How big is your Government

How big is your government?The Index of Economic Freedom is directionally correct at best
By Pradyumna Prasad
Jun 27, 2023

The Index of Economic Freedom ignores an important measure of government size: government ownership of the economy. This distorts its measurements of two entrepots: Singapore and Hong Kong

More importantly, it also ignores land ownership and regulations which shape the economy quite strongly in these two places. Hong Kong’s high rents can in part be blamed on its poor land management policy which incentivizes the government to limit the supply of land increasing rents.

It also ignores corporate economic power which hurts economic freedom strongly in economies with high levels of concentration in a few companies. The government isn’t the only entity hurting economic freedom.

And finally, it doesn’t consider infrastructure and other positive freedoms that make an economy worthwhile to invest, work and live in.

Every year the Heritage Foundation releases its Index of Economic Freedom, and every year the results are nearly the same. Singapore, Hong Kong and Ireland are usually at the top. They are then followed by Taiwan, New Zealand, a number of Nordic countries and so on.

But the Index is a flawed indicator in many ways. One of them is that the size of government component ignores an extremely important part of any economy: the ownership of the means of production. This gives a poor impression of the size of government and its effects in the two high-scoring entrepots in the index: Hong Kong and Singapore.

Singapore from the statistics looks as if it is one of the least interventionist states in the world. Tax rates are low, and it is extremely easy to set up a business in the city-state. Government spending is low at 16% of GDP in FY2022 which is lower than any OECD country. Taxes also are low at 13.8% of GDP in FY2022 which is also lower than any OECD country. It takes just two days to start a business in Singapore which is the second-lowest in the world.

And you wouldn’t be wrong entirely. Lots of companies set up their regional headquarters in Singapore because of the regulatory environment and lots of financial firms are present here for the low tax rates and ease of incorporation. But this focus on taxes and government spending as the measure of the size of government obscures an important fact in understanding Singapore’s government: it owns several companies that are essential to the functioning of Singapore.

The government (through holding company Temasek) has a minority stake in DBS Bank which is the largest company on the Singapore Exchange. The government has a majority stake in the two largest telecom companies: Singtel and Starhub, it has a majority stake in the flag carrier Singapore Airlines and it is the owner of CapitaLand (the largest real estate company in Singapore).

Out of the 25 largest companies listed on the Singapore Exchange (as of 26th June 2023, excluding real estate investment trusts) 9 companies were started by the government. It still maintains at least a minority stake in all of them and a majority stake in Singapore Airlines and ST Engineering. For most of them, it is still the largest shareholder.

Singapore’s Government Linked Companies do not appear to get any special advantages according to this 2003 study, and some of them - like SIA, Singtel, DBS and Keppel - have achieved success out of the home market.

Along with this, the government of Singapore owns the vast majority of land in Singapore. I’m not sure of the exact number (this 2021 article says over 80% while this OECD site says 90% without citing it), but it is likely to be above 80 or 90%. Nearly 80% of Singaporeans live in government built housing.

Now both of these facts about land ownership and government linked companies in the economy paint a very different picture of Singapore than the Index of Economic Freedom would give. For academics studying Singapore relying on the Index of Economic Freedom would mean that their data would misrepresent the size of Singapore’s government, and for foreign investors trying to enter Singapore this would mean they fundamentally misunderstand the business climate they are investing in.

Yes, Singapore is a country with low tax rates and a high ease of doing business. But it is also a country where government owned and linked companies are a non-negligible part of the economy and most of the country works, travels and sleeps on government owned land. And not mentioning this devalues the information in the Index of Economic Freedom!

Another country where the Index of Economic Freedom does not show the size of government well is Hong Kong. The Government of Hong Kong owns all land in the SAR, and gains substantial amounts of revenue leasing it. 20.6% of the Hong Kong SAR’s revenue came from land premiums. And this creates perverse incentives for the Hong Kong government, where the government is incentivized to increase land prices to increase its revenue and keep taxes low. As this WSJ article explains:

How does Hong Kong pull it off? Like much else in the city, the answer is down to real estate. The government owns functionally all land in Hong Kong, with leases auctioned off over time to raise revenue. Revenues accruing to the Capital Works Reserve Fund from land sales and premiums made up more than 20% of the government’s total revenues in the past five full fiscal years, almost twice as much as taxes on salaries.

No wonder then, that the top rates of tax for salaries and corporate profit that the Heritage index prioritizes seem unusually low, and yet the government runs up little debt. The city’s residents are effectively paying additional shadow taxes to their landlords and to the city’s leviathan real-estate developers in the form of extremely high house prices and rents, propping up the government’s source of revenue. The system is no free lunch for Hong Kong.

As author Alice Poon noted a decade ago, the land price policy of successive Hong Kong governments is at the root of “ever-deepening economic concentration,” where real-estate developers continually make bumper profits. “Hopes for diversification into a knowledge-based economy have been constantly dashed due to the entrenched land and tax systems.”

And again, if an investor understood this about Hong Kong, she would have a more complete picture of the HK economy and the conditions for investing there. There are other things about Hong Kong that make it a less economically free place: for a long time Hong Kong had little antitrust enforcement, which allowed for monopolies and cartels back in the day. (I’m not sure of the current situation). To quote from my previous post about Asian Godfathers:

Li’s PARKnSHOP and Jardine’s Wellcome control about 70% of the groceries market in Hong Kong. When Jimmy Lai’s ecommerce AdMart tried to set up shop in Hong Kong, their trucks couldn’t enter any building residential or commercial owned by Li. Let me put that into perspective - if you ran a store in any building owned by Li’s real estate business Cheung Kong, you couldn’t get any shipments from AdMart. If you lived in a service apartment owned by Cheung Kong, you couldn’t get a delivery from AdMart

Despite having labour costs far lower than other countries with similar per capita GDP, terminal handling fees in Hong Kong are fairly high - one report estimates them to be double of that in Germany. Why does this happen? Concentration among port berth owners is the reason. Li’s Hutchison owns 14 out of 24 ports and this has remained his “core” business that funds his real estate business

Sure, Hong Kong is economically free in the sense that it doesn’t have onerous amounts of government regulation and taxes. But it isn’t free from corporate power and government land policy, both of which make it a difficult place to live and do business in.
What does the Index actually tell us?

The Index is relatively good at giving a general idea of how friendly a country is to business and investment. That is mostly because in general the indicators that it picks are directionally accurate about the outcomes they intend to measure. If the UK is ranked 28th and Honduras is ranked 94th, you can be sure that the UK has a better business environment than Honduras has.

But beyond that, it isn’t very useful as a measure for businesses or academics in studying economic freedom or understanding the ease of investment in businesses in that country. The first reason is that many of these are subjective judgements made by other people. For example in the property rights sub-component, they use the US Chamber of Commerce’s Country Risk and Insights and the World Bank’s Worldwide Governance Indicators. These indicators are in the end subjective, and their impressions would differ among people.

For example, India has an economic freedom score of just 52.9 which is below Russia’s 53.8. And yet if you saw what the market said about India’s economic freedom in terms of venture capital investments, the number of new and innovative companies coming out of the country and general investor sentiment about their respective economies, it would be far more positive about India than it is about Russia (even before the invasion). Obviously, much of this can be attributed to demographics where India is expected to have a booming population, and Russia a declining one.

But even then India has undergone massive improvements in its digital infrastructure (in large part because of the government and the entry of a new player in the market for online data), and this would be highly relevant to someone considering economic opportunity in India even though it isn’t directly about economic “freedom”. This is another problem I want to highlight about the Index of Economic Freedom: it doesn’t consider positive freedoms at all.

Negative liberties are the absence of obstacles. For example not having exorbitant taxes or laws that restrict economic activity would be an example of negative freedoms. Positive liberties on the other hand is about the possibility of acting out one’s actions. For example building an airport would increase the positive freedom of entrepreneurs in an economy because it gives them the capability to travel and sell to places they previously wouldn’t have had the ability to do so.

And this is an enormously important part of evaluating an economy. The lack of government interference is one important part. But positive actions by a government to improve infrastructure (like UPI in India, or the Singapore government’s construction of the large Changi Airport) do increase the capabilities of actors in the economy. Those are important aspects too!

What would I change?

There are some things I would add to the Index of Economic Freedom to improve its usefulness as a measure of economic freedom.

I would include restrictions on land use as part of the regulatory environment. Many countries (for example the United Kingdom) are nominally “somewhat free” but their economic potential is capped because of their restrictive land use laws. Hong Kong and Singapore too have land use laws that should make a difference in their index.

I would add a measure of government ownership of the factors of production as a measure of restricting economic freedom. In many countries governments own companies that they use for political purposes (see my article about Pakistan) which limits the economic potential of the rest of the economy by misallocating resources. This is especially true for Hong Kong as explained above, but much less true for Singapore.

They should account for corporate power which reduces economic dynamism via charging higher prices and restricting entry into new sectors. This is true for Hong Kong, but also South Korea’s chaebol run economy. The government isn’t the only thing restricting people’s economic freedom!

And while perhaps this might be out of the scope of the Index of Economic Freedom, having a “positive freedoms” index which measures what is possible given the infrastructural and financial constraints of the economy is valuable.