reasons why institutions and policies guaranteeing economic freedom conceivably have the capacity to provide growth-enhancing incentives: they promote a high return on productive efforts through low taxation, an independent legal system, and the protection of private property; they enable talent to be allocated where it generates the highest value; they foster a dynamic, experimentally organized economy in which not only a large amount of business trial and error can take place, but also competition among different players, because regulations and government enterprises are few; they facilitate predictable and rational decision-making by means of a low and stable inflation rate; and they promote the flow of goods, capital, labor, and services to where preference satisfaction and returns are the highest (Berggren 2003).

Although the composite, multi-dimensional concept of economic freedom does not lend itself to easy measurement and quantitative analysis, differences in how countries deal with economic freedom appear to be a fundamental cause of cross-country differences in economic prosperity. In their survey of the issue, Hanke and Walters (1997) found that, although varying in emphasis and approach, the three most common indices of economic freedom<sup>7</sup> have significant power to explain variation in per capita national income. Not surprisingly, all three indicators are also highly correlated and produce country rankings that have much in common. According to their estimates, the various measures of economic freedom explain from 54 percent to 74 percent of the cross-country variation in income, with each coefficient carrying the correct sign and being highly significant.

Using the Economic Freedom of the World (EFW) index reported by the Fraser Institute during 19802000,<sup>8</sup> Gwartney and Lawson (2004) found that, controlling for initial conditions,<sup>9</sup> the average annual growth rate of real GDP per capita of countries with an EFW rating in the first tier was 3.4 percent, as compared to 0.4 percent for countries whose rating was in the third tier. When developed countries are omitted from the analysis, the differential growth rates between the persistently free and the persistently unfree developing economies are even greater. The persistently free least-developed countries (LDCs) grew at an annual rate of 5.2 percent during the two decades, compared to 0.6 percent for the least free group. The ten freest economies out of those with low incomes in 1980 grew more than four times the average of the other countries. Countries with more economic freedom also tend to achieve far better social outcomes. They have substantially higher per capita incomes, including for the poorest 10 percent of the population,<sup>10</sup> have longer life expectancy, higher adult literacy, lower infant mortality, lower incidence of child labor, better access to improved (treated) water sources, and greater overall “human development” achievement as measured by the UN. Economic freedom is also generally

> 7 The Fraser Institute’s Economic Freedom of the World Index, Freedom House’s Economic Freedom Indicators, and the Heritage Foundation’s Indices of Economic Freedom.

> 8 The Economic Freedom of the World (EFW) index is perhaps the most ambitious attempt to quantify economic freedom and its impact on investment and economic growth. The index, currently available for 141 countries, measures the consistency of a nation’s policies and institutions with economic freedom, in particular the extent to which various countries rely on open markets to allocate goods and resources.

> 9 After adjustment for differences in initial income level, tropical location, share of population near an ocean, and human capital.

> 10 Interestingly, the share of the income earned by the poorest 10 percent of the population was found to be unrelated to the degree of economic freedom in a nation.

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