A Research Paper Presented to the

Faculty of Economics Department

De La Salle University - Manila

Freedom of Economy
A Regression Analysis on the Factors Affecting the Index of Economic
Freedom in OECD Countries (2019)

In Partial Fulfillment of the

Course Requirements for

Econometrics 1 (ECONMET)
3rd Term, SY 2018-2019

Submitted by
Cuevas, Melvin John L.

Submitted to
Dr. Cesar C. Rufino

Submitted on
August 23, 2019
Freedom of Economy

TABLE OF CONTENTS

I. INTRODUCTION

A. Background of the Study

B. Statement of the Problem

C. Objectives

D. Significance of the Study

E. Scope and Limitations

II. Review of Related Literature

A. Index of Economic Freedom

B. Rule of Law

C. Government Size

D. Regulatory Efficiency

E. Open Markets

III. Theoretical Framework

A. Solow-Swan Model

B. Theory and Measurement of Economic Freedom

IV. Operational Framework

A. Description of Variable

B. A-priori Expectations

C. Econometric Model

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Freedom of Economy

TABLE OF CONTENTS

V. Methodology

A. Data Collection

B. Empirical Procedure

VI. Empirical Results

A. Initial Regression and Results

B. Goodness of Fit

C. Overall Test of Significance

D. Test for Multicollinearity

E. Test for Heteroskedasticity

F. Test for Misspecification

G. Corrective Measures and Final Model

VII. Conclusions and Recommendations

A. Conclusion

B. Future Implications

C. Recommendations

VIII. Bibliography

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Freedom of Economy

Introduction

A. Background of the Study

Economic freedom is defined as the “ability prosper through the free exercise of economic

activity while letting others do the same” (Williams, 2015). It is the fundamental right of every

human to control his or her own labor and property. Institutions are consistent with economic

freedom when they allow voluntary exchange and protect individuals their property. An

economically free society means that individuals have the freedom to work, produce, consume

and invest in any way they please, as well as governments allow labor, capital and goods to

move freely and refrain from coercion beyond the necessary extent to maintain liberty itself.

According to Lawson (2016), the key ingredients of economic freedom are property rights,

rule of law, free trade, a constitutionally limited government and sound money supply have a

proven record of generating good economic growth, opportunity and prosperity. Under

property rights, these are the rules that determine how a resource is used that should be free

from corruption and allow us to improve or invest in our private property and our own ideas.

The rule of law is the systematic enforcement of three basic principles; supremacy of law,

equal protection under the law and impartial enforcement for infractions of the law which

empowers us to better plan our choices. Having free trade and open markets allows nations

to compete by producing high quality and low cost goods and services to consumers and

provides incentives to create new opportunities. Another important factor is having a

constitutionally limited government because a limited government allows the people to control

government intervention through representation and the power to vote. Lastly, a sound money

supply is relevant to economic freedom because Protecting the value of our dollar protects

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Freedom of Economy

our investments and enables job creation, which directly impacts our opportunity and

prosperity.

The best way to see the relationship of economic variables to economic freedom is by

analyzing a group of countries sharing similar economic conditions. The Organization for

Economic Co-operation and Development (OECD) is an intergovernmental economic

organization consisting of 37 countries whose mission is to “promote policies that will improve

the economic and social well-being of people around the world (OECD, 2018).” According to

the International Monetary Fund (2018), most countries belonging to the OECD have high

income and are well-developed. The collective nominal gross domestic product (GDP) of the

organization made up 62.2% of global nominal GDP in 2017.

The Index of Economic Freedom (2019) of Heritage Foundation is an index that ranks 186

countries by their jurisdictions against each other in terms of trade freedom, tax burden,

judicial effectiveness and so on (Kenton, 2019). The index scores of economic freedom are

ranged from 0 to 100, 0 having the least freedom and 100 being the most economically free

country. The Heritage Foundation's Index of Economic Freedom has pointed out the

observation that people living in countries categorized as free or mostly free enjoy higher

incomes than those living in lower scoring nations.

B. Statement of the Problem

Economic freedom is an important aspect to be considered for countries to improve their

own economic growth. It creates better opportunities for individuals and businesses and

greater prosperity for the economy. The ideals of economic freedom are strongly associated

with healthier societies, cleaner environments, greater per capita wealth, human

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Freedom of Economy

development, democracy, and poverty elimination. The OECD countries have relatively higher

rank in economic freedom compared to countries that have developing economies. Hence,

economic freedom is an important aspect for other countries to consider and the factors that

are included with having a good score of index of economic freedom. With this, the paper

aims to answer the question:

What economic factors contribute to the Index of Economic Freedom of OECD countries

and how can non-OECD countries follow to further improve their Index of Economic Freedom?

C. Objectives

The paper aims to determine which economic factors contribute and affect the Index of

Economic Freedom in OECD countries, especially the factors under the areas of Inflation,

Unemployment, Tariff, Taxes, GDP Growth Rate, Government Expenditure and Public Debt.

Also, this paper aims to show how non-OECD countries can improve their score on economic

freedom. The objective of this paper for the researcher is to:

(a) Determine the relationship of the variables contributing to economic freedom

(b) Determine the variable that contributes most to the Index of Economic Freedom

(c) Establish the effectiveness of each economic factor contributing to economic

freedom

(d) Create an econometric model that fits best for the relationship of the variables and

economic freedom.

(e) Recommend policies that could help other economies strengthen their economic

freedom

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Freedom of Economy

D. Significance of Study

Individuals and businesses have the incentive to create more opportunities for themselves

and to help others improve their livelihood through economic freedom. Investors can use the

index of economic freedom as a quick way to monitor the changes in economies they have or

want exposure to. Attracting investment is key to growth and instituting good public policies,

including economic freedom, and is significant for any country looking to improve its

attractiveness on the global scale (Olson, 2014). Knowing the Index of Economic Freedom

can be a helpful tool for people to determine which factors needs improvement to further

increase efficiency in the economy. Countries that may need to strengthen their economy may

find significant opportunities for improving economic performance in those factors in which

they score the lowest. Economic freedom can be also a guide for policymakers to consider in

shaping the laws and implementing proper regulations on the community. Determining the

relationship of the economic factors affecting economic freedom is relevant for most people

to consider in building a more prosperous economy and having strong opportunities for

individuals to work harder.

E. Scopes and Limitations

The regression will be done through a cross-sectional analysis, hence, the dataset

used consists of variables that were recorded in one year, 2019. 2019 was the year used

since this is the most recent record of economic data that the Heritage Foundation have

provided on their database. For the 2019 Index, most data covers the second half of 2017

through the first half of 2018. According to the Heritage Foundation (2019), to the extent

possible, the information considered for each factor was current as of June 30, 2018. All 37

member-countries of the OECD will serve as the entities for the cross-sectional analysis, as

the data provided by the aforementioned sources are complete for all 37 countries. Although,

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Freedom of Economy

the country of North Korea would be excluded from the list of the OECD countries for the

cross-sectional analysis because the data of North Korea regarding Index of Economic

Freedom is inconsistent and insufficient compared to the other OECD countries. Therefore,

there would be 36 OECD countries that would be observed in the data.

The Index of Economic Freedom based from Heritage Foundation (2019) is the dependent

variable for this paper, which ranges from 0 to 100, 0 having the least freedom and 100 being

the most economically free society. There are twelve factors in this study which are divided

into four categories. The four categories to measure economic freedom are; rule of law,

government size, regulatory efficiency, and open markets. The factors under rule of law are

property rights, government integrity, and judicial effectiveness. In government size, the

factors are government spending, tax burden and fiscal health. Under regulatory efficiency,

the factors include business freedom, labor freedom and monetary freedom. Lastly, the

factors under the category of open markets are trade freedom, investment freedom and

financial freedom. There are nine independent variables, specifically Inflation, Income Tax

Rate, GDP growth rate, Unemployment, Tariff Rate, Corporate Tax Rate, Tax Burden,

Government Expenditure and Public Debt, which are all measured in percentage.

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Review of Related Literature

A. Index of Economic Freedom

“For well over a hundred years, the economic world has been engaged in a great

intellectual debate” (Lawson, 2016). On one side of this debate have been those

philosophers and economists who advocate an economic system based on private

property and free markets—or what one might call economic freedom. The economic and

social consequences of economic freedom have shown a vast and rapid growth in field of

research since its first publication of Heritage Foundation in 1995. Eiras (2003) of Heritage

Foundation identifies that countries with a lower economic freedom index, due to lack of

rule of law, overregulation, and a large public sector – contribute highly to engagement in

informal economic activity which is a situation that is more prone to corruption. The Index

of Economic Freedom is a helpful objective tool for analyzing 186 economies throughout

the world and each country page is a resource for in-depth analysis of a country’s political

and economic developments. The index scores of economic freedom are ranged from 0

to 100, 0 having the least freedom and 100 being the most economically free society. It is

important to understand that some factors are based on historical information.

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Freedom of Economy

Figure 1 Regional Map of the 2019 Index of Economic Freedom of Heritage Foundation

(2019)

B. Rule of Law

Valcke (2012) define rule of law as a concept that describes the supreme authority

of the law over governmental action and individual behavior. Rule of law correlates to a

situation where the government and individuals have to comply with the law because they

are bound to it. According to Eiras (2003), the key to prosperity is open markets with a

strong rule of law. Societies have no mechanism or procedures to stop private abuses and

public mismanagement if there is no rule of law. There are no guarantees that any effort

by citizens will be respected, nor there are no limits for government to take bribes and

generalized corruption. However, stronger rule of law leads to less corruption. People

would feel that their personal liberty and the fruits of their labor will be protected. This is

the basis of sustained economic activity because businesses and people will work, save

and invest.

In a working paper series by Zywicki (2002), there was a direct correlation between

economic development and the rule of law. It is stated that the rule of law covers the

boundaries of the values such as stability in legal regulations, restrictions on negative

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Freedom of Economy

actions of the government and ensures safety of investment capital. Moreover, Zywicki

illustrated that individuals are more willing to invest in economic growth where property

rights are stable and contracts are more secure. Property rights are an important factor

for the rule of law, in which it is an assessment of the ability of individuals to accumulate

private property, secured by clear laws that are fully enforced by the state.

Furthermore, an essential component of the rule of law is indeed based on

effective and fair judicial systems to ensure that the laws are respected and appropriate

sanctions are taken when they are violated. According to Botero & Ponce (2011), effective

criminal justice systems are capable of investigating and adjudicating criminal offences

effectively and impartially, while ensuring that the rights of suspects and victims are

protected. Government integrity is also a relevant factor for ensuring the rule of law.

Heritage Foundation (2019) states that Corruption erodes economic freedom by

introducing insecurity and uncertainty into economic relationships. The score for this

component is derived primarily from Transparency International’s Corruption Perceptions

Index (CPI) for 2011, which measures the level of corruption in 183 countries.

C. Government Size

According to Berry & Lowery (1984), analysts have defined "government size" as

the ratio of government expenditures to the total output of an economy. Even though many

policymakers understand that government spending undermines economic performance,

some think that special-interest groups are too politically powerful and that reducing the

size of government is an impossible task. Moreover, Mitchell (2005) stated that, there is a

concern that the transition to smaller government may be economically harmful. In other

words, the economy may be stronger in the long run if the burden of government is

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Freedom of Economy

reduced, but the short-run consequences of spending reductions could make such a

change unsustainable. The size of government has a major impact on economic

performance, but it is just one of many important variables.

Furthermore, the conclusions of Mitchell (2005) demonstrated that most

government spending has a negative economic impact. If government spends money in a

productive way that generates a sufficiently high rate of return, the economy will benefit,

but this is the exception rather than the rule. If the rate of return is below that of the private

sector-as is much more common-then the growth rate will be slower than it otherwise

would have been. In addition to this, Heritage Foundation (2019) considers the level of

government expenditures as a percentage of GDP. Government expenditures, including

consumption and transfers, account for the entire score of the government size.

According to a study by Tanzi & Schuknecht (1996) published by the IMF, as the

international economy becomes more competitive, and as capital and labor become more

mobile, countries with big and especially inefficient governments risk falling behind in

terms of growth and welfare. This means that having a big government size requires a lot

of responsibility in keeping the economy stable and constantly knowing the condition of

the economy. Also, Heritage Foundation (2019) stated that “volumes of research have

shown that excessive government spending that causes chronic budget deficits”, this

leads to a very serious drag on economic dynamism as well as the accumulation of

sovereign debts.

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Freedom of Economy

D. Regulatory Efficiency

According to World Bank, regulatory efficiency captures perceptions of the ability

of the government to formulate and implement sound policies and regulations that permit

and promote private sector development. Regulatory efficiency is important for setting the

standards of a good system for both the public and private sector of an economy. The

three factors that are needed to be considered in determining regulatory efficiency are;

business freedom, monetary freedom and labor freedom. All of these contribute to the

perception of the economic freedom of a particular country.

Business freedom is a component which measures the extent to which the

regulatory and infrastructure environments constrain the efficient operation of businesses.

Basically, it is an overall indicator of the efficiency of government regulation of business.

Heritage Foundation scores business freedom by analyzing business regulations based

on qualitative information from reliable and internationally recognized sources.

Furthermore, the factor of labor freedom is a quantitative measure that considers

various aspects of the legal and regulatory framework of a country’s labor market,

including regulations concerning minimum wages, laws inhibiting layoffs, severance

requirements and measurable regulatory restrictions upon hiring and the number of hours

worked. The labor force participation rate is also included as an indicative measure of the

opportunities of employment in the labor market. Labor freedom is scored by looking at

labor market flexibility based on qualitative information from other reliable and recognized

sources.

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Freedom of Economy

Lastly, monetary freedom is a component in determining the index of economic

freedom in which it combines a measure of price stability with an assessment of price

controls. Market activity is distorted by inflation and price controls. The ideal state for the

free market is having price stability without macroeconomic intervention. According to

Heritage Foundation (2019), monetary freedom is based on two factors which are; price

controls and the weighted average inflation rate for the most recent three years. Other

studies in which monetary freedom is observed as an integral part of an overall freedom

score suggest a positive relationship (De Haan & Sturm, 2000). According to Cebula &

Clark (2012), the effects of monetary freedom on economic performance have been

grouped with other aspects and overall economic freedom. Some of these studies have

found quite compelling evidence and causality that economic growth is determined by

monetary freedom.

E. Open Markets

An open market, as defined by Segal (2019), is an economic system with no

barriers to free market activity. Anyone can participate in an open market, which is usually

characterized by the absence of tariffs, taxes and licensing requirements. Segal (2019)

stated that open markets are considered highly accessible with few boundaries that is

preventing a person or entity from participating. An open market may have competitive

barriers to entry. Major market players might have an established and strong presence,

which makes it more difficult for smaller or newer companies to penetrate the market.

However, there are no regulatory barriers to entry.

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Open markets, as similar to regulatory efficiency, are determined by three factors

which are about the freedom in the sectors of a market. These three factors that contribute

to the value of open markets in determining the index of economic freedom are; trade

freedom, financial freedom and investment freedom.

Heritage Foundation (2019) defined trade freedom as a composite measure of the

extent of tariff and non-tariff barriers that affect imports and exports of goods and services.

There are two inputs which contribute to the score of trade freedom which are; non-tariff

barriers and the trade weighted average tariff rate. The categories of the non-tariff barriers

include: quantity restrictions – which import quotas and expect limitations, price

restrictions – which tackles tariff rate quotas, regulatory restrictions, customs restrictions

and the direct government intervention – where policies for industries are implemented.

For investment freedom, it is where there would be no constraints on the flow of investment

capital. Individuals and firms would be allowed to move their resources into and out of

specific activities, both internally and externally. Lastly, financial freedom is an indicator of

banking efficiency as well as a measure of independence from government control and

intervention in the financial sector. Heritage Foundation (2019) demonstrated that state

ownership of banks and other financial institutions reduces competition and generally

lowers the level of access to credit. Financial freedom is determined by considering five

factors which are; the extent of government regulation, degree of intervention in banks

and other financial institutions, government influence on allocation of credit, the extent of

financial and capital market development and the openness to foreign competition. These

five areas are considered to assess an economy’s overall level of financial freedom which

ensures better opportunities for individuals and businesses to finance their interests.

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Theoretical Framework

A. Solow-Swan Model

The Solow-Swan growth model is the macroeconomic theory of economic growth

which illustrates the effects of saving, population growth and technological progress on

economic growth. The model was developed independently by Robert Solow and Trevor

Swan in 1956. According to Mankiw (2012), higher savings would lead to a higher capital

stock and therefore would lead to higher output and higher depreciation. In addition,

Mankiw (2012) stated that the Solow model expanded to include the effects of the size of

the labor force on growth as well; an increase in size of the labor force would lead to lower

income per person or GDP per capita.

B. Theory and Measurement of Economic Freedom

According to Scully (2004), social scientists recognize three broad categories of

freedom; political, civil or legal, and economic. Economic freedom is about the right to

organize one’s pecuniary affairs with minimal interference by the state, and not about just

economic outcomes. While the measurement of political and civil liberty has been with us

for four decades or so, the measurement of economic freedom is more recent.

The measurement of economic freedom is based on sub-indices of the right to private

property, freedom of association, freedom of travel, and the right to information. However,

freedom of property includes land reform which is frequently about confiscation without

compensation, the extent of social services and income distribution. A quantitative

measure of economic freedom should be more precise and comprehensive compared to

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other factors of freedom. In the component of economic freedom, it includes items such

as right to private property, freedom of contract, rule of law, the size of government and

its command over resources, the extent of fiscal state, the degree of government

economic regulation of business, labor and many other factors. Scully (2004) further

demonstrated that having a high or low level of economic freedom would correlate to a

high or low ranking based on measure. However, the index is based on objective criteria,

the countries ranked in between high and low are a matter of dispute. Therefore, the level

of economic freedom has a direct correlation to economic growth.

Operational Framework

A. Description of Variable

The table presented below shows the variables to be used in the econometric

model, with the labels on Gretl, the definitions of each term, unit of measurement and the

sources of the definitions. The model will be using the 2019 Index of Economic Freedom

(labelled as index score) for its dependent variable, which is taken from Heritage

Foundation. The model will have nine regressors or independent variables, namely,

Inflation (inflation), Income Tax Rate (income), GDP growth rate (GDP), Unemployment

(unemployment), Tariff Rate (tariff), Corporate Tax Rate (corporate), Tax Burden (burden),

Government Expenditure (expenditure) and Public Debt (debt)

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Freedom of Economy

Variable Gretl Definition Unit Source

Label

Dependent Variable

Index of index Index of Economic Freedom 0-100, 100 Heritage

Economic _score is a quantitative variable being the Foundati

Freedom measuring the level of most on

economic freedom in a economically (2019)

country in terms of Trade free

policy, Fiscal burden of

government, Government

intervention in the economy,

Monetary policy, Banking and

finance, Capital flows and

foreign investment, Wages

and prices, Property rights,

Regulation, and Informal

market.

Independent Variable

Inflation inflation Inflation is a quantitative Percentage OECD

variable measuring the (2019)

increase in the price of goods

over time.

Income Tax Income Income Tax Rate is a Percentage Heritage

Rate quantitative variable Foundati

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measuring personal income on

tax and employees’ social (2019)

security contribution as a

percentage of gross wage

earnings

GDP Growth GDP The GDP Growth Rate is a Percentage OECD

Rate quantitative variable (2019)

measuring the change in an

economy’s GDP relative to

the previous period

Unemploy- Unemplo- Unemployment rate is a Percentage OECD

ment yment quantitative variable (2019)

measuring the proportion of

the labor force that is

unemployed

Tariff Rate tariff A rate derived from the data Percentage Heritage

in the tariff of rates, for Foundati

example, schedules and on

rating tables. This rate is set (2019)

forth by a rating organization.

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Freedom of Economy

Corporate corporate Corporate tax rate is a Percentage Heritage

Tax Rate quantitative measurement Foundati

that shows levy placed on a on

firm's profit by the (2019)

government. The money

collected from corporate

taxes is used for a nation's

source of income.

Tax Burden burden Tax Burden is a measure of Percentage Heritage

the tax burden imposed by Foundati

government. It includes direct on

taxes, in terms of the top (2019)

marginal tax rates on

individual and corporate

incomes, and overall taxes,

including all forms of direct

and indirect taxation at all

levels of government, as a

percentage of GDP.

Government expenditure This component considers Percentage Heritage

Expenditure the level of government Foundati

expenditures as a percentage on

of GDP. Government (2019)

expenditures, including

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Freedom of Economy

consumption and transfers,

account for the entire score.

Public Debt debt The public debt is how much Percentage Heritage

a country owes to lenders Foundati

outside of itself. These can on

include individuals, (2019)

businesses, and even other

governments.

B. A-priori expectations

The table below presents the A-priori Expectations between the dependent

variable economic freedom and the independent variables. The consistency of these a-

priori expectations will be verified by the regression analysis in the succeeding parts of

this paper. Take note that the variable of index of economic freedom measurement

ranging from 0 – 100, with 0 being the least economically free and 100 being the most

economically free country. Therefore, when the expected relationship is positive, an

increase in the independent variable increases economic freedom. On the other hand, a

negative relationship means that an increase in the independent variable will to a decrease

in economic freedom.

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Freedom of Economy

Variable Expected Relationship Rationale

Inflation Negative (-) An increase in the inflation

(inflation) rate implies an increase in

prices which reduces the

purchasing power of

individuals.

Income Tax Rate Negative (-) An increase in the income

(income) tax rate means that there

are more money taxed from

the income of workers

which reduces their

income.

GDP Growth Rate Positive (+) Lower income growth can

(GDP) stimulate lower economic

freedom through the

deprivation of the work

ethics of individuals or

organizations.

Unemployment Negative (-) The more the unemployed,

(Unemployment) the more people without

means to an income,

Hence, the higher the

unemployment, the lower

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Freedom of Economy

the index of economic

freedom

Tariff Rate Negative (-) The higher the tariff rates

(tariff) are, it affects the index of

economic freedom

because it hinders people

to export or import goods

and services due to high

tariffs

Corporate Tax Rate Negative (-) The income of the country

(corporate) are affected when the

corporate tax rate is higher

because it reduces the

income since more money

are being taxed.

Tax Burden Negative (-) The increase in tax burden

(burden) implies that there is a big

tax burden on the total tax

of the people, businesses

and other institutions.

Government Expenditure Negative (-) Research has shown that

(expenditure) excessive government

spending that causes

chronic budget deficits. The

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Freedom of Economy

methodology treats zero

government spending as

the benchmark

Public Debt Negative (-) The increase in public debt

(debt) causes a negative effect on

the index of economic

freedom because there is a

big present factor of deficit

whenever public debt is

large which causes to tax

people more.

C. Econometric Model

The aforementioned a-priori expectations must be considered in the construction

of the econometric model, which will be verified by the regression results run by Gretl. The

econometric model is therefore given by

index _ score  0  1inflation  2income  3GDP  4unemployment 

5tariff  6corporate  7burden  8expenditure  9debt  i

Take note that from the model, i is maintained. This implies that i will factor

in all the other variables that affect the dependent variable, which is index_score and is

not explained by the independent variables in the econometric model.

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 Freedom of Economy

Methodology

A. Data Collection

The table below presents the dataset on the Index of Economic Freedom, Inflation,

Income Tax Rate, GDP growth rate, Unemployment Rate, Tariff Rate, Corporate Tax

Rate, Tax Burden, Government Expenditure and Public Debt of the 36 OECD Countries.

The data is provided by the Heritage Foundation. It is significant to remember that the

following data are taken from one year, 2019

Country Name 2019 Score Inflation Income Tax Rate GDP Growth Rate Unemployment Tariff Rate Corporate Tax Rate Tax Burden Gov't Expenditure Public Debt
Australia 80.9 2 45 2.3 5.6 1.2 30 28.2 36.5 41.6
Austria 72 2.2 50 2.9 5.5 2 25 42.7 50.2 78.8
Belgium 67.3 2.2 50 1.7 7.4 2 29 44.2 53.2 103.2
Canada 77.7 1.6 33 3 6.3 1.6 15 31.7 40.3 89.7
Chile 75.4 2.2 35 1.5 7 0.6 25 20.4 25.2 23.6
Czech Republic 73.7 2.4 15 4.3 2.9 2 19 34 40 34.7
Denmark 76.7 1.1 56 2.1 5.7 2 23.5 45.9 53.4 36.4
Estonia 76.6 3.7 20 4.9 5.8 2 20 34.7 40.4 8.8
Finland 74.9 0.8 31.3 3 8.6 2 20 44.1 55.6 61.4
France 63.8 1.2 45 1.8 9.4 2 33 45.3 56.6 97
Germany 73.5 1.7 47.5 2.5 3.8 2 15.8 37.6 43.9 64.1
Greece 57.7 1.1 42 1.4 21.5 2 29 38.6 50.6 181.9
Hungary 65 2.4 15 4 4.2 2 19 39.4 47.7 69.9
Iceland 77.1 1.8 31.8 3.6 2.8 1.5 20 36.4 43.2 40.9
Ireland 80.5 0.3 41 7.8 6.4 2 12.5 23 27.4 68.5
Israel 72.8 0.2 48 3.3 4.3 2.8 23 31.2 39.8 61
Italy 62.2 1.3 43 1.5 11.2 2 27.5 42.9 49.5 131.5
Japan 72.1 0.5 40.8 1.7 2.8 2.5 23.9 30.7 38.7 236.4

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Korea, North 5.9 N/A N/A 1.1 4.8 50 N/A N/A 100 N/A
Korea, South 72.3 1.9 46.2 3.1 3.7 4.8 27.5 26.3 32.4 39.8
Latvia 70.4 2.9 31.4 4.5 8.7 2 20 30.2 37.8 34.8
Lithuania 74.2 3.7 15 3.8 7.1 2 15 30.2 34.1 36.5
Luxembourg 75.9 2.1 42 3.5 5.5 2 18 37.1 42.2 23
Mexico 64.7 6 35 2 3.4 4.3 30 17.2 26.9 54.2
Netherlands 76.8 1.3 52 3.1 4.8 2 25 38.8 43.6 56.7
New Zealand 84.4 1.9 33 3 4.9 1.3 28 32.1 40.7 26.4
Norway 73 1.9 47.8 1.8 4.2 3.4 23 38 49.9 36.7
Poland 67.8 2 32 4.6 4.9 2 19 33.6 41.3 51.4
Portugal 65.3 1.6 48 2.7 8.9 2 23 34.4 46.3 125.6
Slovakia 65 1.3 25 3.4 8.1 2 21 32.7 42.4 50.4
Slovenia 65.5 1.4 50 5 6.6 2 17 37 45.4 75.4
Spain 65.7 2 45 3.1 17.2 2 25 33.5 42.3 98.4
Sweden 75.2 1.9 57 2.4 6.7 2 22 44.1 49.4 40.9
Switzerland 81.9 0.5 40 1.1 4.8 1.3 24 27.8 34.3 42.8
Turkey 64.6 11.1 35 7 11.3 2.7 22 25.5 34.1 28.5
United Kingdom 78.9 2.7 45 1.8 4.3 2 20 33.2 41.6 87
United States 76.8 2.1 37 2.3 4.4 1.7 21 26 37.8 107.8

The data presented in the table shows the index score for the year 2019 and the

nine independent variables affecting the index of economic freedom. In addition, the nine

independent variable are all in percentage form. Recall that North Korea is excluded from

the list of the OECD countries.

B. Empirical Procedure

The dataset entitled “Melvin Cuevas freedom index data.gdt” is viewable for

testing. The data presented in the table will be regressed and tested using the software,

Gretl.

The researcher made use of the Ordinary Least Squares (OLS) estimators in order

to achieve the objective of determining the relationship of the variables and the index of

economic freedom in creating an econometric model. The model will be using a lin-lin

25
Freedom of Economy

form, thus, unit changes in the independent variables will yield changes in the dependent

variable index_score by  j units where j = 1 – 12.

The hypotheses to test the individual significance of the independent variables

are given by:

Null Hypothesis H0 :  j  0 for j 1 7

Alternative Hypothesis
(as discussed in the a-priori
expectations)
H1 :  j  0 for j  3
(GDP)
H1 :  j  0 for j 1,2,4,5,6,7,8,9
(inflation, income, GDP, unemployment, tariff,

corporate, burden, expenditure, debt)

This paper will make use of a 95% confidence interval (5% level of significance) which

is the usual confidence level used in an empirical research paper. According to Gujarati &

Porter (2005), whenever the resulting p-value of a regressor is less than 0.05 or 5% level

of significance, then the variable becomes statistically significant at 95% confidence

interval, resulting to a rejection of the null hypothesis. On the other hand, if the resulting

p-values of the regressor is greater than 0.05, then at 95% confidence interval, we fail to

reject the null hypothesis. In addition, the model will be tested for significance,

multicollinearity, heteroskedasticity and misspecification.

26
Freedom of Economy

Empirical Results

A. Initial Regression and Results

The researcher obtained the following results, using the provided dataset, in the

software Gretl by running the initial Ordinary Least Squares (OLS) regression:

Model 1: OLS, using observations 1-36

Dependent variable: index_score
Coefficient Std. Error t-ratio p-value
const 96.5472 7.60105 12.70 <0.0001 ***
inflation −0.649839 0.500555 −1.298 0.2056
income 0.122235 0.0767914 1.592 0.1235
GDP −0.337031 0.732307 −0.4602 0.6492
unemployment −0.712031 0.232864 −3.058 0.0051 ***
tariff −3.02195 1.10196 −2.742 0.0109 **
corporate −0.130921 0.220969 −0.5925 0.5586
burden −0.0247941 0.414188 −0.05986 0.9527
expenditure −0.211206 0.384093 −0.5499 0.5871
debt −0.0429158 0.0198536 −2.162 0.0400 **

Mean dependent var 72.17500 S.D. dependent var 6.319239

Sum squared resid 477.2840 S.E. of regression 4.284516

R-squared 0.658509 Adjusted R-squared 0.540301

F(9, 26) 5.570745 P-value(F) 0.000269

Log-likelihood −97.60446 Akaike criterion 215.2089

Schwarz criterion 231.0441 Hannan-Quinn 220.7358

27
Freedom of Economy

The researcher is able to determine the coefficients to empirically establish the

relationship between the dependent variables and the independent variables, index_score

and to determine the level of significance of each variable. Given by the regression results,

the econometric model is presented by:

index _ score  96.5472  0.649839(inflation)  0.122235(income)  0.337031(GDP)

0.712031(unemployment)  3.02195(tariff)  0.130921(corporate)  0.0247941(burden)
0.211206(expenditure)  0.0429158(debt)

Based from the regression results, it is seen that the intercept  0 has a p-value

of 0.0001, which is less than 0.05. This implies that the intercept is significant at 5% level

of significance. Also, it is seen that intercept  0 has p-value of 0.0001, which is less than

0.01. This means that the intercept is significant at 1% level of significance. In addition,

without the other factors affecting the index of economic freedom, the intercept  0

resulting to 96.5472 means that the average score of index of economic freedom is

96.5472. Thus, the index of economic freedom is generally high in OECD countries.

It can be seen that 3 independent variables; unemployment, tariff, debt, yield p-

values that are less than 0.05. Therefore, these three independent variables are

statistically significant. In addition, there is a strong evidence that these variables can

explain the dependent variable index_score. Thus, at a 5% level of significance, we reject

the null hypothesis for the three variables; unemployment, tariff, debt

For the nine independent variables; inflation, income, GDP, unemployment, tariff,

corporate, burden, expenditure, debt, only one variable; unemployment has yield a p-value

that is less than 0.01, which implies that the variables are statistically significant even at

28
Freedom of Economy

1% level of significance. Therefore, at 99% confidence interval, we reject the null

hypothesis for the unemployment variable.

Six independent variables, inflation, income, GDP, corporate, burden and

expenditure, yield p-values that are greater than 0.05. Thus, these variables are

statistically insignificant and implies that there is no evidence that these variables can

explain the dependent variable index_score. Therefore, at a 5% level of significance, we

fail to reject the alternative hypothesis for the six variables inflation, income, GDP,

corporate, burden and expenditure.

The next step would be to verify the consistency of the three variables to the

aforementioned a-priori expectations, given that three variables are significant

independent variables specifically, unemployment, tariff and debt. The initial

interpretations are presented in the table below:

Regressor Interpretation

unemployment A unit increase in the unemployment would yield a decrease in the

Index of Economic Freedom by 0.649839, which implies a

decrease in economic freedom. This is consistent with the a-priori

expectation which stated that a higher unemployment rate, which

means less work force, will lead to a decrease in economic freedom

because productivity is lower.

tariff A unit increase in the tariff rates would yield a decrease in the Index

of Economic Freedom by 3.02195, which implies a decrease in

29
Freedom of Economy

economic freedom. This is consistent with the a-priori expectation

which stated that a higher tariff rates would result to lower

economic freedom. Higher tariff rates imply that people would

export and import less goods and services other countries because

of high tariff rates. Therefore, it contradicts the concept of free trade

which is a good factor for economic freedom. According to Lawson

(2016), if the government taxes or otherwise prevents people from

buying or selling with people in other countries, it reduces their

freedom. This implies that tariffs hinder people to engage in trade

with any person of their choosing.

debt A unit increase in public debt, which is a percentage of GDP, would

yield a decrease in the Index of Economic Freedom by 0.0429158,

which implies a decrease in economic freedom. This is consistent

with the a-priori expectation that the increase in public debt causes

a negative effect on the index of economic freedom because there

is a big present factor of deficit whenever public debt is large which

causes to tax people more. An increase in public debt leads for the

government to pay off more countries and institutions which makes

them create regulations for them to tax people and businesses and

therefore contradicts the concept of economic freedom.

30
Freedom of Economy

B. Goodness of Fit

R-squared 0.658509 Adjusted R-squared 0.540301

According to Gujarati & Porter (2009), the goodness of fit, also known as R2, is

defined as “the proportion of percentage of the total variation in Y explained by the

regression model.” The goodness of fit is a coefficient of determination for multiple

regression, which is another test that distinguishes the significance of the regression.

In addition, the goodness of fit serves as an explanatory power of the regression

model, which has a value between 0 and 1. There is a higher explanatory power of the

model if the value of the goodness of fit is closer to 1. This implies that the sample

regression line fits the data well.

Using Gretl to perform the regression, the regression yielded a R2 value of

0.658509, which means that the value of R2 is 65.8509%. This implies that the

regression model explains 65.8509% of the variation found in index_score, which is

the index of economic freedom.

On the other hand, the R2 should not be the only test taken into consideration

because the regression model used more than one regressor, nine to be exact. The

adjusted R2 would provide a better and unbiased measure for the goodness of fit with

respect to the number of regressors in the model. The adjusted R2 yielded a value of

0.540301, which implies that the model explains 54.0301% of the variation in index of

economic freedom. The model has a high explanatory power because 0.540301 is

closer to 1, thus the model has a good fit.

31
Freedom of Economy

C. Overall Test of Significance

The ANOVA, which stands for Analysis of Variance, is used to find the overall

level of significance of the model. The hypotheses to test the overall significance of

the independent variables are given by:

Null Hypothesis H 0 : 1  2  3  4  5  6 
7  8  9  0
(all regressors are insignificant)

Alternative Hypothesis

At least one regressor is not 0, there is at least one

significant regressor

Based from Gujarati & Porter (2009), the paper will make use of the 95%

confidence interval, which is also 5% level of significance, this is the confidence level

usually used in empirical research. Therefore, when the resulting p-value of a regressor

is less than 0.05 or 5% level of significance, this implies that at least one of the

regressors becomes statistically significant at 95% confidence interval and it would

result to the rejection of the null hypothesis. However, if the resulting p-value of the

regressor is greater than 0.05 or 95% confidence interval, this implies that all the

regressors are statistically insignificant and it would result to failure to reject the null

hypothesis. This would lead for the model to be insignificant.

32
Freedom of Economy

The ANOVA test conducted in Gretl yielded the following results:

Analysis of Variance:

Sum of squares df Mean square

Regression 920.363 9 102.263

Residual 477.284 26 18.3571

Total 1397.65 35 39.9328

R^2 = 920.363 / 1397.65 = 0.658509

F(9, 26) = 102.263 / 18.3571 = 5.57075 [p-value 0.0003]

The R2 can be determined from the ANOVA test with a value of 0.658509, the

corresponding p-value of the model is almost or extremely near to zero. The F-value is

computed in the ANOVA test as well, resulting to a value of 5.57075. It can also be

seen that the p-value, 0.0003, is less than 0.05 level of significance. Therefore, at 95%

confidence interval, we reject the null hypothesis, meaning that the model is statistically

significant.

It is important to take note that it is relevant to check for violations in the critical

assumptions of the model. Checking for violations in the critical assumptions of the

model is included in the responsibilities of econometric analysts, not just checking for

the mathematical adequacy and statistical significance of the models. Since the

33
Freedom of Economy

researcher uses cross-sectional data in the paper, the researcher would test the model

for the violations namely, multicollinearity, heteroskedasticity, and misspecification.

D. Test for Multicollinearity

Non-multicollinearity is one of the critical assumptions of the classic linear

regression model or CLRM, in which independent variables should not relate to other

independent variables (Gujarati & Porter, 2009). The estimates would be unstable with

respect to small changes in data and there may exist a multicollinearity paradox when

the assumption is violated. Multicollinearity paradox is the assymetry of results of the

joint test of the individual tests. Therefore, one of the most important tests to conduct

is checking for the presence of multicollinearity among the regressors.

In testing for collinearity, the Variance Inflation Factor or VIF can be used. If any

Variance Inflation Factor, which is measured by 1 / (1 – R2), which is at least 10, which

would mean that the model exhibits near perfect multicollinearity therefore, the

correction for the model is needed. In running the Variance Inflation Factor in Gretl,

the results are:

Variance Inflation Factors

Minimum possible value = 1.0
Values > 10.0 may indicate a collinearity problem

inflation 1.669

income 1.388

GDP 2.256

unemployment 1.523

34
Freedom of Economy

tariff 1.334

corporate 2.126

burden 16.579

expenditure 17.127

debt 1.607

VIF(j) = 1 / (1 - R(j)^2), where R(j) is the multiple correlation coefficient

between variable j and the other independent variables

Belsley-Kuh-Welsch collinearity diagnostics:

--- variance proportions ---

lambda cond const inflation incom GDP unemploy~ tariff corporate

8.686 1.000 0.000 0.002 0.001 0.001 0.002 0.001 0.000

0.578 3.877 0.000 0.239 0.002 0.017 0.005 0.001 0.000

0.254 5.852 0.001 0.182 0.010 0.017 0.244 0.016 0.000

0.181 6.924 0.000 0.152 0.003 0.124 0.238 0.079 0.003

0.144 7.758 0.000 0.009 0.018 0.211 0.087 0.007 0.013

0.075 10.760 0.002 0.263 0.001 0.002 0.304 0.599 0.000

0.045 13.873 0.000 0.015 0.781 0.036 0.003 0.158 0.000

0.029 17.259 0.036 0.126 0.163 0.038 0.020 0.105 0.378

0.007 35.915 0.944 0.002 0.001 0.539 0.074 0.000 0.588

0.001 89.580 0.017 0.011 0.020 0.014 0.024 0.033 0.018

35
Freedom of Economy

lambda cond burden expendit~ debt

8.686 1.000 0.000 0.000 0.002

0.578 3.877 0.000 0.000 0.088

0.254 5.852 0.000 0.000 0.128

0.181 6.924 0.000 0.000 0.118

0.144 7.758 0.000 0.000 0.446

0.075 10.760 0.004 0.002 0.102

0.045 13.873 0.006 0.004 0.004

0.029 17.259 0.009 0.004 0.000

0.007 35.915 0.008 0.002 0.034

0.001 89.580 0.972 0.987 0.079

lambda = eigenvalues of inverse covariance matrix (smallest is 0.00108241)

cond = condition index

note: variance proportions columns sum to 1.0

Based from the results above, there are two independent variables that have VIF

values that are greater than ten, which are burden and expenditure and has a value

of 16.579 and 17.127 respectively. Therefore, multicollinearity likely would exist in the

model since there are two variables that have VIF values greater than ten. In addition

to this, it implies that the two variables are correlated with one another. Thus,

corrective measures are needed to be implemented in the model for multicollinearity.

One of the corrective measures is to omit the variables, though one must exercise

caution when doing so as this may either result to another problem known as omitted

variable bias.

36
Freedom of Economy

The model’s tolerance can also be measured which is given by 1 / VIF. If the

tolerance is less than or equal to 0.1, then the model exhibits dangerous

multicollinearity. Since the highest VIF run by Gretl is 17.127, then the tolerance is

given by 1 / 17.127 = 0.058387341 < 0.1. Therefore, multicollinearity is present in the

model because the tolerance is less than 0.1.

E. Test for Heteroskedasticity

Homoscedasticity is another critical assumption of the classical linear regression

model or CLRM which means that the variance of the error term is constant for all

observations. The model exhibits heteroskedasticity, meaning that the variance cannot

be fixed because there is an uneven spread of the variance in the residuals when the

assumption is violated. This implies that the standard error is not constant, and we

need a constant standard error to minimize the residual sum of squares (objective of

OLS). There are three tests that can be run on Gretl to test for the model’s

heteroskedasticity; White’s Test, Breusch-Pagan-Godfrey (BPG) Test, Koenker

Bassett Test.

(1) White’s Test

White’s Test is the general test of heteroskedasticity because it considers

the cross products and the squares of the independent variables as well. Recall

that the researcher makes use of the 95% confidence interval or at 5% level of

significance. If the resulting p-value of the White’s Test is less than 0.05, which is

at 5% level of significance, then at 95% confidence interval, we have to accept the

alternative hypothesis. Therefore, this implies that the model is heteroskedastic

and needs corrective measures, either using Robust Option or White’s Correction.

37
Freedom of Economy

However, when the resulting p-value of White’s Test is greater than 0.05,

then at 95% confidence interval, we fail to reject the null hypothesis. This implies

that the model is homoscedastic and no longer needs corrective measures.

The results of the White’s Test are presented below:

White's test for heteroskedasticity

OLS, using observations 1-36
Dependent variable: uhat^2

coefficient std. error t-ratio p-value

----------------------------------------------------------------------------------------------------------

const 30.4789 125.181 0.2435 0.8105

inflation −0.791205 7.39436 −0.1070 0.9160

income 0.395935 2.24011 0.1767 0.8618

GDP 10.8182 14.5460 0.7437 0.4672

unemployment 3.51448 4.07632 0.8622 0.4006

tariff −56.3201 34.7575 −1.620 0.1236

corporate 0.478139 7.30302 0.06547 0.9486

burden −7.25787 11.0939 −0.6542 0.5217

expenditure 5.82054 12.8408 0.4533 0.6561

debt −0.157091 0.315644 −0.4977 0.6251

sq_inflation −0.112763 0.682045 −0.1653 0.8706

sq_income −0.00773281 0.0314302 −0.2460 0.8086

sq_GDP −0.699468 1.81542 −0.3853 0.7048

sq_unemployment −0.171118 0.172203 −0.9937 0.3343

sq_tariff 9.34647 6.36266 1.469 0.1601

38
Freedom of Economy

sq_corporate −0.0239976 0.153323 −0.1565 0.8775

sq_burden 0.0616686 0.153181 0.4026 0.6923

sq_expenditure −0.0273691 0.141561 −0.1933 0.8490

sq_debt 0.000958680 0.00128842 0.7441 0.4670

Unadjusted R-squared = 0.404216

Test statistic: TR^2 = 14.551780,

with p-value = P(Chi-square(18) > 14.551780) = 0.692478

The p-value from White’s Test is 0.692478, which is greater than 0.05, then

at 95% confidence interval, we fail to reject the null hypothesis. This implies that

the model is homoscedastic and there is no longer the need to apply corrective

measures for heteroskedasticity.

(2) Breusch-Pagan-Godfrey (BPG) Test

The Breusch-Pagan-Godfrey Test or BPG is often referred to as the Lagrange

Multiplier test, which is another test for heteroscedasticity. The BPG Test will test

the dependency of the variance against the independent variables. Contrary to the

White’s Test, which considers the cross products and the squares of the

independent variables, Breusch- Pagan Test takes into consideration the average

squared residual. The test uses a statistical chi-squared test, and using the 5%

level of significance, when the p-value of the BPG Test results into a value less

than 0.05 or 5% level of significance, it implies that at 95% confidence interval, we

39
Freedom of Economy

accept the alternative hypothesis. The alternative hypothesis states that the model

is heteroskedastic and needs corrective measures.

In addition, when the p-value of the BPG Test resulted to a value greater

than 0.05, then at 95% confidence interval, we fail to reject the null hypothesis.

The results of the Breusch-Pagan-Godfrey Test are presented below:

Breusch-Pagan test for heteroskedasticity

OLS, using observations 1-36
Dependent variable: scaled uhat^2

coefficient std. error t-ratio p-value

----------------------------------------------------------------------------------------------------------

const 1.66828 2.27890 0.7321 0.4707

inflation −0.167378 0.150073 −1.115 0.2749

income −0.0172791 0.0230231 −0.7505 0.4597

GDP 0.200068 0.219556 0.9112 0.3705

unemployment −0.0358368 0.0698160 −0.5133 0.6121

tariff −0.433716 0.330384 −1.313 0.2007

corporate 0.0238823 0.0662496 0.3605 0.7214

burden −0.213021 0.124179 −1.715 0.0982 *

expenditure 0.188087 0.115157 1.633 0.1145

debt −0.00418947 0.00595238 −0.7038 0.4878

40
Freedom of Economy

Explained sum of squares = 11.9351

Test statistic: LM = 5.967542,

with p-value = P(Chi-square(9) > 5.967542) = 0.743162

It can be seen that the p-value from the Breusch-Pagan-Godfrey Test is

0.743162, which is greater than 0.05. Therefore, at 95% confidence interval, we

fail to reject the null hypothesis, which implies that the model is homoscedastic.

Since the model is homoscedastic, then there is no longer the need to apply

corrective measures for heteroskedasticity.

(3) Koenker Bassett Test

The third and last test to determine heteroskedasticity is using the Koenker-

Basett Test. Similar to the BPG Test, it uses a statistical chi-squared test, and

using the 5% level of significance. If the resulting p-value of the Koenker-Bassett

Test gives a value that is less than 0.05 or 5% level of significance, then at 95%

confidence interval, we accept the alternative hypothesis. This means that the

model is heteroscedastic and needed to apply corrective measures.

However, if the resulting p-value of the Koenker-Basset Test yields a value

greater than 0.05, then at 95% confidence interval, we fail to reject the null

hypothesis. This implies that the model is homoscedastic and there is no longer

the need to apply corrective measures.

41
Freedom of Economy

The results of the Koenker-Bassett Test are presented below:

Breusch-Pagan test for heteroskedasticity

OLS, using observations 1-36
Dependent variable: scaled uhat^2 (Koenker robust variant)

coefficient std. error t-ratio p-value

------------------------------------------------------------------------------------------------

const 8.85995 30.2134 0.2932 0.7717

inflation −2.21908 1.98966 −1.115 0.2749

income −0.229085 0.305238 −0.7505 0.4597

GDP 2.65248 2.91085 0.9112 0.3705

unemployment −0.475121 0.925612 −0.5133 0.6121

tariff −5.75016 4.38020 −1.313 0.2007

corporate 0.316628 0.878329 0.3605 0.7214

burden −2.82422 1.64635 −1.715 0.0982 *

expenditure 2.49364 1.52673 1.633 0.1145

debt −0.0555436 0.0789160 −0.7038 0.4878

Explained sum of squares = 2097.85

Test statistic: LM = 7.835223,

with p-value = P(Chi-square(9) > 7.835223) = 0.550833

It can be seen that the p-value from the Koenker-Basset Test is 0.550833,

which is greater than 0.05. Therefore, at 95% confidence interval, we fail to reject

the null hypothesis, which implies that the model is homoscedastic. Since the

42
Freedom of Economy

model is homoscedastic, then there is no longer the need to apply corrective

measures for heteroskedasticity. Therefore, all three tests for heteroskedasticity

yielded consistent results and no longer needs correcting.

F. Test for Misspecification

Misspecification is another violation of the classical linear regression model or

CLRM. Misspecification occurs if the models are incorrectly specified, this means that

the functional form is incorrect, the method of measurement is also incorrect or when

errors use the incorrect functional form. The test for misspecification includes the test

for omitted variable bias or OVB. This happens when significant variables were not

included in the model. This would lead to inconsistency of results for the regression

model. Therefore, the model would become less significant, and making it difficult to

identify the relevance of the regression results.

Ramsey’s Reset Test, also known as Regression Specification Error Test

(RESET), is used to test for omitted variable bias. Using the 5% level of significance,

when the p-value of the Ramsey’s Reset Test resulted to a value less than 0.05 or 5%

level of significance, this means that at 95% confidence interval, we accept the

alternative hypothesis. Accepting the alternative hypothesis implies that the model is

misspecified and needs corrective measures.

However, if the resulting p-value of the Ramsey’s Reset Test yields a value greater

than 0.05, then at 95% confidence interval, we fail to reject the null hypothesis. This

implies that the model is correctly specified and there is no longer the need to apply

corrective measures.

43
Freedom of Economy

The results of the Ramsey’s Reset Test are presented below:

RESET Test for specification (squares and cubes)

Test statistic: F = 0.965192,

with p-value = P(F(2,24) > 0.965192) = 0.395

RESET Test for specification (squares only)

Test statistic: F = 0.118324,

with p-value = P(F(1,25) > 0.118324) = 0.734

RESET Test for specification (cubes only)

Test statistic: F = 0.078838,

with p-value = P(F(1,25) > 0.0788376) = 0.781

There are three types that Gretl generated p-values for the RESET Test, these

are; squares and cubes, squares only and cubes only. The p-values for squares and

cubes, squares only, and cubes only for the RESET Test are 0.395, 0.734 and 0.781

respectively. It can be seen that the three RESET Test for specification all yielded p-

values that are greater than 0.05 level of significance. Thus, at 95% confidence

interval, we fail to reject the null hypothesis. This implies that the model contains no

misspecification error and no corrective measures needed for misspecification in the

model.

44
Freedom of Economy

G. Corrective Measures and Final Model

In testing for possible violations made in regressing, there is only one problem

encountered and violated the CLRM assumption which is multicollinearity. The

consequence is specified in the respective part aforementioned.

According to Gujarati & Porter (2009), the possible solutions in addressing

multicollinearity includes doing nothing, using a-priori information, using pooled data,

which is a combination of cross-series and time-series data, dropping a variable(s)

with justification, and transforming data, which is mostly used to more advanced

regression techniques.

Recall from the previous sections that there are two independent variables that

have VIF values that are greater than ten, which are burden and expenditure and

has a value of 16.579 and 17.127 respectively. This implies that the variables are

correlated and multicollinearity most likely exists in the model. For this paper, the

variables burden and expenditure are removed from the regression. The new

regression is given by:

Model 2: OLS, using observations 1-36

Dependent variable: index_score
Coefficient Std. Error t-ratio p-value
const 87.2162 6.58577 13.24 <0.0001 ***
inflation −0.439101 0.510289 −0.8605 0.3968
income 0.0925448 0.0782074 1.183 0.2466
GDP −0.132705 0.758000 −0.1751 0.8623
unemployment −0.827640 0.235878 −3.509 0.0015 ***
tariff −2.92882 1.13404 −2.583 0.0153 **
corporate −0.118266 0.229269 −0.5158 0.6100

45
Freedom of Economy

debt −0.0434118 0.0199539 −2.176 0.0382 **

Mean dependent var 72.17500 S.D. dependent var 6.319239

Sum squared resid 565.0824 S.E. of regression 4.492384
R-squared 0.595690 Adjusted R-squared 0.494613
F(7, 28) 5.893407 P-value(F) 0.000283
Log-likelihood −100.6439 Akaike criterion 217.2879
Schwarz criterion 229.9560 Hannan-Quinn 221.7094

For the new regression, the estimated model becomes:

index _ score  87.2162  0.439101(inflation)  0.0925448(income)  0.132705(GDP)

0.827640(unemployment)  2.92882(tariff)  0.118266(corporate)
0.0434118(debt)

From the new regression results, it is seen that the intercept  0 has a p-value of

0.0001, which is less than 0.01 and less than 0.05. This implies that not only is the

intercept significant at 5% level of significance, but also at 1% level of significance. Since

the intercept  0 has a coefficient of 87.2162, then if the other factors are excluded, the

average level of economic freedom is 87.2162.

It can be seen that 3 independent variables; unemployment, tariff, debt, yield p-

values that are less than 0.05. Therefore, these three independent variables are

statistically significant. In addition, there is a strong evidence that these variables can

explain the dependent variable index_score. Thus, at a 5% level of significance, we reject

the null hypothesis for the three variables; unemployment, tariff, debt. The new

interpretations for the 3 independent variables is shown below:

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Freedom of Economy

Regressor Interpretation

unemployment A unit increase in the unemployment would yield a decrease in the

Index of Economic Freedom by 0.827640, which implies a

decrease in economic freedom. This is still consistent with the a-

priori expectation.

tariff A unit increase in the tariff rates would yield a decrease in the Index

of Economic Freedom by 2.92882, which implies a decrease in

economic freedom. This is still consistent with the a-priori

expectation which stated that a higher tariff rates would result to

lower economic freedom.

debt A unit increase in public debt, which is a percentage of GDP, would

yield a decrease in the Index of Economic Freedom by 0.0434118,

which implies a decrease in economic freedom. This is still

consistent with the a-priori expectation that the increase in public

debt causes a negative effect on the index of economic freedom.

Four independent variables, inflation, income, GDP, and corporate, yield p-values

that are greater than 0.05. Thus, these variables are statistically insignificant and implies

that there is no evidence that these variables can explain the dependent variable

index_score. Therefore, at a 5% level of significance, we fail to reject the alternative

hypothesis for the four variables inflation, income, GDP, and corporate.

47
Freedom of Economy

The goodness of fit indicators only decreased slightly, with R2 becoming 0.595690 or

59.5690% and the adjusted R2 becoming 0.494613 or 49.4613%. Therefore, the model

remains to be significant, having a p-value of 0.000283, which is still less than 0.05 or

5% level of significance.

Testing for multicollinearity:

Variance Inflation Factors

Minimum possible value = 1.0
Values > 10.0 may indicate a collinearity problem
VIF 1 / VIF

inflation 1.578 0.633713561

income 1.310 0.763358778

GDP 2.198 0.454959053

unemployment 1.421 0.703729767

tariff 1.285 0.778210116

corporate 2.082 0.480307396

debt 1.477 0.67704807

Mean VIF 1.622

VIF(j) = 1/(1 - R(j)^2), where R(j) is the multiple correlation coefficient

between variable j and the other independent variables

After dropping the two variables, burden and expenditure, the new independent

variables only show tolerable multicollinearity. It can be seen in the new table of the

Variance Inflation Factors that all the variables have a VIF value less than ten. This

implies that the variables are not correlated with one another.

48
Freedom of Economy

However, by dropping the two variables, there is a risk in committing an omitted

variable bias or OVB as well as worsen autocorrelation (Gujarati & Porter, 2009).

Therefore, after re-running the regression after dropping burden and expenditure, there

is a need to test for these violations using again the Ramsey’s Reset Test (for omitted

variable bias) and the Breusch-Pagan-Godfrey Test (for autocorrelation).

The results for the two tests are presented below:

RESET Test for specification (squares and cubes)

Test statistic: F = 0.973935,

with p-value = P(F(2,26) > 0.973935) = 0.391

RESET Test for specification (squares only)

Test statistic: F = 1.740220,

with p-value = P(F(1,27) > 1.74022) = 0.198

RESET Test for specification (cubes only)

Test statistic: F = 1.784360,

with p-value = P(F(1,27) > 1.78436) = 0.193

Breusch-Pagan test for heteroskedasticity

OLS, using observations 1-36
Dependent variable: scaled uhat^2

Test statistic: LM = 6.734437,

with p-value = P(Chi-square(7) > 6.734437) = 0.457044

The p-values for squares and cubes, squares only, and cubes only for the

RESET Test are 0.391, 0.198 and 0.193 respectively. It can be seen that the three

RESET Test for specification all yielded p-values that are greater than 0.05 level

49
Freedom of Economy

of significance. Thus, at 95% confidence interval, we fail to reject the null

hypothesis. Therefore, dropping the variables burden and expenditure does not

cause an omitted variable bias in the model.

It can be seen that the p-value from the Breusch-Pagan-Godfrey Test is

0.457044, which is greater than 0.05. Therefore, at 95% confidence interval, we

fail to reject the null hypothesis, which implies that the model is homoscedastic.

Therefore, the variables are not autocorrelated.

Conclusions and Recommendations

A. Conclusions

There are numerous economic factors that affect the economic freedom of

a particular country. Policy makers may be able to analyze the important economic

factors that have a strong impact on economic freedom. Since the chosen

countries of the researcher limited it to the OECD and considering that the OECD

countries are relatively strong performers in the global economy, then other

countries, mainly developing countries, can base their policy making in improving

their sectors that have a strong impact on economic freedom. From the performed

regression analysis, the researcher was able to determine five significant variables

that affect a country’s index of economic freedom. Those variables are

unemployment rate, tariff rate, and public debt. However, the initial model did not

pass the test for the violations of the classical linear regression model (CLRM),

specifically multicollinearity for the variables of burden and expenditure. When the

50
Freedom of Economy

model was regressed again for the corrective measures, the three same variables

in the initial regression still determine to be significant variables. The variables –

unemployment rate, tariff rate and public debt, are statistically significant at 95%

confidence interval as well as passing the tests of the CLRM for multicollinearity,

heteroskedasticity and misspecification, then the model is deemed significant.

Therefore, policy makers can base recommendations from the findings of the

presented regression model. Other countries can improve their economic freedom

by focusing their policies on strengthening employment, fixing the tariff rate to an

efficient rate, and addressing the public debt.

Countries that may need to strengthen their economy may find significant

opportunities for improving economic performance in those factors in which they

score the lowest. Economic freedom can be also a guide for policymakers to

consider in shaping the laws and implementing proper regulations on the

community.

B. Recommendations

It should be apparent that a government’s most effective stimulus activity

will not be to increase its own spending or increase layers of regulation, both of

which reduce economic freedom. The best results are likely to be achieved instead

through policy reforms that improve the incentives that drive entrepreneurial

activity, creating more opportunities for greater economic dynamism. Therefore,

strong competition in the open market is a key factor in strengthening economic

freedom.

51
Freedom of Economy

To address the problem of unemployment and to reach full employment

that maximizes productivity, policy makers can help deliver broadly shared wage

growth through monetary and budgetary policy. Policies that will help create jobs

and reach full employment include keeping interest rates unchanged until wage

growth improves; enacting employment programs targeted toward hard-hit

communities; increasing public investment in transportation, research and

development, education and reducing the trade deficit. Policy makers can help to

grow wages by raising the minimum wage; updating overtime rules; strengthening

rights to collective bargaining; regularizing undocumented workers and ending

forced arbitration.

Having high tariff rates can affect the foreign and domestic trade and

investment of countries. It hinders businesses and investors to conduct proper

trade when there is too much regulations imposed on trade and it is very costly for

them to conduct business. Policy makers can consider trade facilitation, logistics

and border management; helping countries integrate into global value chains

through targeted reforms and investments. Also efficient trade agreements can

help improve the tariff rates by advising countries on their technical details and

supporting implementation of commitments made through these agreements.

Emphasizing trade and competitiveness at the core of national development

strategies and creating market and competition policies thorugh encouraging

growth and shared prosperity by opening and transforming markets.

52
Freedom of Economy

Considering these recommendations for policy makers, addressing the

issues in the employment sector and the trade sector can help the public debt of a

particular country as well. It is important to consider the best and efficient policies

for each economic sector that improves economic freedom because great policies

improve the economic condition and leads to great prosperity in a country.

Economic freedom is an important aspect for each country to consider because it

helps build competition and great improvement in the open markets.

53
Freedom of Economy

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