Does Greater Economic Freedom Foster Economic Growth? District-level Evidence from Germany

Aleksandar Keseljevic (University of Ljubljana - Laibach)
Rok Spruk (University of Ljubljana - Laibach)

Abstract: In this paper, we revisit the relationship between economic freedom and growth using the sub-national variation in fiscal and economic institutions across 407 German districts (Kreise) for the period 2000-2010. To this end, we build ten indicators of economic freedom for each district and classify them into three latent categories: (i) taxes and government spending, (ii) business regulation, and (iii) size of the public sector. Exploiting the variation in the constructed indices of economic freedom, the evidence suggests less indebted districts with less stringent business regulation, lower share of taxes and relatively smaller public sectors achieve consistently higher productivity growth. The beneficial effect of economic freedom on growth is robust to the variety to exclusion restrictions and to numerous specification checks. The evidence unveils persistent distributional effects of economic freedom on growth and highlights a U-shaped pattern. Economic freedom is most beneficial for growth in the districts with the lowest per capita income, the effects fades away at the median of district-level income distribution, and tends to increase above the median. The evidence does not advocate lower level of economic freedom in former East German districts or greater economic freedom in West German districts. However, the evidence unveils a persistent North-South institutional gap which possibly accounts for per capita income gaps within Germany. In the counterfactual scenario, moving the level of economic freedom to the 90th percentile is associated with large-scale gains in district-level per capita income and growth rates

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