Economic Freedom And Entrepreneurship Russell S Sobel

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On this illustration with regards to economic freedom and entrepreneurship russell s. sobel.

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2. Economic Freedom and
Entrepreneurship
Russell S. Sobel
School of Business Administration, Te Citadel
1. Introduction
Entrepreneurship is a primary driving force behind economic growth and prosper-
ity. A large share of the diferences in national economic growth rates across coun-
tries is explained simply by difering levels of entrepreneurial activity. Reynolds,
Hay, and, Camp (1999) fnd that one-third of the diference in economic growth
rates across countries is explained by difering levels of entrepreneurship, while
Zacharakis, Bygrave, and Sheperd (2000) fnd that difering levels of entrepreneur-
ial activity explain approximately one half of the diferences in economic growth
among countries.
Te actions of entrepreneurs create not only wealth and jobs, but also new
goods and services that improve the well-being of consumers. During the past
century alone, medical innovations have resulted in life expectancy increasing by
approximately 30 years in the United States,1 and those years are spent in more
comfort because of entrepreneurs such as Willis Carrier who invented modern
air conditioning, and Italian immigrant Candido Jacuzzi who developed the frst
hydrotherapy pump for bathtubs to help his son who sufered from juvenile rheu-
matoid arthritis.
Economists have long recognized the important role that entrepreneurs play
in advancing society. Schumpeter (1942) described how entrepreneurs search for
new combinations of resources, guided by the proft and loss system, and unleash
1. Life expectancy at birth was 78.7 in 2010 and 47.3 in 1900 (United States Centers for Disease
Control and Prevention, 2014: table 19).
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38 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
a process of “creative destruction” in which new goods and services replace old
ones. Kirzner (1997) argued that the entrepreneurial discovery process is vital to
the efectiveness of markets.
As is discussed at length elsewhere in this book, there is a clear and robust
link between the level of economic freedom across countries (and states) and their
levels of economic performance. Simply stated, beter institutions that are con-
sistent with more economic freedom result in higher levels of income and faster
economic growth. However, entrepreneurship is a main reason higher levels of
economic freedom promote growth. More economic freedom results in higher
prosperity precisely because it results in higher levels of entrepreneurial activity
(Sobel, 2008a; Kref and Sobel, 2005; Sobel, Clark, and Lee, 2007; Hall and Sobel,
2008; Hall, Sobel, and Crowley, 2010).
More specifcally, beter economic institutions tend to more productively
allocate the entrepreneurial talent within a society (Sobel, 2008a, Baumol, 1990,
1993, 2002). Every state and nation has large numbers of people who are innova-
tive and entrepreneurial. However, the proportion of those individuals who choose
to actually pursue a life as a for-proft market entrepreneur is infuenced by the
existing institutions. Tese individuals have many options, including using their
talents to generate income for themselves in the political and legal arenas. Tus,
diferences in measured rates of private-sector entrepreneurship are due to the dif-
ferent directions entrepreneurial energies are channeled by prevailing economic
and political institutions through the rewards and incentive structures they create
for entrepreneurial individuals.
In countries with institutions providing secure property rights, a non-corrupt
and independent judicial system, contract enforcement, and efective limits on
government’s ability to transfer wealth through taxation and regulation, creative
individuals are more likely to engage in productive market entrepreneurship—
activities that create wealth (for example, deliver innovative products such as the
smart phone). In areas without strong institutions, these same individuals are
instead more likely to atempt to manipulate the political or legal process to capture
transfers of existing wealth through unproductive political and legal entrepreneur-
ship—activities that destroy wealth (for example, lobbying and unjustifable law-
suits). Tis reallocation of efort occurs because the institutional structure largely
determines the relative personal and fnancial rewards that accrue to investing
entrepreneurial energies into productive market activities compared to investing
those same energies instead into unproductive political and legal activities.
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2. Economic Freedom and Entrepreneurship d Sobel d 39
Tis chapter discusses this relationship between institutions consistent with
economic freedom and entrepreneurship. I begin by providing a more detailed
discussion of the underlying ideas and literature summarized above, then continue
to explore data on institutions and entrepreneurship rates both internationally and
across US states.
2. Understanding market entrepreneurship
and its role in prosperity
For over three centuries, economists have atempted to understand and defne the
concept of an “entrepreneur” and the role such people play in economic progress.
In the 1700s, Richard Cantillion identifed the willingness to bear the personal
fnancial risk of a business venture as the defning characteristic of an entrepre-
neur (Sobel, 2008b). In the mid-1800s, John Stuart Mill used the term to refer
to a person who assumes both the risk and management of a business, providing
a clearer distinction than Cantillon between an entrepreneur and other business
owners (such as shareholders of a corporation) who assume fnancial risk, but do
not actively participate in the day-to-day operations of the frm (Sobel, 2008b).
Schumpeter ([1911] 1934, 1942) stressed the role of the entrepreneur as an
innovator who fnds new combinations of resources and creates new goods and
services. He termed this process “creative destruction” because the introduction
of new products and production processes ofen leads to the obsolescence of oth-
ers, such as when the car replaced the horse and buggy. Because new products
displace old industries this process is disruptive, and ofen leads to calls to restrict
or prohibit the new products. Te opposition to new “big box” stores, and calls to
ban them so they do not displace “mom and pop” stores is one example. However,
to Schumpeter this process of creative destruction is the source of true economic
progress. Societies that can and do tolerate this recycling of labor and capital from
older and less productive industries to new ones are the ones that prosper and grow.
According to McCloskey (2010), innovation and creative destruction increase
when societal atitudes become more favorable.
Kirzner (1973, 1997) viewed entrepreneurship as an equilibrating force in
which entrepreneurs discover previously unnoticed proft opportunities and act
on them, bringing markets toward equilibria. Holcombe (1998) ties the ideas of
Kirzner and Schumpeter together by noting that Schumpeterian innovation results
in a host of new proft opportunities in related complementary areas (such as pro-
ducing tires or accessories for the automobile once it is invented).
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40 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
Wealth creation is fundamentally about channeling limited resources into the
production of those goods and services with the highest value in the marketplace.
According to Hayek (2002 [1968]), the patern of resource use that yields the high-
est value, however, is something that must be discovered within the marketplace
through competition, and entrepreneurial trial and error. Tis target is an ever
shifing one, with new opportunities arising and others dwindling every day. One
important reason the economic system of capitalism is especially good at generat-
ing prosperity is that it does a good job at chasing this ever-moving target through
the continuous process of entrepreneurship and discovery.
Sifing through these many combinations is a difcult task because the num-
ber of possible combinations of society’s resources is almost limitless. Two quick
illustrations will help to clarify the vastness of these opportunities. First, consider
the typical automobile license plate. Many have three leters, a space, and three
numbers. Tere is a formula for calculating the total number of “combinations”—
the total number of possible diferent license plates—that could be created using
these three leters and three numbers. Te number is more than you might think:
17,576,000. Second, let us consider the number of possible ways to arrange a deck of
cards. Even with only 52 cards, there is a mind-blowing number of ways to arrange
them—the answer is a 68 digit number: 80, 658, 175, 170, 943, 878, 571, 660, 636, 856,
403, 766, 975, 289, 505, 440, 883, 277, 824, 000, 000, 000, 000.
With this many ways to rearrange a deck of 52 cards, the astonishing implica-
tion is that every time you shufe a deck of cards you are most likely making a new
ordering of cards that has never been seen before, and is likely never to be seen
again. In fact, even if every human who has ever lived on the Earth did nothing
but shufe cards 24 hours a day their entire life, and even unrealistically assuming
they could shufe the deck 1,000 times per second, we would have not even come
close to making it through a fraction of the number of total possible arrangements
of the deck throughout all of human history.
Now, returning to the economy, we clearly have more than just three leters
and numbers, or 52 cards, with which to work. Instead, we have millions, or even
billions, of diferent resources that could be combined into fnal products. With this
many inputs to work with, the number of possible diferent fnal product combina-
tions that could be produced is practically infnite (Romer, 2008).
Entrepreneurship is important because it is the competitive behavior of
entrepreneurs that drives this search for new possible combinations of resources
that create more value. A vibrant entrepreneurial climate is one that maximizes the
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2. Economic Freedom and Entrepreneurship d Sobel d 41
number of new combinations atempted. Some of these new combinations will be
more valuable than existing combinations and some will not. In a market economy,
it is the proft-and-loss system that is used to sort through these new resource
combinations discovered by entrepreneurs, discarding bad ideas through losses
and rewarding good ones through profts. A growing, vibrant economy depends
not only on entrepreneurs discovering, evaluating, and exploiting opportunities
to create new goods and services, but also on the speed at which ideas are labeled
as successes or failures by the proft-and-loss system.
Countries with higher levels of economic freedom promote entrepreneurship
by increasing the rate of experimentation—entrepreneurial trial and error. In coun-
tries in which everyone is allowed to try out their unique and crazy ideas for new
products, there is a greater rate of business failure but, because of the higher level of
experimentation, the odds of stumbling onto the one-in-a-million new venture like
Microsof or Apple are higher. Table 2.1 shows the data for OECD countries on the
relationship between economic freedom and the rates of entrepreneurial activity and
business failures from Sobel, Clark, and Lee (2007). Tose countries with higher
levels of economic freedom have statistically signifcant higher mean levels of both
entrepreneurship and business failures (at the 5% level of statistical signifcance).2
As the data show, higher economic freedom is associated both with higher
rates of new business formation, and more business failures—a truly robust engine
of creative destruction. A point worth clarifying is that it is much beter to have a
decentralized proft-and-loss system sorting through these new combinations than
a government approval board or decision-making process. Te reason is that the
2. Te total entrepreneurial activity index is a measure of the proportion of the population
engaged in entrepreneurial activities, so this increase is roughly equivalent to an increase of 1
percentage point of the population engaged in entrepreneurial activities.
Table 2.1. Economic feedom, entrepreneurial activity, and business failure
Economic
freedom
Total Entrepreneurial
Activity Index
Business failures
per 10,000 frms
Top half of sample (half with the
most economic freedom)
7.51 116.70
Bottom half of sample (half with
the least economic freedom)
6.74 67.58
Source: Sobel, Clark, and Lee (2007).
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42 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
incentives facing public ofcials are very diferent than those facing venture capitalists
and entrepreneurs. While each venture capitalist and entrepreneur brings diferent
motivations to the table, ultimately their success or failure is determined by whether
their idea generates wealth. Te same is not true for public ofcials in charge of hand-
ing out tax incentives or low-interest loans. Tey may have other concerns beyond
creating wealth. For example, ofcials may be concerned about where a new business
is located in order to maximize political support among voters. But there is no reason
to think that this decision corresponds with the most economically advantageous one.
From society’s perspective, the profts earned by entrepreneurs (and assessed
by investors) represent gains to society as a whole. Because entrepreneurs must bid
resources away from alternative uses, production costs refect the value of those
resources to society in their alternative uses. Tus, proft is earned only when an
entrepreneur takes a set of resources and produces something worth more to con-
sumers than the other goods that could have been produced with those resources.
A loss happens when an entrepreneur produces something that consumers do
not value as highly as the other goods that could have been produced with those
same resources. For example, an entrepreneur who takes the resources necessary
to produce a feece blanket that sold for $50 and instead turns them into a pullover
that sells for $60 has earned a $10 proft. Since the prices of the resources used by
entrepreneurs refect the opportunity cost of their employment in other uses, the
$10 proft generated by the entrepreneur refects the amount by which he/she
has increased the value of those resources. By increasing the value created by our
limited resources, entrepreneurs increase overall wealth in a society.
No one individual, or group of individuals, could be in charge of this entre-
preneurial discovery process. Tere is nobody, not even those seemingly in the best
position to know, who can predict which business opportunities are the most viable
in advance. For example, Ken Olson, president, chairman, and founder of Digital
Equipment Corporation, who was at the forefront of computer technology in 1977,
stated: “Tere is no reason anyone would want a computer in their home”. Today
his remark sounds funny because we all have computers in our homes (indeed, now
even in our pockets and purses!), but at the time even those in the infant computer
industry did not see this coming. An even beter example might be the story of
Fred Smith, the founder of Federal Express Corporation. He actually wrote the
business plan for FedEx as his senior project for his strategic management class
at Yale. While we all know in retrospect that FedEx was a successful business idea,
Smith’s professor at Yale, one of the leading experts on business strategy, wrote on
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2. Economic Freedom and Entrepreneurship d Sobel d 43
his paper in red ink: “Te concept is interesting and well-formed, but in order to
earn beter than a C the idea must be feasible”. Te point? Even smart professors,
business leaders, and government ofcials cannot possibly pre-evaluate business
ideas and identify those that will be most successful and those that will fail. A
thriving economy is created when individual entrepreneurs have the freedom to
try new ideas, risking their own assets, or the assets of their private investors, and
the proft-and-loss system is used to decide their fate. To quote Nobel laureate W.
Arthur Lewis: “[c]ollective judgment of new ideas is so ofen wrong that it is argu-
able that progress depends on individuals being free to back their own judgment
despite collective disapproval … To give a monopoly of decision to a government
commitee would seem to have the disadvantage of both worlds” (1955: 172).
Far too ofen governments atempt to adopt the wrong policies to promote
entrepreneurship—such as state-run venture capital funds, government-funded
or subsidized business incubators, economic development authorities, or new
employees within the education system aimed at expanding entrepreneurship edu-
cation within schools and colleges. Unfortunately, these policies expand the gov-
ernment sector, thereby resulting in a decline in the economic freedom score of the
country (or state).3 To encourage entrepreneurship, policy should instead focus on
reducing the burdens on entrepreneurial start-ups and tolerating business failures—
precisely those policies consistent with economic freedom. Figure 2.1 shows the
relationship between the level of entrepreneurial activity in OECD countries and
their level of economic freedom from Sobel, Clark, and Lee (2007). As is clearly
visible in the fgure, those countries with higher levels of economic freedom and
smaller governments are those that have the highest rates of entrepreneurial activity.
Ofen overlooked is the importance of the rule of law for promoting a robust
entrepreneurial climate. Te “rule of law” refers to governance by predictable
rules that are not dependent on the whims of currently elected politicians. When
undertaking the construction of a skyscraper, for example, long-term contracts
that govern fnancing and liability are critically important. Tis type of entrepre-
neurship therefore depends on the ability to undertake long-term contracting in
an environment within which future disputes can be predictably setled under
the previously agreed upon rules. Atempting to plan in a society in which rules
are constantly changing is not easy, and it frustrates the ability of entrepreneurs to
promote productive economic change.
3. See Landes, Mokyr, and Baumol, 2010 for examples.
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44 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
Because entrepreneurs frequently create new products that require new
interpretations of existing statutory and common law (or the creation of new law),
it is the predictability of the dynamic application of the law into new areas that
maters most in atracting entrepreneurs to an area and supporting innovation
within an economy, a point frst recognized by Dove and Sobel (forthcoming).
Innovations like the internet create a need for applications of law into the digital
arena, while innovations like the automobile require new applications of precedent
from existing laws that applied to horses and buggies. Similarly, medical innova-
tions in cloning and stem cells create a need for entirely new areas of law to be
developed. Terefore, what maters most to an entrepreneur is the predictability
with which a jurisdiction’s laws will be applied into these new areas. For entrepre-
neurs to be willing to make large up-front investments in research, development,
and manufacturing facilities, they need to be fairly certain how the existing laws in
the geographic area in which they locate will be applied and interpreted into the
new areas related to the innovative good or service produced by the entrepreneur.
Te wide variation in how states and countries are applying existing laws to
driverless automobiles is one such example. Despite the fact that cars have had
cruise control for decades, and that airplanes use auto-pilot, and that the liability
issues are clearly setled in those cases, many jurisdictions insist on treating driver-
less cars as a completely diferent and entirely new area of law and, hence, subjecting
6.0 6.5 7.0 7.5 8.0 8.5
0
2
4
6
8
10
12
14
16
Figure 2.1. Economic feedom and entrepreneurial activity in OECD countries, 2002
Source: Sobel, Clark, and Lee, 2007.
Economic Freedom Score
E
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e
n
e
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A
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2. Economic Freedom and Entrepreneurship d Sobel d 45
them to unnecessary legal uncertainty. Jurisdictions with good dynamic applica-
tion of the rule of law, such as Nevada, allow for a straightforward application of
existing law in those other areas to driverless cars and create a more certain legal
environment within which entrepreneurship can take place and fourish.
As a second example, consider the recent innovations in the process of
hydraulic fracking in shale formations to extract oil and gas. Some US state gov-
ernments, such as Pennsylvania’s, explained that all existing drilling laws applied
to this new technology and simply passed a few new paragraphs of law to clarify
how it applied. Other state governments, such as West Virginia’s, treated the new
technology like an entirely new industry, puting it on hold and going through a
long negotiated process of outlining an entirely new set of rules and taxes to be
applied. As a result, the shale industry boomed early in Pennsylvania, while it was
slow and reluctant to develop in West Virginia.
One of Adam Smith’s insights in his famous 1776 book, An Inquiry Into the
Nature and Causes of the Wealth of Nations, is that specialization and the division
of labor (key sources of productivity, wage, and income growth) are limited by the
size or “extent” of the market. When consumer markets are larger in size, smaller
specialized stores can survive that could not survive in a smaller marketplace. A
small town population, for example, may be able to support two general purpose
pet stores, each carrying a broad line of products. In a large city, however, a dozen
or more pet stores can fourish, with a greater extent of specialization. One store,
for example, might specialize in snakes and other reptiles, while another special-
izes in birds. Increasing the size of the markets to which entrepreneurs’ goods and
services sell increases wealth by allowing them to specialize more narrowly in areas
where they do best. One primary way government policies can therefore promote
more specialization and wealth creation is by having policies that enable entrepre-
neurs to sell and compete in larger national and global marketplaces and, hence,
expand their customer base. To compete in these markets businesses ought not be
hampered by unreasonable taxes and government regulations that raise the cost of
doing business. In addition, policies consistent with free trade—those that make
importing and exporting easy and without unnecessary costs and regulations—
also enable entrepreneurs to produce more wealth through greater specialization.
Another reason policies consistent with free trade promote entrepreneurship
is that they subject domestic frms to greater foreign competition. Tis greater com-
petition forces domestic frms to try harder to innovate and reduce costs so as to be
competitive on a global scale. Areas that restrict free trade end up with domestic
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46 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
frms that cannot compete efectively on a global level due to higher costs and less
innovative products. Free trade also beter allows domestic frms to use low cost
inputs into their production process. Sugar tarifs in the United States, for example,
raise the cost of sugar, so domestic candy makers and sof drink makers use high
fructose corn syrup as a cheaper alternative. By changing the input mix of domestic
frms, these frms do not innovate in the same areas as their global competitors and
ofen have inferior products. Tese are two additional reasons economic freedom,
through free trade, promotes a healthier entrepreneurial sector. Ironically while
many governments enact restrictions on free trade with the intention of expanding
domestic industry, the empirical evidence shows that higher tarif rates result in
fewer new entrepreneurial ventures. Estimates from Sobel, Clark, and Lee (2007)
fnd that among OECD countries, each 1-percentage point increase in the average
tarif rate in a country is associated with seven fewer new entrepreneurial ventures
per 1,000 people in the population.
The impact of regulation on entrepreneurship also merits discussion.
Regulatory climates with numerous and burdensome regulations have three harm-
ful efects on the entrepreneurial climate. First, they limit the number of experi-
ments happening. With a higher hurdle and steeper costs of going into business,
fewer new combinations of resources are atempted—fewer new startups are
created—lessening the odds of fnding those rare true success stories. Even at an
early age, experimentation with selling and business is important for developing
an interest in entrepreneurship for individuals. Lemonade stands and bake sales,
for example, were historically typically activities children undertook to learn about
entrepreneurship. Cities across the United States have taken serious measures to
shut down precisely these types of activities due to health and regulatory concerns.
Without the required (and expensive) business permits, and food and drug regula-
tions and product labeling satisfed, police have shut down children’s lemonade
stands in states from Georgia to Iowa. With fewer children experimenting, fewer
adult entrepreneurs are spawned.
In addition to limiting experimentation, regulations function as a fxed cost,
distorting the size of frms and the viability of small entrepreneurial frms. As a
simple example, consider that installing a handicapped ramp is equally expensive
for a small restaurant and a larger one. For smaller frms, the compliance cost of
regulations therefore is more burdensome as a share of their budget. With the
multitude of regulations that must be satisfed, large frms with tax and legal depart-
ments have the advantage because they have the resources and knowledgeable staf
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2. Economic Freedom and Entrepreneurship d Sobel d 47
to comply, while small frms—especially startups—do not. Calcagno and Sobel
(2014) fnd that as regulatory levels grow, it disproportionately afects smaller frms
(those with fewer than 5 employees). Tus areas with more regulatory burdens end
up with fewer new small frms in the marketplace; an engine of economic growth
and prosperity is stalled.
Te third and fnal reason why heavy regulation hurts entrepreneurship is that
it forces frm owners and employees to devote a larger share of their time toward
regulatory compliance and away from the internal activities of the business, such as
product development and customer relations. With the recent signifcant increases
in banking regulation in the United States, for example, senior bank employees now
have to spend more time complying with regulations and regulators, and, hence,
have less time lef to spend on the internal operation of the real business functions
of the bank [see Allison (2013)]. Tus, higher regulations lead to increased time
spent on compliance by frm owners and employees, leaving less efort to be put
into business development and expansion.
Tis section has outlined the economic understanding of for-proft market
entrepreneurship, and considered how policies consistent with economic freedom
are both necessary and benefcial in promoting entrepreneurial innovation. Low
levels of government spending leave more resources available for entrepreneurs in
the private sector, low taxes on business owners and capital allow higher returns to
entrepreneurial ventures and capital formation, reasonable regulations lessen the
burden on entrepreneurial trial and error, a strong rule of law enables the long-term
contracting necessary to undertake and fnance entrepreneurial ventures, and free
trade allows for greater specialization and higher incomes.
3. Understanding the entrepreneur—an agent of change
Until this point, we have restricted our discussion to only one half of the equation—
entrepreneurship within the private, for-proft, sector. While historical defnitions
of entrepreneurship rest on the role of the entrepreneur in creating and managing
a for-proft business in the market sector, the modern economics literature ofers
a broader understanding of the activities of entrepreneurial individuals.
Every society has a large number of potential entrepreneurs—creative indi-
viduals. However, not all of them choose to employ their talents to open new busi-
nesses in the marketplace. Like all other individuals they allocate their talents to
where they each receive the highest return. Tere are many alternative activities
an entrepreneurial individual may choose to pursue.
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48 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
At a fundamental level, entrepreneurial individuals can choose to devote
their labor eforts toward either private-sector wealth creation, or securing wealth
redistribution through the political and legal processes (for example, lobbying and
lawsuits), as has been stressed recently by Baumol (1990, 1993, 2002) and Sobel
(2008a). Tis decision is infuenced by the corresponding rates of return—or proft
rates—of these alternative activities. Institutions providing for secure property
rights, a fair and balanced judicial system, contract enforcement, and efective limits
on government’s ability to transfer wealth through taxation and regulation, reduce
the proftability of unproductive political and legal entrepreneurship. Under this
incentive structure, creative individuals are more likely to engage in the creation
of new wealth through productive market entrepreneurship.
In areas with litle economic freedom, these same individuals are instead more
likely to atempt to manipulate the political or legal process to capture transfers of
existing wealth through unproductive political and legal entrepreneurship—activi-
ties that destroy overall wealth. Tis reallocation of efort occurs because the insti-
tutional structure largely determines the relative personal and fnancial rewards
to investing entrepreneurial energies into productive market activities rather than
investing those same energies instead into unproductive political and legal activities.
For example, a steel entrepreneur might react to competition by trying either to fnd
a beter way of producing steel (productive entrepreneurship) or by lobbying for sub-
sidies or tarif protection, or fling anti-trust actions (unproductive entrepreneurship).
To understand this distinction beter, consider the diference between positive-
sum, zero-sum, and negative-sum economic activities. Activities are positive sum
when net gains are created to society. Private market activities are positive sum
because both parties gain in voluntary transactions. When you purchase a pizza, you
value the pizza more than what you otherwise would have bought with the money
you pay for it, while the pizzeria values the money it receives from you more than it
did the pizza. Government actions that transfer wealth, regulate, subsidize, or protect
industries from competition are not positive sum. One party’s gain (for example, the
subsidy) is ofset by another party’s loss (for example, the taxes). However, because
securing the transfer requires an investment of resources in, say, lobbying, the overall
impact on the economy is negative (Tullock, 1967). Magnifying this reality is the
fact that others will devote resources to political lobbying on the “defensive side” of
transfers to protect their wealth from being seized (Wenders, 1987). Te resources
devoted toward securing (and fghting against) zero-sum political transfers have a
cost; we have more lobbyists and thus fewer scientists and engineers.
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2. Economic Freedom and Entrepreneurship d Sobel d 49
Unproductive entrepreneurship is unproductive because it uses up valuable
resources in the process of capturing zero-sum transfers. Entrepreneurs exploit
proft opportunities not only within private markets but also within the political
and legal arenas. Tus, diferences in measured rates of private-sector entrepreneur-
ship are partially due to the diferent directions entrepreneurial energies are chan-
neled by prevailing economic and political institutions, through the rewards and
incentive structures they create for entrepreneurial individuals.
While this idea has mostly captured atention in the literature since Baumol’s
(1990) exposition, and he is ofen credited with the origin of the idea, the basic
idea in reality dates back to the works of Bastiat and Hayek. In his 1850 pamphlet,
Bastiat noted:
Man can only derive life and enjoyment from a perpetual search and appro-
priation; that is, from a perpetual application of his faculties to objects, or
from labor. Tis is the origin of property.
But also he may live and enjoy, by seizing and appropriating the pro-
ductions of the faculties of his fellow men. Tis is the origin of plunder.
Now, labor being in itself a pain, and man being naturally inclined to
avoid pain, it follows, and history proves it, that wherever plunder is less
burdensome than labor, it prevails; and neither religion nor morality can,
in this case, prevent it from prevailing. (Bastiat, 1850 [2007]: 5)
Similarly, according to Hayek:
Having seen what I have of the world, it appears to me that the proportion of
people who are prepared to try out new possibilities that promise to improve
their situation—as long as others do not prevent them from doing so—is
more or less the same everywhere. It seems to me that the much-lamented
lack of entrepreneurial spirit in many young countries is not an unchange-
able atribute of individuals, but the consequence of limitations placed on
individuals by the prevailing point of view. For precisely this reason, the
efect would be fatal if, in such countries, the collective will of the majority
were to control the eforts of individuals, rather than that public power limits
itself to protecting the individual from the pressure of society—and only the
institution of private property, and all the liberal institutions of the rule of
law associated with it, can bring about the later. (Hayek, [1968] 2002: 19).
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50 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
As is clear, both of these authors make the same point—in societies governed by
bad rules, creative people devote their time and talents in ways to generate income
for themselves outside of the market sector—through political and legal plunder.
Tus, a more complete understanding of the role of economic freedom in promot-
ing productive entrepreneurship and prosperity requires a broader defnition of
entrepreneurship than simply applying the idea to for-proft activities in a busi-
ness within the marketplace. In reality, entrepreneurial individuals are agents of
change—individuals who come up with new ways of doing things and implement
them. Tese activities are not limited to the for-proft marketplace business sector.
For example, there are “academic entrepreneurs” who come up with new pro-
grams and implement them within the educational system, “social entrepreneurs”
who come up with new non-proft foundations, “military entrepreneurs” who come
up with new batlefeld strategies, “sports entrepreneurs” who come up with new
ways to play their sport, “political entrepreneurs” who come up with new ways of
manipulating the political system for gain, and “legal entrepreneurs” who come up
with new ways of litigating cases.
As one simple case in point, American football had been played for decades
prior to anyone atempting a forward pass. In the 1876 game between Yale and
Princeton, Yale’s Walter Camp threw forward to a teammate as he was being tackled,
resulting in a touchdown. Despite protests by the opposing team, the referee actu-
ally tossed a coin to make his decision and allowed the touchdown to stand. Walter
Camp is an entrepreneur, albeit not in the for-proft market sector creating a business.
Another example is the case of the gerrymandering of political districts. A
brainchild of Massachusets Governor Elbridge Gerry, it was the frst time political
district boundaries were signifcantly manipulated to alter the outcomes of elections.
Te frst use of the flibuster in the US Senate in the 1830s is another example of
political entrepreneurship. While these are examples of people within the political
sector thinking creatively to get ahead, the more appropriate examples are of private
individuals fnding new ways to redistribute wealth to themselves through the politi-
cal process. Holcombe (1999) discusses one such example. In the late 1800s, the
union veterans of the US Civil War were able to become the frst group to receive
large-scale selective transfers through the federal government. Once they opened
the door, it made it easier for other groups to seek selective transfer funding that ben-
efted their narrow groups, paving the way for the modern American welfare state.
In the legal arena, creative atorneys frequently come up with new ways of
litigating cases. One such example is the case of medical monitoring damages in the
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2. Economic Freedom and Entrepreneurship d Sobel d 51
state of West Virginia. When the environmental spillover efects from a business’s
activities result in physical injury to non-consenting third parties, courts have long
allowed damages to be awarded to the injured parties, including damages for moni-
toring of their medical condition. However, in all cases the person fling the claim
was required to show that actual physical injury was present. In 1999, the plaintif’s
atorney litigating the case of Bower v. Westinghouse [206 W.Va. 133, 522 S.E.2d
424 (1999)] was able to argue creatively that individuals who showed no physical
injury should be given damage awards for future medical monitoring in case they
started developing problems (Leddy and Yanni, 2009). Te legal brilliance of the
precedent is that it provides lump-sum payments to large classes of uninjured parties
living near a business even when there is no evidence of actual physical harm, with
no restriction that the money actually be spent on the medical monitoring. Now
jokingly known as the “Ford F-150 rule” because large groups of individuals have
spent their checks on new pickup trucks, the creative thinking of one atorney has
opened the door to many new lawsuits representing class actions of uninjured par-
ties to seek transfers through the legal process from surrounding business entities.
Back to the bigger picture. What is important in a society is the proportion
of entrepreneurial individuals who spend their time and talent creating wealth
through engaging in productive, wealth-creating market entrepreneurship, rather
than trying to secure wealth through unproductive, wealth-destroying political and
legal plunder. Higher levels of economic freedom increase the returns to produc-
tive market entrepreneurship and lower the returns to unproductive political and
legal entrepreneurship. Areas with higher economic freedom, therefore, will have
not only higher rates of measured market entrepreneurship, but also lower levels
of unproductive political and legal entrepreneurship.
While measures of unproductive entrepreneurship across countries are not
available, it is possible to estimate them across the U.S. states. Sobel (2008a) shows
that states with higher economic freedom scores both have more productive private
sector entrepreneurship and less unproductive entrepreneurship. He constructs
an index of “net entrepreneurial productivity” that grows with the proportion
of entrepreneurial talent allocated to the private sector, and falls with increasing
political activity or lawsuit abuse.4 Figure 2.2 shows the clear, and strong, relation-
ship between the economic freedom scores of US states and their levels of net
4. Te index is basically the diference in the state’s ranking relative to other states on measures
of productive entrepreneurship minus its ranking on measures of unproductive entrepreneurship.
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52 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
entrepreneurial productivity. Higher levels of economic freedom therefore not
only promote the good types of entrepreneurship, but also lower the destructive
types of entrepreneurship.
4. Economic freedom, the productivity
of capital, and crony capitalism
Human and physical capital, when employed productively by entrepreneurs, are
engines of wealth creation. Human capital refers to the education and talents of
individuals, while physical capital refers to man-made resources such as machines
that go into the production of other goods and services. Te ability of capital to
generate wealth depends on how productively it is allocated by entrepreneurs.
Gwartney, Holcombe and Lawson (2006) postulated that countries with
higher levels of economic freedom—specifcally, those countries that rely chiefy
on the market to allocate investment into physical capital, should be able to gener-
ate a higher level of productivity and wealth for any given level of investment. Tey
test their hypothesis and indeed fnd that the contribution of investment in physical
capital to economic growth is higher in countries with more economic freedom.
Expanding on that idea, Hall, Sobel, and Crowley (2010) apply the same
concept to human capital. Considering the contrast between productive and
unproductive entrepreneurship, they postulate that the returns to investments in
5.0 5.5
6.0 6.5 7.0 7.5 8.0
-40
-30
-20
-10
0
10
20
30
40
Figure 2.2. Economic feedom and the productivity of entrepreneurship, 2001
Source: Sobel, 2008a.
Economic Freedom Score
N
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t

E
n
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r
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p
r
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P
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(
N
E
P
)

I
n
d
e
x
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2. Economic Freedom and Entrepreneurship d Sobel d 53
human capital (for example, schooling) should be higher in countries with more
economic freedom. Not only do they confrm this hypothesis, they actually fnd
that in countries with very low levels of economic freedom the returns to schooling
are negative—implying that higher levels of education destroy wealth. Tis fnding
suggests that, in these societies, as people become beter educated, they simply use
these talents to manipulate the political and legal systems for wealth transfers. Tey
become more efective rent seekers.
Economic freedom improves the productivity of both human and physical
capital in a society. Terefore, with any given level of entrepreneurial efort or level
of investment in physical capital, societies with more economic freedom generate
more wealth and economic growth from those investments.
A closely related issue is “crony capitalism” and the use of selective incentive
policies by governments. Tere is a diference between what economists call capi-
talism and what some might consider “business-friendly” policies. When govern-
ment gives subsidies or tax breaks to specifc frms or industries that lobby but not
to others, this practice is at odds with the institutions, or rules of the game, consis-
tent with capitalism and economic freedom. When it becomes more proftable for
companies and industries to invest time and resources into lobbying the political
process for favors, or into initiating unjustifed lawsuits, we end up with more of
these types of destructive activities, and less productive activity. Firms compete in
the government decision-making process for tax breaks rather than in the market-
place for consumers’ patronage. Tey spend time lobbying rather than producing.
In addition, by arbitrarily making some industries more (or less) proftable
than others, government distorts private-sector economic activity. For growth,
market-determined returns (proft rates) and market prices should guide invest-
ments, not government taxes and subsidies. Capitalism is about a fair and level
playing feld for everyone. Tis does mean lower overall levels of taxes and regula-
tions—ones that are applied equally to everyone.
Business subsidies may visibly create jobs, but the unseen cost is that the
tax revenue or other resources necessary to fund these subsidies generally destroy
more jobs than are created. Tey result in a net reduction in economic activity. Te
problem, politically, is that these losses are not as visible. When every taxpayer has
to pay, say, $1 more in taxes to fund some multi-million-dollar subsidy, the resulting
reduction in consumer spending is spread out over the entire economy, causing job
losses in multitudes of other businesses, and a reduction in consumer well-being.
But because each individual loss is small, these losses go unnoticed. Government
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54 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
subsidy programs can, thus, create jobs in the relatively few favored industries, but
only by destroying jobs in numerous unfavored industries. And because the favored
industries will generally be less efcient than are the unfavored ones, the overall
economic impact is negative. When business interests capture government’s power,
things can go just as bad for capitalism as when government power is held in the
hands of groups less friendly to business. For example, when companies persuade
government to use the power of eminent domain to take property from others, or
use lobbying or connections to get special tax favors, subsidies, or exemptions for
their business, this policy climate is not conducive to capitalism either.
Economic progress, growth, and development are not about having business
take over government policy making. Unconstrained democracy is a threat to capi-
talism regardless of who is in power. Progress is not about turning policy over to a
specifc industry; instead it is about being competitive across the board to atract
many new types of businesses in diferent locations. It is about an environment in
which small rural entrepreneurs have maximal opportunities to compete and thrive
in the global marketplace that is now becoming more connected to them through
the Internet. It is about creating more wealth across the board.
Government ofcials ofen cite the necessity to ofer these credits to entice
frms to locate in particular jurisdictions. However, the main reason such incentives
are necessary is the high taxes that already exist in these areas on these types of
frms and the appropriate solution is to lower the taxes that prevent the jurisdiction
from being competitive in the frst place. Tese incentives would not be necessary
if the tax structure were less burdensome.5
When governments give favors to some businesses (or groups) but not others,
it unfairly distorts the competitive market process as unsubsidized frms must now
compete with the politically favored, subsidized frms for employees, resources,
land, and consumers. All frms should have a good business climate, without hav-
ing to devote time, efort, and resources toward political lobbying and favor seek-
ing to get it. Unlike the large companies who receive selective incentives from
governments, many businesses—including small entrepreneurs—simply do not
have the political power even to begin negotiating a beter business climate. Te
resources devoted toward ofering these special favors to big businesses would be
beter spent making across-the-board, broad-based tax reductions that apply to
5. Recently in Illinois, for example, when the corporate income tax was raised across the board,
subsidies had to be given to specifc high-profle frms to get them to stay in the state.
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2. Economic Freedom and Entrepreneurship d Sobel d 55
all entrepreneurs and businesses. But when governments engage in this type of
activity it promotes an environment of favor seeking and fosters a higher level of
unproductive entrepreneurship. Society is not only poorer because of the resources
withdrawn from the productive sector as each group spends time and efort to get
a political favor, but also because it necessitates that other groups now spend time
and talent to get similar favorable treatment. Tis is why broad-based policies that
are fair and equally applied to all outperform environments where policies are
selectively applied.
In the United States, the federal government’s response to the 2008 fnancial
crisis and recession included an unprecedented increase in the number of govern-
ment subsidies, grants, and contracts given directly to specifc private businesses.
For example, in October 2008 the Troubled Asset Relief Program (TARP) autho-
rized $700 billion in expenditures to purchase assets and equity from more than
a dozen fnancial institutions. Also in late 2008, the Federal Reserve’s “Maiden
Lane Transactions” set up limited-liability companies with nearly $100 billion to
aid JPMorgan Chase, Bear Stearns, and AIG. In early 2009, the American Recovery
and Reinvestment Act (ARR ) began spending over $840 billion, which included
many tax benefts, contracts, grants, and loans, and entitlements, going to thou-
sands of specifc private companies.
As a result of this major increase in government involvement, companies
have rushed to make sure their interests are being heard in the political process that
allocates these government favors. According to the Center for Responsive Politics,
total expenditures on lobbying the federal government rose by over 20% from 2007
to 2010 (afer adjusting for infation) to more than $3.5 billion. Lobbying by the
fnance, insurance, and real-estate sector alone has been over $450 million per year
since 2008, and the industry is now represented by approximately 2,500 individu-
ally registered federal lobbyists.

In addition to increasing its lobbying activities,
the fnance, insurance, and real-estate sector has also increased political donations
given directly to federal political campaigns. Tese donations are made largely
through PAC contributions, rising from $287 million during the 2006 election
cycle to $503 million during the 2008 election cycle and $319 million during the
2010 election cycle. Some of the industrial sectors to which ARR money is specif-
cally targeted, such as energy, have seen the biggest increases in lobbying activity,
with a 66% increase in federal lobbying expenditures between 2007 and 2010. Te
industry now spends over $450 million annually on lobbying and is represented by
over 2,200 registered federal lobbyists.

Similarly, the energy sector has increased its
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56 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
donations to federal political campaigns, raising them from $51 million during the
2006 election cycle to $81 million during the 2008 election cycle, and $76 million
during the 2010 election cycle.
Political connections or, more precisely, government grants, contracts, and
bailouts, are becoming increasingly important in determining which frms suc-
ceed and which fail. Tese policies followed in the United States over the past
decade have resulted in a signifcant decline in the economic freedom score of
the United States. Tis reduced economic freedom has fostered an environment
in which businesses invest signifcantly more resources in lobbying—unproduc-
tive entrepreneurship. Te result is that fewer resources are devoted to productive
entrepreneurial endeavors such as research and development eforts to generate
new products and innovations.
5. Foreign aid and dead capital—the importance
of property rights
Private property rights that are well defned and enforced are an important compo-
nent of economic freedom. In the least developed countries, the lack of these rights
is a signifcant factor limiting entrepreneurship. Financing for new entrepreneurial
ventures is critical. In most societies, individual entrepreneurs can mortgage their
assets, such as homes or cars, using them as collateral to secure loans to provide
equity for their new businesses. But in many countries with low levels of economic
freedom, property rights are informal at best. Without proper titles, deeds, and
identifcation systems, individuals may own assets such as a home, but be unable
to collateralize them to take out loans. Tis lack of collateralization holding back
the ability of entrepreneurs in such countries has been a major research area of
Hernando de Soto (2000, 2006). While some people in the United States actu-
ally complain about the large number of businesses ofering auto-title loans, they
instead should feel extremely lucky this opportunity exists so easily. According to
de Soto (2006), in Tanzania, for example, pledging moveable property such as a
car as collateral for a loan takes 297 days on the mainland, while on the semiau-
tonomous part of Tanzania known as Zanzibar, such pledges do not exist. Tis lack
of the ability to collateralize assets is a major hurdle to entrepreneurial fnancing.
In eforts to help ailing, less-developed economies, the developed world has
given billions in foreign aid to governments. Not only do such government-to-
government transfers (as the late economist Peter Bauer called them) not solve the
fundamental problems with the institutions in these countries, they ofen prop up
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2. Economic Freedom and Entrepreneurship d Sobel d 57
corrupt political leaders, leading to few incentives for internal economic reform.
Even worse, according to Coyne, Sobel, and Dove (2010) foreign aid results in aid
recipients investing resources in establishing networks and relationships that maxi-
mize the amount of aid received. Once these networks are in place, they can have
the counterproductive efect of making change toward liberal market and political
institutions that much more difcult given the rent-seeking nature nurtured by
the foreign aid. Large infows of foreign aid, just like large amounts of government
spending in any area, lead to business frms learning efectively how to compete for
government favors, rather than learning how to compete in the marketplace. Tus,
foreign aid ofen promotes the harmful types of unproductive entrepreneurship
in these countries and builds human capital in favor seeking.
Creating an environment within which individual entrepreneurs generate
wealth has been difcult for less-developed countries. But the solution is not for-
eign aid that promotes government favor seeking by individuals. Te solution is
reforms that promote economic freedom through greater use of private ownership
rights—secure and defned property rights that allow for collateralization. Te rise
of the internet and private microlending to small entrepreneurs in less-developed
countries, through organizations such as Kiva.org, has shown signifcant poten-
tial. But until signifcant reforms to promote economic freedom are undertaken,
the wealth generating creativity of billions of entrepreneurial individuals in these
less-developed countries remains harnessed and underused. Te vast majority of
measured entrepreneurship in such countries simply refects “necessity-driven”
entrepreneurship in which individuals must grow their own food, make their own
clothes, and undertake household production because of the lack of private-sector
job opportunities.
6. Updated evidence on economic freedom
and entrepreneurship rates
Using the most recent economic freedom ratings and most recent data on entre-
preneurship rates, this section presents new evidence on the relationship between
economic freedom and rates of entrepreneurial activity both across countries and
across US states.
Te most recent scores for economic freedom around the world were obtained
for each country available from Economic Freedom of the World (EFW) (Gwartney,
Lawson, and Hall, 2014). Tese data were matched with cross-country data on
entrepreneurship rates from a joint efort of the World Bank and the Kaufman
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58 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
Foundation (World Bank Group, 2013). According to the World Bank, the data
collection was completed in June 2013 directly from 139 countries based on com-
pany registrations of new frms. Data are provided on new business entry density,
defned as the number of newly registered corporations (private companies with
limited liability) per 1,000 working-age people (aged 15–64). Once the matching
was complete, there were 105 countries for which data were available on both
variables. Tis is a signifcantly larger number of countries than has been examined
in previous literature, which looked at OECD countries only.
How large are the diferences in entrepreneurship rates by levels of economic
freedom in 2014? To answer this question, the countries were then ranked by their
level of economic freedom, and averages were computed for the data divided into
three groupings. Tat is, the countries were broken down into the third having the
highest EFW scores, the third in the middle, and the third having the lowest EFW
scores (making for 35 countries in each grouping). Figure 2.3 shows the diferences
in entrepreneurship rates across these groupings.
As can be seen in fgure 2.3, the impact of economic freedom on entrepre-
neurship rates is strong. Te third of the countries with the lowest economic free-
dom scores had just slightly more than one new private entrepreneurial venture
0
1
2
3
4
5
6
7
Top Third Middle Third Bottom Third
Figure 2.3. Entrepreneurship rates of countries grouped by lowest, middle, and highest
scores for economic feedom, 2014
Sources: Gwartney, Lawson, and Hall, 2014; World Bank Group, 2013.
Economic Freedom Scores
N
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B
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s

D
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2. Economic Freedom and Entrepreneurship d Sobel d 59
per 1,000 people (the actual value is 1.19) in 2014. Countries in the middle third
achieved almost three new ventures per 1,000 people (the actual value is 2.89).
But the third of the countries with the highest economic freedom scores achieved
a rate of new venture formation of more than six per 1,000 people (the actual
value is 6.63). In essence, each move to a higher third doubles the number of new
entrepreneurial ventures.
As one might imagine, the extremes of the ratings were glaring. For example,
the three countries in the overlapping dataset with the highest economic freedom
scores (Hong Kong, Singapore, and New Zealand) averaged 17.1 new ventures
per 1,000 people, while the three countries in the overlapping dataset with the
lowest economic freedom scores (Democratic Republic of the Congo, Algeria, and
Argentina) managed only 0.249 new ventures per 1,000 people (or alternatively
stated, approximately one new venture per 4,000 people).
To further illustrate the data, fgure 2.4a shows all 105 countries ploted with
their associated levels of new business formation (per 1,000 people) and economic
freedom scores. A simple linear regression using these data produces a coefcient of
3.33, with an associated t-value of 5.62 (signifcant at the 1% level) with an R-squared
of 0.23. What this means is that each one-unit increase in a country’s economic
freedom score produces roughly a 3.33-unit increase in new business ventures per
1,000 people. Eyeing the data reveals that a non-linear estimation would be more
appropriate and would result in a higher R-squared, although such an estimation
would require excessive complexity for this chapter. Fortunately, the reality and
signifcance of the non-linear relationship can be seen clearly in the fgure. Basically,
entrepreneurship rates are fat under an EFW score of about 7.0. Below that level,
a country’s institutions simply are not supportive of the entrepreneurial process.
So moving from a very low score of 5.5 to another low score below 7.0 such as 6.5
would have litle efect in promoting entrepreneurship due to the generally weak
institutions. Once a country’s institutions get above an EFW score of 7.0, however,
increases in economic freedom result in increased entrepreneurship rates. While the
EFW index tries to present the issue of socialism to capitalism on a spectrum, the
result here indicates that countries with an EFW score below 7.0 simply fail to have
an economy that features private entrepreneurship of any meaningful magnitude.
Te relationship among those countries above an EFW score of 7.0 shows
a much more linear relationship, as is shown in fgure 2.4b. Countries among this
group clearly improve their rates of entrepreneurship as they increase their eco-
nomic freedom, even if only modestly.
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60 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
7.0 7.5 8.0 8.5 9.0
0
5
10
15
20
25
30
Figure 2.4b. Entrepreneurship rates and economic feedom for countries with an EFW
score of 7.0 and above, 2014
Sources: Gwartney, Lawson, and Hall, 2014; World Bank Group, 2013.
Economic Freedom Score
N
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B
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D
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4 5 6 7 8 9 10
0
5
10
15
20
25
30
Figure 2.4a. Entrepreneurship rates and economic feedom for 105 countries, 2014
Sources: Gwartney, Lawson, and Hall, 2014; World Bank Group, 2013.
Economic Freedom Score
N
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B
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D
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2. Economic Freedom and Entrepreneurship d Sobel d 61
As mentioned earlier, the United States’ level of economic freedom has fallen in
recent years, from a peak of 8.65 in 2000 to 7.74 in the most recent report (using the
chain-linked index). Using the above results as a guide, this 0.91-unit decline in eco-
nomic freedom in the United States will result in a 3.03-unit decline in entrepreneurial
ventures per 1,000 people among the working-age population. Using 2014 data, this
implies that, for each of the preceding ten years, approximately 740,000 fewer new
business ventures were launched in the United States than would have been launched
had economic freedom not fallen in the 21st century from its level in 2000. Again, had
the relationship been estimated using a non-linear model, this impact would have
been even larger (approaching 1,000,000 fewer new ventures annually).
We move now to the US state level. Te most recent economic freedom
levels of the US states are obtained from Stansel and McMahon (2013). Data on
establishment birth rates for the US states are obtained from the US Small Business
Administration, Ofce of Advocacy (2014). Figure 2.5 shows the relationship across
all US states. Again, as in the case of countries shown before, the data show a clear
positive relationship between economic freedom and productive entrepreneurship.
States with higher economic freedom scores have higher rates of new ventures
being formed. A simple linear regression produces a coefcient of 1.957 (with a
statistically signifcant t-ratio of 2.63). Tis fnding implies that for every one-unit
increase in a US state’s economic freedom score, the birth rate of new establish-
ments goes up by almost two percentage points. Using the average state, that con-
verts into approximately 2,600 new establishment births annually in the state for
every one-unit increase in economic freedom.
Again, comparisons of the top three and botom three states are striking.
Te three states with the highest economic freedom scores (Delaware, Texas, and
Nevada) have an average establishment birth rate of 10.9% per year, while the three
states with the lowest economic freedom scores (Mississippi, West Virginia, and
New Mexico) have an average establishment birth rate of 8.4% per year, meaning
they have establishment birth rates 2.5 percentage points lower each year than
states with higher levels of economic freedom (or approximately 3,300 fewer new
frms for the average state).
Tis section has shown that, using the most recent data available, the positive
relationship between economic freedom and the rates of productive entrepreneur-
ship remains strong and robust. Both countries and states with higher levels of
economic freedom have higher rates of new venture creation—that is, productive
entrepreneurship.
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62 d What America’s Decline in Economic Freedom Means for Entrepreneurship and Prosperity
7. Conclusion
It has long been established in the literature that areas with higher economic free-
dom are both more prosperous and have faster rates of economic growth. Te
important point made in this chapter is that an important medium through which
economic freedom produces growth is productive entrepreneurship. Tat is, eco-
nomic freedom produces growth because economic freedom promotes entrepre-
neurship, and this additional entrepreneurship produces economic prosperity.
Tis chapter discussed the relationship between economic freedom and
prosperity through its impact on entrepreneurship. It also reviewed the existing
literature on the topic, and provided updated empirical evidence on the relation-
ship, which remains robust even in the post-great recession world.
From the discussion, it is clear that all component areas of economic freedom
play an important role in fostering entrepreneurial activity. Tis chapter has out-
lined the specifc ways in which the rule of law, regulation, government spending
and taxation, and free trade afect the productivity of entrepreneurship. Even more
important, however, is the fact that the overall level of economic freedom alters
the balance between the rewards for productive and unproductive entrepreneur-
ship. In short, more freedom generates more productive entrepreneurship and less
unproductive entrepreneurship.
6.7 6.9 7.1 7.3 7.5 7.7 7.9
6
8
10
12
14
Figure 2.5. Establishment birth rates and economic feedom in US states, 2013
Sources: Stansel and McMahon, 2013; US Small Business Administration, Ofce of Advocacy, 2014.
Economic Freedom Score
E
s
t
a
b
l
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h
m
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B
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R
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(
%
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2. Economic Freedom and Entrepreneurship d Sobel d 63
Entrepreneurship is a key source of economic growth and prosperity. A thriv-
ing entrepreneurial sector is enabled by good policies and institutions. Te empiri-
cal evidence from both previous literature and the updated data presented here is
robust and consistent—areas with higher economic freedom have greater levels
of productive entrepreneurial activity.
Many states and nations have signifcantly misguided policies (such as gov-
ernment run venture capital frms, business development centers, and incubators)
that are ostensibly intended to promote entrepreneurship but in the end only grow
the size and scope of government. Such policies lower economic freedom and
actually harm entrepreneurship. To promote and foster entrepreneurial activity
requires policies and institutions that enhance economic freedom.
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