with specified expenditure limits also are states that, on average, tend to have higher credit ratings and lower borrowing costs. Deller et al. (2010) find that restrictive tax and expenditure limits lower local bond ratings, but do not influence bond ratings when applied to states, though the latter result varies across bond rating agencies. Studies also have looked at political aspects of state administration to explain bond ratings. Jimenez (2011) finds that states with management systems that reduce bureaucratic waste, or adopt management structures that are more efficient and transparent are more likely to experience improved bond ratings. Schelker's (2012a; 2012b) analysis of term limits and requirements that state auditors hold professional degrees indicates that both raise state bond ratings. Krueger and Walker's (2008) analysis indicates that turnover of existing coalitions of elected representatives and divided government (e.g., a state in which the governor and the majority of the state legislature are of two different parties) lowers bond ratings. …