A Dynamic Analysis of Economic Freedom and Income Inequality in the 50 U.S. States: Empirical Evidence of a Parabolic Relationship

Abstract

Abstract. This paper examines the dynamic relationship between economic freedom and income inequality in the fifty U.S. states the 1979-2004 period. Using fixed effects regression analysis, we find evidence that increases in economic freedom are associated with lower income inequality, but the dynamic relationship between the two variables depends on the initial level of economic freedom. This suggests that there may be an inverted U-shaped relationship between economic freedom and income inequality. The inflection point at which additional increases to economic freedom in a state result in less income inequality is estimated. The results are robust to various time periods and several alternative measures of income inequality.(ProQuest: ... denotes formulae omitted.)1. IntroductionEconomic inequality is one of the most divisive contemporary political issues in the United States. In a 2011 speech, President Obama invoked the age- old dogma that the rich are getting richer while the poor are getting poorer in claiming that over the past three decades, the middle class has lost ground while the wealthiest few have become even wealthi- er/'1 In doing so, President Obama was making the case for a second government stimulus since taking office, with the implicit message that government redistribution is a corrective mechanism necessary to reduce the inequalities created under a market system.President Obama is correct in suggesting that in- come inequality has increased the past 30 years in the United States, according to most aggregate measures. The household income Gini coefficient, a measure of relative inequality in the distribution of income among households that ranges from zero (perfect equality) to one (perfect inequality), in- creased from 0.403 to 0.469 the 1980-2010 peri- od, a 16.5% increase in inequality.2 Figure 1 displays the trend in the income Gini household measure in the U.S. from 1980-2010. Across the fifty U.S. states, a similar pattern of increased income inequality emerged, with the average state-level household income Gini measure increasing by 13.2% the 1980-2010 period.3 Among the states, inequality grew by the least (6.4%) in Mississippi and the most (24.6%) in Connecticut.To the extent that reducing inequality is a policy objective, gaining a better understanding of the rela- tionship between economic freedom and inequality is needed. In this paper, we empirically examine the relationship between state-level economic freedom, as measured by the Fraser Institute's Economic Freedom of North America Index, and relative in- come inequality for the fifty U.S. states the 1979-2004 period. We use the family income Gini coefficients of Galbraith and Hale (2006), hereafter GH, as our primary measure of income inequality.4In empirically examining the effect that economic freedom exerts on income inequality, there are gen- erally two channels to examine. The first is to ana- lyze the relationship between levels of economic freedom and inequality through panel analysis. Using a variety of methods, we fail to find a statisti- cally significant relationship between the level of economic freedom and income inequality in the U.S. While the static relationship between the two varia- bles is unclear, fixed effects models exploring the dynamic relationship between economic freedom and income inequality are more revealing. Our find- ings suggest that increases in economic freedom are associated with lower income inequality, but this effect depends on the initial level of economic free- dom, implying that there is an inverted U-shape re- lationship between economic freedom and income inequality. The results are robust to various Lime spans and several alternative measures of income inequality.The remainder of the paper is organized as fol- lows. Section two provides a brief literature review and is followed by a discussion of the Economic Freedom of North American Index. …