American exceptionalism has been propelled by exceptionally free markets, so it’s tempting to think the United States has a freer economy than Western European countries — particularly those soft-socialist Scandinavian social democracies with punishing tax burdens and lavish, even coddling, welfare states. As late as 2000, the American economy was indeed the freest in the West. But something strange has happened since: Economic freedom in the United States has dropped at an alarming rate.
Meanwhile, a number of big-government welfare states have become at least as robustly capitalist as the United States, and maybe more so. Why? Because big welfare states needed to become better capitalists to afford their socialism. This counterintuitive, even paradoxical dynamic suggests a tantalizing hypothesis: America’s shabby, unpopular safety net is at least partly responsible for capitalism’s flagging fortunes in the Land of the Free. Could it be that Americans aren’t socialist enough to want capitalism to work? It makes more sense than you might think.
America’s falling economic freedom
From 1970 to 2000, the American economy was the freest in the West, lagging behind only Asia's laissez-faire city-states, Hong Kong and Singapore. The average economic freedom rating of the wealthy developed member countries of the Organization for Economic Cooperation and Development (OECD) has slipped a bit since the turn of the millennium, but not as fast as America's.
"Nowhere has the reversal of the rising trend in the economic freedom been more evident than in the United States," write the authors of Fraser Institute’s 2015 Economic Freedom of the World report, noting that "the decline in economic freedom in the United States has been more than three times greater than the average decline found in the OECD."
The Heritage Foundation and the Canadian Fraser Institute each produce an annual index of economic freedom, scoring the world’s countries on four or five main areas, each of which breaks down into a number of subcomponents. The main rubrics include the size of government and tax burdens; protection of property rights and the soundness of the legal system; monetary stability; openness to global trade; and levels of regulation of business, labor, and capital markets. Scores on these areas and subareas are combined to generate an overall economic freedom score.
The rankings reflect right-leaning ideas about what it means for people and economies to be free. Strong labor unions and inequality-reducing redistribution are more likely to hurt than help a country’s score.
So why should you care about some right-wing think tank’s ideologically loaded measure of economic freedom? Because it matters. More economic freedom, so measured, predicts higher rates of economic growth, and higher levels of wealth predict happier, healthier, longer lives. Higher levels of economic freedom are also linked with greater political liberty and civil rights, as well as higher scores on the left-leaning Social Progress Index, which is based on indicators of social justice and human well-being, from nutrition and medical care to tolerance and inclusion.
The authors of the Fraser report estimate that the drop in American economic freedom "could cut the US historic growth rate of 3 percent by half." The difference between a 1.5 percent and 3 percent growth rate is roughly the difference between the output of the economy tripling rather than octupling in a lifetime. That’s a huge deal.
Over the same period, the economic freedom scores of Canada and Denmark have improved a lot. According to conservative and libertarian definitions of economic freedom, Canadians, who enjoy a socialized health care system, now have more economic freedom than Americans, and Danes, who have one of the world’s most generous welfare states, have just as much.
What the hell’s going on?
The redistributive state and the regulatory state are separable
To make headway on this question, it is crucial to clearly distinguish two conceptually and empirically separable aspects of "big government" — the regulatory state and the redistributive state.
The redistributive state moves money around through taxes and transfer programs. The regulatory state places all sorts of restrictions and requirements on economic life — some necessary, some not. Most Democrats and Republicans assume that lots of regulation and lots of redistribution go hand in hand, so it’s easy to miss that you can have one without the other, and that the relationship between the two is uneasy at best. But you can’t really understand the politics behind America’s declining economic freedom if you fail to distinguish between the regulatory and fiscal aspects of the economic policy.
Standard "supply-side" Republican economic policy thinking says that cuts in tax rates and government spending will unleash latent productive potential in the economy, boosting rates of growth. And indeed, when taxes and government spending are very high, cuts produce gains by returning resources to the private sector. But it’s important to see that questions about government control versus private sector control of economic resources are categorically different from questions about the freedom of markets.
Free markets require the presence of good regulation, which define and protect property rights and facilitate market processes through the consistent application of clear law, and an absence of bad regulation, which interferes with productive economic activity. A government can tax and spend very little — yet still stomp all over markets. Conversely, a government can withdraw lots of money from the economy through taxes, but still totally nail the optimal balance of good and bad regulation.
Whether a country’s market economy is free — open, competitive, and relatively unmolested by government — is more a question of regulation than a question of taxation and redistribution. It’s not primarily about how "big" its government is. Republicans generally do support a less meddlesome regulatory approach, but when they’re in power they tend to be much more persistent about cutting taxes and social welfare spending than they are about reducing economically harmful regulatory frictions.
If you’re as worried about America’s declining economic freedom as I am, this is a serious problem. In recent years, the effect of cutting taxes and spending has been to distribute income upward and leave the least well-off more vulnerable to bad luck, globalization, "disruptive innovation," and the vagaries of business cycles.
If spending cuts came out of the military’s titanic budget, that would help. But that’s rarely what happens. The least connected constituencies, not the most expensive ones, are the first to get dinged by budget hawks. And further tax cuts are unlikely to boost growth. Lower taxes make government seem cheaper than it really is, which leads voters to ask for more, not less, government spending, driving up the deficit. Increasing the portion of GDP devoted to paying interest on government debt isn’t a growth-enhancing way to return resources to the private sector.
Meanwhile, wages have been flat or declining for millions of Americans for decades. People increasingly believe the economy is "rigged" in favor of the rich. As a sense of economic insecurity mounts, people anxiously cast about for answers.
Easing the grip of the regulatory state is a good answer. But in the United States, its close association with "free market" supply-side efforts to produce growth by slashing the redistributive state has made it an unattractive answer, even with Republican voters. That’s at least part of the reason the GOP wound up nominating a candidate who, in addition to promising not to cut entitlement spending, openly favors protectionist trade policy, giant infrastructure projects, and huge subsidies to domestic manufacturing and energy production. Donald Trump’s economic policy is the worst of all possible worlds.
This is doubly ironic, and doubly depressing, once you recognize that the sort of big redistributive state supply-siders fight is not necessarily the enemy of economic freedom. On the contrary, high levels of social welfare spending can actually drive political demand for growth-promoting reform of the regulatory state. That’s the lesson of Canada and Denmark’s march up those free economy rankings.
The welfare state isn’t a free lunch, but it is a cheap date
Economic theory tells you that big government ought to hurt economic growth. High levels of taxation reduce the incentive to work, and redistribution is a "leaky bucket": Moving money around always ends up wasting some of it. Moreover, a dollar spent in the private sector generally has a more beneficial effect on the economy than a dollar spent by the government. Add it all up, and big governments that tax heavily and spend freely on social transfers ought to hurt economic growth.
That matters from a moral perspective — a lot. Other things equal, people are better off on just about every measure of well-being when they’re wealthier. Relative economic equality is nice, but it’s not so nice when relatively equal shares mean smaller shares for everyone. Just as small differences in the rate at which you put money into a savings account can lead to vast differences in your account balance 40 years down the road, thanks to the compounding nature of interest, a small reduction in the rate of economic growth can leave a society’s least well-off people much poorer in absolute terms than they might have been.
Here’s the puzzle. As a general rule, when nations grow wealthier, the public demands more and better government services, increasing government spending as a percentage of GDP. (This is known as "Wagner’s law.") According to standard growth theory, ongoing increase in the size of government ought to exert downward pressure on rates of growth. But we don’t see the expected effect in the data. Long-term national growth trends are amazingly stable.
And when we look at the family of advanced, liberal democratic countries, countries that spend a smaller portion of national income on social transfer programs gain very little in terms of growth relative to countries that spend much more lavishly on social programs. Peter Lindert, an economist at the University of California Davis, calls this the "free lunch paradox."
Lindert’s label for the puzzle is somewhat misleading, because big expensive welfare states are, obviously, expensive. And they do come at the expense of some growth. Standard economic theory isn’t completely wrong. It’s just that democracies that have embraced generous social spending have found ways to afford it by minimizing and offsetting its anti-growth effects.
If you’re careful with the numbers, you do in fact find a small negative effect of social welfare spending on growth. Still, according to economic theory, lunch ought to be really expensive. And it’s not.
There are three main reasons big welfare states don’t hurt growth as much as you might think. First, as Lindert has emphasized, they tend to have efficient consumption-based tax systems that minimize market distortions.
When you tax something, people tend to avoid it. If you tax income, as the United States does, people work a little less, which means that certain economic gains never materialize, leaving everyone a little poorer. Taxing consumption, as many of our European peers do, is less likely to discourage productive moneymaking, though it does discourage spending. But that’s not so bad. Less consumption means more savings, and savings puts the capital in capitalism, financing the economic activity that creates growth.
There are other advantages, too. Consumption taxes are usually structured as national sales taxes (or VATs, value-added taxes), which are paid in small amounts on a continuous basis, are extremely cheap to collect (and hard to avoid), while being less in-your-face than income taxes, which further mitigates the counterproductively demoralizing aspect of taxation.
Big welfare states are also more likely to tax addictive stuff, which people tend to buy whatever the price, as well as unhealthy and polluting stuff. That harnesses otherwise fiscally self-defeating tax-avoiding behavior to minimize the costs of health care and environmental damage.
Second, some transfer programs have relatively direct pro-growth effects. Workers are most productive in jobs well-matched to their training and experience, for example, and unemployment benefits offer displaced workers time to find a good, productivity-promoting fit. There’s also some evidence that health care benefits that aren’t linked to employment can promote economic risk-taking and entrepreneurship.
Fans of open-handed redistributive programs tend to oversell this kind of upside for growth, but there really is some. Moreover, it makes sense that the countries most devoted to these programs would fine-tune them over time to amplify their positive-sum aspects.
This is why you can’t assume all government spending affects growth in the same way. The composition of spending — as well as cuts to spending — matters. Cuts to efficiency-enhancing spending can hurt growth as much as they help. And they can really hurt if they increase economic anxiety and generate demand for Trump-like economic policy.
Third, there are lots of regulatory state policies that hurt growth by, say, impeding healthy competition or closing off foreign trade, and if you like high levels of redistribution better than you like those policies, you’ll eventually consider getting rid of some of them. If you do get rid of them, your economic freedom score from the Heritage Foundation and the Fraser Institute goes up.
This sort of compensatory economic liberalization is how big welfare states can indirectly promote growth, and more or less explains why countries like Canada, Denmark, and Sweden have become more robustly capitalist over the past several decades. They needed to be better capitalists to afford their socialism. And it works pretty well.
If you bundle together fiscal efficiency, some offsetting pro-growth effects, and compensatory liberalization, you can wind up with a very big government, with very high levels of social welfare spending and very little negative consequences for growth. Call it "big-government laissez-faire."
The missing political will for genuine pro-growth reform
Enthusiasts for small government have a ready reply. Fine, they’ll say. Big government can work through policies that offset its drag on growth. But why not a less intrusive regulatory state and a smaller redistributive state: small-government laissez-faire. After all, this is the formula in Hong Kong and Singapore, which rank No. 1 and No. 2 in economic freedom. Clearly that’s our best bet for prosperity-promoting economic freedom.
But this argument ignores two things. First, Hong Kong and Singapore are authoritarian technocracies, not liberal democracies, which suggests (though doesn’t prove) that their special recipe requires nondemocratic government to work. When you bring democracy into the picture, the most important political lesson of the Canadian and Danish rise in economic freedom becomes clear: When democratically popular welfare programs become politically nonnegotiable fixed points, they can come to exert intense pressure on fiscal and economic policy to make them sustainable.
Political demand for economic liberalization has to come from somewhere. But there’s generally very little organic, popular democratic appetite for capitalist creative destruction. Constant "disruption" is scary, the way markets generate wealth and well-being is hard to comprehend, and many of us find competitive profit-seeking intuitively objectionable.
It’s not that Danes and Swedes and Canadians ever loved their "neoliberal" market reforms. They fought bitterly about them and have rolled some of them back. But when their big-government welfare states were creaking under their own weight, enough of the public was willing, thanks to the sense of economic security provided by the welfare state, to listen to experts who warned that the redistributive state would become unsustainable without the downsizing of the regulatory state.
A sound and generous system of social insurance offers a certain peace of mind that makes the very real risks of increased economic dynamism seem tolerable to the democratic public, opening up the political possibility of stabilizing a big-government welfare state with growth-promoting economic liberalization.
This sense of baseline economic security is precisely what many millions of Americans lack.
Learning the lesson of Donald Trump
America’s declining economic freedom is a profoundly serious problem. It's already putting the brakes on dynamism and growth, leaving millions of Americans with a bitter sense of panic about their prospects. They demand answers. But ordinary voters aren’t policy wonks. When gripped by economic anxiety, they turn to demagogues who promise measures that make intuitive economic sense, but which actually make economic problems worse.
We may dodge a Trump presidency this time, but if we fail to fix the feedback loop between declining economic freedom and an increasingly acute sense of economic anxiety, we risk plunging the world’s biggest economy and the linchpin of global stability into a political and economic death spiral. It’s a ridiculous understatement to say that it’s important that this doesn’t happen.
Market-loving Republicans and libertarians need to stare hard at a framed picture of Donald Trump and reflect on the idea that a stale economic agenda focused on cutting taxes and slashing government spending is unlikely to deliver further gains. It is instead likely to continue to backfire by exacerbating economic anxiety and the public’s sense that the system is rigged.
If you gaze at the Donald long enough, his fascist lips will whisper "thank you," and explain that the close but confusing identification of supply-side fiscal orthodoxy with "free market" economic policy helps authoritarian populists like him — but it hurts the political prospects of regulatory state reforms that would actually make American markets freer.
Will Wilkinson is the vice president for policy at the Niskanen Center.