Economic Freedom

in

India and China

based on the

Economic Freedom of the World 2006

Annual Report

ia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia Economic Freedom Network Asia E c o no m i c F r e e d o m N e t w ork Asia Economic Freedom o mN Network etwork A Asia sia

ECONOMIC FREEDOM IN ASIA

Comparative Perspective on performance of India and China
based on the

Economic Freedom of the World 2006 Annual Report by James D. Gwartney and Robert A. Lawson

with commentaries from

P.D. Kaushik and Mao Yushi

Preface
It has now been almost ten years since the first Economic Freedom of the World (EFW) report was published. The roots of the EFW index go back to a series of conferences hosted by Michael Walker of the Fraser Institute and Nobel Laureate Milton Friedman from 1986 to 1994. These conferences focused on the development of a clear definition of economic freedom and the design of a tool for its measurement. Approximately 60 of the world's leading scholars, including Nobel Prize winners Gary Becker and Douglass North, also participated in the series. Eventually the conferences led to the development of the EFW index. The EFW index measures the degree to which the policies and institutions of countries are supportive of economic freedom. The cornerstones of economic freedom are personal choice, voluntary exchange, freedom to compete, and security of privately owned property. This paper focuses on the results of India and China, the two Asian economic giants. The development of economic freedom since 1970 of each country will be shown, as well as a comparative ranking for 2002. The empirical result of the EFW study is a significant correlation of economic freedom with higher income per capita, higher economic growth rates and lower unemployment rates. Additionally, there is also congruity with many components of human development: Countries with more economic freedom have a higher life expectancy and lower rates of illiteracy and infant mortality, and the incidence of child labour declines as economic freedom increases.

Economic Freedom in India and China

Contents
Preface Development of Economic Freedom from 1970-2004Overview 6 Ranking Overview Ranking Economic Freedom Index Asia 2004-by Area Results for China and India 1970-2004 Economic Freedom: a Comparison of India and China by P.D. Kaushik Economic Freedom: a Comparison of China and India by Mao Yushi The methods of the Economic Freedom of the World Index Economic Freedom Network Asia Members Partners
Economic Freedom in India and China

7 7 8

20

26 28 29 30
5

Development of Economic Freedom from 1970 to 2004 Overview

(Max. score: 10 points for highest degree of economic freedom)

Countries

1970 1980 1990 2000 2001 2002 2003 2004

Bangladesh China Hong Kong SAR India Indonesia Japan Malaysia Myanmar Nepal Pakistan Philippines Singapore South Korea Sri Lanka Taiwan Thailand Vietnam 6.6 5.7 4.3 5.2 7.5 5.4 8.2 4.9 4.8 6.2 6.0

3.0 3.8 8.5 4.9 5.2 6.4 6.4 4.5 5.3 4.5 4.9 7.5 5.7 4.9 6.7 5.9

4.2 4.2 8.5 4.8 6.6 7.1 7.1 2.8 5.1 5.0 5.4 8.5 6.3 4.9 7.1 6.8

5.7 5.8 8.8 6.2 5.9 7.3 6.8 3.6 5.8 5.4 7.1 8.5 6.6 6.1 7.2 6.7

5.7 5.9 8.7 6.2 5.5 7.0 6.4 3.5 5.9 5.6 6.7 8.5 7.0 6.0 7.1 6.7

5.7 5.9 8.8 6.4 6.2 7.4 6.5 3.4 5.4 5.6 6.6 8.5 7.0 6.2 7.3 6.6

5.9 5.8 8.8 6.4 5.7 7.0 6.5 3.1 5.7 5.9 6.6 8.6 6.9 6.0 7.3 6.7 5.6

5.7 5.7 8.7 6.7 6.0 7.5 6.7 3.3 5.2 5.7 6.3 8.5 7.1 6.0 7.3 6.6 5.9

The methods of the Economic Freedom of the World index is explained on page 26-27

Economic Freedom in India and China

Ranking Overview
10 9 8 7 6 5 4 3 2 1 0

Total Score

1 Hong Kong SAR

5 South Korea

13 Bangladesh

9 Philippines

2 Singapore

10 Indonesia

11 Sri Lanka

Ranking Economic Freedom Index Asia 2004-by Area

Countries Bangladesh China Hong Kong SAR India Indonesia Japan Malaysia Myanmar Nepal Pakistan Philippines Singapore South Korea Sri Lanka Taiwan Thailand Vietnam Area 1
8.1 3.8 9.1 8.2 6.4 6.6 5.3 3.5 5.2 7.2 7.0 8.2 6.5 7.4 6.2 6.8 5.6

Area 2
2.7 4.9 7.5 6.3 3.9 7.5 7.2 2.2 2.5 2.5 3.7 8.1 6.3 3.8 6.4 5.5 4.4

Area 3
7.0 8.0 9.2 7.0 7.9 9.6 6.9 3.9 6.9 6.4 8.1 9.6 9.5 6.5 9.7 7.0 6.4

Area 4
5.4 7.4 9.5 6.4 7.2 6.7 7.5 1.9 5.4 5.8 7.5 9.3 7.2 6.5 8.0 7.5 6.7

Area 5
5.4 4.2 8.3 5.4 4.7 7.0 6.4 5.0 5.7 6.5 5.4 7.6 5.8 5.7 6.0 6.3 6.3

Area 5a
5.7 4.5 8.9 5.9 5.5 7.1 6.0 5.2 6.8 7.6 7.4 7.9 7.4 6.9 6.3 7.0 9.8

Area 5b
6.7 4.7 8.6 5.7 5.0 7.0 7.9

Area 5c
3.7 3.5 7.4 4.7 3.8 6.8 5.2

17 Myanmar

6 Malaysia

14 Pakistan

8 Thailand

12 Vietnam

4 Taiwan

15 China

16 Nepal

3 Japan

7 India

Total Score
5.7 5.7 8.7 6.7 6.0 7.5 6.7 3.3 5.2

7.8 5.0 6.9 4.9 6.4 5.3 7.3 4.8

4.2 3.6 7.9 5.1 3.9 6.5 4.8 4.2

5.7 6.3 8.5 7.1 6.0 7.3 6.6 5.9

1. Size of Government: Expenditures, Taxes, and Enterprises 2. Legal Structure and Security of Property Rights 3. Access to Sound Money 4. Freedom to Trade Internationally 5. Regulation of Credit (5a), Labour (5b), and Business (5c) have graph Economic Freedom in India and China

Results for China and India 1970-2004

China
1970 1980 1990 2000 2001 2002 2003 2004

Area 1 Area 2 Area 3 Area 4 Area 5 Area 5A Area 5B Area 5C Total Score 3.2 5.8

2.6 6.2 4.2 3.0

3.6 5.8 6.5 4.9 3.3 3.2

3.8 5.1 8.4 7.5 4.7 4.7 4.6 4.8 5.9

3.7 5.2 8.3 7.5 4.4 4.7 4.5 4.2 5.8

3.8 5.3 8.3 7.5 4.6 4.7 4.4 4.6 5.9

3.8 4.9 8.0 7.4 4.2 4.5 4.7 3.5 5.7

3.8 4.9 8.1 7.2 5.0 4.7 4.7 5.6 5.8

4.0

4.8

1. Size of Government: Expenditures, Taxes, and Enterprises 2. Legal Structure and Security of Property Rights 3. Access to Sound Money 4. Freedom to Trade Internationally 5. Regulation of Credit (5a), Labour (5b), and Business (5c)

India
1970 1980 1990 2000 2001 2002 2003 2004

Area 1 Area 2 Area 3 Area 4 Area 5 Area 5A Area 5B Area 5C Total Score

3.6 4.1 6.7 5.7 5.3

4.5 5.8 6.1 4.2 5.7 5.2

4.4 4.4 6.5 3.9 5.3 5.1 6.3

6.8 6.0 6.9 5.6 5.8 5.5 6.1 5.0 6.2

7.4 5.7 6.9 5.7 5.2 5.9 6.1 3.7 6.2

7.1 6.0 6.9 6.3 5.4 5.9 6.1 4.3 6.4

7.2 6.0 7.0 6.4 5.5 5.8 5.7 4.9 6.4

8.2 6.3 7.0 6.4 5.4 5.9 5.7 4.7 6.7

5.0

5.2

4.9

Economic Freedom in India and China

Economic Freedom: a Comparison of India and China

By P.D. Kaushik
India and China are the two fastest growing economies of the world. India and China ranked 53rd and 95th respectively in the assessment of Economic Freedom of the World, 2006. Personal ownership of self is an underlying postulate of economic freedom. Essentials of economic freedom are personal choice, voluntary exchange coordinated by markets, freedom to enter and compete in markets, and protection of persons and their property from aggression by others. In other words, it is the measure of degree of government intervention or coercion in the respective economic arena. In this regard, the comparison outlines a variety of commonalities and divergences between the two countries.

India and China: Some Facts 2005

Features
Area (million sq. km) Population (billion) Provinces GDP (growth rate) GDP per capita Exports ($ 'billion) Imports ($ 'billion) HDI rank (2006) EFI rank (2006) * Centrally administered Union Territories China outweighs India in almost all respects, like size, population, economy, human development indicators, etc., except economic freedom. In terms of personal liberty, India is better placed in overall terms. Government promotes economic freedom by establishing an independent legal structure for the protection of individuals and their property. But when taxes, government expenditures and regulations are substituted for personal choice, economic freedom is reduced. Similarly, restrictions that limit
Economic Freedom in India and China

India
3.287 1.09 29 + 9 UT* 8.4 % $ 3,400 76.23 113.1 126 53

China
9.596 1.36 23 10.5% $ 6,800 752.2 631.8 81 95

entry into occupations and business activities also limit economic freedom. A comparison between the two Asian giants highlights that both countries have made considerable progress over time in freeing their respective economies. But more than that, it shows there is also a lot of scope for improvement.

Composite Economic Freedom

As mentioned above the composite index of economic freedom is calculated from five areas, where both India and China have shown improvement over the past 15 years period. In 1985, both countries were at the same position, which indicates considerable influence of government in respective economic territories. But from Figure [1] it is evident that economic reforms undertaken by India in the 90's has improved India's composite rating. Although external sector reforms in China came about much early in the 80's, the dominant role of state enterprises in Chinese economy continued. However, in the early 90's, coinciding with India's external sector reforms, China also surged ahead in terms of economic freedom ratings.

Fig. [1] Economic Freedom Composite Ratings for India and China 1985-2004
8 7 6 5 4 3 2 1 0

Composite EFI Ratings

India China

1985

1990

1995

2000

It also needs to be mentioned that the speed of liberalisation and privatisation in India was much faster vis- -vis China. Eventhough both economies made considerable progress in terms of economic freedom, India's performance was much better. In the last five years, India has achieved improvement by almost 1 point in terms of composite rating, which took China almost 15 years to achieve. In fact, China's performance can be assessed as conflicting and gradual progress because its rating fell on every alternate year after 2000. In 2004, India jumped 12 places and China slid 6 places in overall ranking vis- -vis 2003.

2001 Year

2002

2003

2004

10

Economic Freedom in India and China

In overall terms of economic freedom, one can safely say that India is far more near to the developed economies than China. In other words, India is a better destination for economic activity than China.

COMPARISON ON INDIVIDUAL AREAS

Economic freedom is measured in five areas, namely Size of Government, Legal Structure and Security of Property Rights, Access to Sound Money, Freedom to Trade Internationally, and Regulation of Credit, Business and Labour.

Area I - Size of Government: Expenditure, Taxes and Enterprises

This area indicates the extent to which a country relies on the political process to allocate resources. When the government spending increases relative to spending by individuals (citizens, households, businesses), government decision making is substituted for personal choice.

Fig. [2] Area I - EFI Ratings of India and China 1985-2004

8 7 6 5 4 3 2 1 0 1985 1990 1995 2000 2001 Year 2002 2003 2004
India China

Area I - EFI Ratings

In 1985, both countries were at the same position. Excessive government spending, widespread subsidies, protected markets, etc., was a common scenario. From Fig. [2], it is quite evident that 90s reforms unshackled India from government controls. India undertook a massive disinvestment of state-owned enterprises during the 90s, thus reducing the size of government considerably. In fact, Area-1 is solely responsible for pushing India to the 53rd position. China, on the other hand, failed to undertake any stringent measures to reduce the size of government. Since 1985, its rating for Area-1 continues to remain constant. Government consumption and transfers & subsidies remained the Achilles heel for China. On top marginal tax rates (both income tax rate and payroll tax rate), India is just ahead of China by one point.
Economic Freedom in India and China

11

India outperforms China by a sizeable margin in terms of Size of Government. In 2004, India is placed much better, with a rating of 8.2, than the average rating of 7 for the top ten countries. While China's rating of 3.8 is even less than the average rating of 4.4 for the bottom ten countries. Therefore, it can be safely mentioned that high government consumption and existence of subsidies distort the Chinese market, which stifles entrepreneurship.

Area II - Legal Structure & Security of Property Rights

Protection of persons and their rightfully acquired property is a central element of economic freedom. If individuals and businesses lack confidence in the legal system, their incentive to engage in productive activity will be eroded.

Fig. [3] Area II - EFI Ratings of India and China 1985 - 2004
8

Area II - EFI Ratings

7 6 5 4 3 2 1 0 1985 1990 1995 2000 2001 Year 2002 2003 2004

India China

India and China have taken a different path over the past 15 years (see Fig. 3). In terms of Area-2, China started with a better rating of 6.8, vis- -vis India with a rating of 4.9. However, China followed a path of gradual deterioration, while India took the path of gradual improvement. There were instances when India faltered but it recovered its progress in 2000. Undoubtedly, the integrity of Chinese legal system remained intact, which is rated better than India. But doubts were raised over independence of judiciary and impartiality of courts in China. Both India and China continued at more or less similar level when it came to the protection of intellectual property rights and military interference. Still, India fared slightly better than China.

12

Economic Freedom in India and China

In 2004, India with a rating of 6.3 in Area-2 consolidated its position against China, which received a rating of 3.9. However, India and China were well below the average rating of 8.5 for top 10 countries. China was pulled down in the rating mainly on account of independence of judiciary and protection of intellectual property. On the other side, India was pulled ahead of China on account of judicial independence, impartial courts and military interference. One can easily deduct the fluctuations in India's rating over the past years, by referring to the respective USTR. In the last ten years, India was put on the US 301 Watch List on account of violation of intellectual property rights. Likewise, India's patenting regime became TRIPs compliant as late as 2005. Though being TRIPs compliant, China continues to remain a major violator of copyrights as per the International Intellectual Property Association Report-2006.

Area III - Access to Sound Money

Sound money is essential for economic freedom. High and volatile rates of inflation distort relative prices, thus increasing risks on investment decisions. Besides, when government removes barriers against accessing foreign capital, it allows business to procure capital at lowest cost, thereby improving competitiveness in overall terms.

Fig. [4] Area III - EFI Ratings of India and China 1985 - 2004
9 8

Area III - EFI Ratings

7 6 5 4 3 2 1 0 1985 1990 1995 2000 2001

Year

India China

2002

2003

2004

Economic Freedom in India and China

13

Fig. [4] telltales China's success story and provide an insight to India's rigid monetary policy. In 1985, India was rated better than China in terms of access to sound money. With initial hiccups, China recovered and gained almost two points in a span of five years (between 2000-2005). In absolute terms, foreign direct investment in China became a focus of debate in the global financial markets. On the other hand, India continued to practice a rigid monetary policy thereby improving its rating marginally by attaining a rise of just 0.5 point in a span of 15 years. China's consolidated its position in terms of growth in money supply and pegging the inflation rate at acceptable levels. But it continued to exercise somewhat protectionist regime when it came to freedom to own foreign currency. Indian experience was much better than China in terms of growth in money supply and controlled inflation rate within acceptable limits. But there was no freedom for Indians to own foreign currency. In 2004, China fared better than India in terms of freedom to own foreign currency. But in all other respect, India improved its position vis- -vis China. In the overall rating on Area 3, China is ranked 75, with almost 1.5 points behind the average rating of top ten countries (9.5). India is ranked 98, with almost 1.8 points higher than the average rating of bottom ten nations (5.2).

Area IV - Freedom to Exchange with Foreigners

Freedom to Trade Internationally is a key ingredient of economic freedom. But more than that globalisation has become a means of survival for enterprises. Voluntary exchange is a positive sum activity, gain for both trading partners. Tariffs and quotas are obvious impediments to freedom to exchange with foreigners because they reduce convertibility of currencies, control the exchange rates, and also retard international trade. Size of trade figures of India and China in the table Some Facts (page 9) exhibits China's superiority over India. In terms of exports, China is almost 10 times more than India. China's imports are also 6 times more than India. Thus, it is safe to mention that China outpaces India in Area 4. Nevertheless, a close look at Area 4 portrays robustness of India's trade policy and paves way to look forward. It also needs to be mentioned that one cannot observe large variations in trade policies of both countries due to the influence of the World Trade Organisation. However, a more favourable trade policy of China is obvious because of its time of entry within the WTO framework.

14

Economic Freedom in India and China

Fig. [5] Area IV - EFI Ratings of India and China 1985 - 2004
8

Area IV - EFI Ratings

7 6 5 4 3 2 1 0 1985 1990 1995 2000 2001 Year 2002 2003 2004

India China

In 1985, China was 2 points higher than India in its rating for Area 4. However, India closes the gap after the reforms of 1990, as shown in fig. 5. This is the area where the difference in rank between China (37) and India (82) is highest. China is better off than India on account of taxes on international trade and size of trade sector. Mean tariff rate has experienced downward trend in China, whereas India experienced almost a consistent mean tariff rate. Even in 2004, the mean tariff rate was higher in India vis- -vis China. In terms of variability of tariff rates, China performs better than India since 1985. In terms of regulatory trade barriers, China is slightly better off than India. In fact, China has more hidden import barriers than India. However, the cost of importing in China is relatively less than in India, which improves China's rating. It is obvious that difference in the size of trade sector pulls China in the overall Area 4 ratings. Both countries received identical ratings for official versus black market exchange rate. Convertibility of respective currencies remains a major issue for both countries. Both countries exercise restrictions on capital markets. China in 2000 and India in 2002 lifted certain restrictions on access to foreign capital. The capital account convertibility initiative in India has put it in a better position than China. However, China continues to put restrictions on capital transactions, which pulls it down in terms of overall rating. India, however, has taken no initiative to move towards full convertibility of Rupee, thus restrictions on capital transactions continue.
Economic Freedom in India and China

15

In 2004, China received a rating of 7.4 for Area 4, which was less than one point from the average rating (8.2) of top 10 nations. On the other side, India lies at the midpoint, which is almost equidistant from average rating of top and bottom ten countries. India continues to remain a protectionist trade regime with higher taxes on international trade vis- -vis China. But India is considerably better in terms of transparency, as China has higher hidden trade barriers to imports. Both countries exercise excessive restrictions on capital markets.

Area V - Regulations on Credit, Business and Labour

In the event that government regulations interfere with the freedom to engage in voluntary exchange, it reduces economic freedom. Regulations also mean compliance cost for business. Restrictions on credit stifle the expansion of economic activity and inflexible labour regulations distort labour market.

Fig. [6] Area V - EFI Ratings of India and China 1985 - 2004
8

Area V - EFI Ratings

7 6 5 4 3 2 1 0 1985 1990 1995 2000 2001 Year 2002 2003 2004

India China

Both countries remain heavily regulated, but China exhibited considerable improvement during the 90's. In 1985, India was almost 3 points higher than China in its Area 5 rating. However, liberalisation of the Chinese economy started showing results by closing the gap between the two countries. Since 2001, India and China continues to show a gradual increase in the degree of regulating business (see Fig. 6). It needs to be mentioned that any incremental improvement in China is worth appreciation because of its system of governance. Being a communist regime, its foray with the market economy is no easy task.

16

Economic Freedom in India and China

Area 5 is also one of the reasons for pulling down both countries in the overall composite rating of economic freedom. In fact, it is observed that both countries have yet to adopt a more liberal view with respect to regulation of credit, business and labour. In terms of regulation of credit markets, both countries are poorly placed in terms of private ownership of banks and competition from foreign banks. Financial sector reforms in India came about in the late 90's. Thus, private ownership of banks is still gathering a threshold mass to really emerge as competitor before the government banks. Chinese experience is no different. Though number of foreign banks has increased in India and China in the recent past, but again these banks are not placed in a situation to show any significant improvement in rating. China performs better than India in terms of extending credit to private sector. Indian financial sector regime exercises less control over the interest rates than China. China remains a highly regulated labour market as compared to India, which further deteriorates with time. Both countries exercise controls on the labour market, but the impact of minimum wages is more detrimental on India than China. Similarly, the Indian regime is less flexible in terms of hiring and firing. In collective bargaining, India regulations are slightly better than China. Incentives from unemployment benefits are almost identical in terms of rating for both countries. However, military conscription pulls down China for compulsory military service. India receives a perfect 10 rating under this category. Both countries excessively regulate business, India being slightly better off than China. Both countries exercise excessively high control over prices. Burden of regulation is more on the business in India than China. Both countries experienced a downward trend in terms of burden of regulation since 2000. Business environment in China remains under the control of bureaucracy because for any activity there is a process of approvals, permissions, licenses, etc. In other words, an entrepreneur spends more time with government officials in China than India. However, China is better placed in terms of starting business. India is more corrupt than China, especially in terms of irregular payments made to government officials. It can also be viewed in terms of compliance cost being excessively higher in India than China, therefore irregular payments are made to officials. In 2004, India ranked 97th in Area 4, as compared to 127th rank of China. On subarea basis, India ranked 114th in regulation of credit, 48th in regulation of labour market and 69th in business regulations. China was worse off in all respects, ranking 128th for regulation of credit, 86th in regulation of labour market, and 106th in business regulations. It is a reason for concern for both countries, especially China,
Economic Freedom in India and China

17

because this ranking is out of 130 countries. On closer look at the average Area 5 rating, China is near to the bottom 10 countries and India is also in bottom quartile of countries.

Scope for Improvement: Policy Prescription

Although both countries have undertaken considerable measures to free their respective economies, there are some significant moves to be made to improve their overall rating. Some of the immediate measures both countries need to take are as follows;

Areas
Size of Government

India
Reduce government consumption further; reduce tax rates - both income & payroll tax.

China
Reduce government investment on PSUs and government consumption; reduce tax rates- both income & payroll tax Immediate measures needed for judicial independence, impartial courts, protection of IPRs. Curb military interference in economic activity. Remove controls on acquiring foreign currency Reduce taxes as a percentage of imports and exports; beneficial to further reduce minimum mean tariff rates Establish transparent system for imports and eliminate non-tariff barriers; reduce costs of importing

Legal Structure & Immediate measures needed Security of Property for judicial independence, Rights impartial courts, protection of IPRs. Curb military interference in economic activity. Access to Sound Money Freedom to exchange with foreigners Remove controls on acquiring foreign currency Reduce taxes as a percentage of imports and exports; lower tariffs; eliminate non-tariff barriers; adhere to international standards Full Convertibility of Rupee

Ease restrictions on imports and Remove restrictions on capital reduce costs of importing markets, especially restrictions on capital transactions

18

Economic Freedom in India and China

Scope for Improvement: Policy Prescription Areas

Regulation of Credit, Labour & Business

India
Remove restrictions on private ownership, free entry of foreign banks, remove controls on fixing interest rates. Undertake labour reforms, especially on hiring & firing of manpower. Remove entry and exit barriers, remove price controls, remove government controls on business, make government functioning transparent and efficient

China
Remove restrictions on private ownership, free entry of foreign banks, remove controls on fixing interest rates. Undertake labour reforms, especially on hiring & firing of manpower. Remove entry and exit barriers, remove price controls, remove government controls on business, make government functioning transparent and efficient.

More or less, policy prescriptions are almost identical for both countries. However, the time and extent of removal differs from country to country. There is a lot of scope for improvement for both countries. Any incremental improvement is a considerable progress for both countries. It is therefore essential that both countries must free their respective economies from government controls.

China

ndia

Economic Freedom in India and China

19

Economic Freedom : a Comparison of China and India

By MAO Yushi
India and China are large, low per capita income developing countries with long histories and celebrated cultural traditions, but they are now lagging behind in social development. In recent decades, both countries have set out on paths to rapid economic development and their growth is leading the world economy. If we look at the details of their development patterns, we can find many differences, which are due to different cultures, histories, natural environments and international circumstances. Difference means possibility and opportunity. Without drawing comparisons, we do not realise that there are other possibilities to development, what is discovered gives us the opportunity to think about and find development alternatives. The Economic Freedom Index in Asia provides a quantitative comparison for Asian countries. I will focus on the comparison between India and China. India got a score of 6.7, and China 5.7 (10 being the highest). India is freer than China. Five areas were compared and these are discussed in turn as follows:

1. Size of Government: Expenditures, Taxes, and Enterprises

In this area, India scores 8.2, while China scores only 3.8, this 4.4 points difference significantly impacts the total scores (by 0.9) between India and China (0.9 = 4.4/5). If China could catch up to India's score of 8.2 in this area, China would be at the same level overall as India. China has a much larger government and a higher fraction of tax in GDP, notably, a bigger government has resulted in more resources to be distributed not by the market, but by government, or authorities. Therefore economic efficiency has been affected. In the last decade, the growth of tax in China has doubled the growth of GDP, the percentage of tax revenue grew from 9% in the early nineties to 18% of GDP in 2006. However, governmental expenditure has not been properly allocated. Education expenditure is one of the lowest in the world, while governmental buildings everywhere are luxurious, particularly those built by governmental departments that have direct power and control over people, such as police offices, courts, tax offices and highway administration offices. Since the year 2000, the government's administrative expenses, which include study visits abroad, conferences, banquets, have grown by 21% annually, while GDP has grown by 9.5% and population growth of only 0.6%.

20

Economic Freedom in India and China

The threshold for income tax in China is RMB1600/month ($207), which is about the same as the average monthly salary (RMB1530 in 2005, RMB1335 in 2004). When China imposed income tax in 1980, the threshold for income tax was RMB800, and the average monthly salary was about RMB80. So the threshold for tax income has fallen by almost ten times and ensures tax collection from people who have an average income. The top income tax bracket is 45%, which is applied to monthly incomes of over RMB100,000. The progressive income tax applies only for salaries and the tax on other than wages is a flat rate of 20%. Companies generally use creative book-keeping to evade tax, but in China firms are forced by the government to alter their books by law to ensure companies pay more tax. For example, labour costs (employees' salary) are not allowed to be fully classified as costs, only a small part (in Beijing this is RMB1,200/month) are allowed to be itemised as a firm's cost. The lower costs in the accounts result in larger profits so the Tax Office can collect more tax from firms. Another problem in China's taxation system is that the cost of taxation is partly paid for by taxpayers so tax offices wantonly enforce supervision without any concern on its negative results. Goods and services produced by non state-owned-enterprises (SOE) have grown from zero in 1978 when economic reform began, to about 65% of total output. Most of the small SOEs have changed to private ownership, but the restructuring of ownership for big SOEs have been hampered because of the fear of the loss of State assets during transition. The financial sector, in particular, is still monopolised by the State and is only open to foreign capital, but not to domestic market. Big government is not good, particularly a government without any supervision from its people. However, it is not true that the smaller the government the better. I believe, that the Indian government is too small and too weak to provide adequate infrastructure and sufficient public services. There are only a few kilometres of express highway in India, and even in its capital, New Delhi, the roads are poor and congested. The airport is outdated and passengers have to wait a long time to get baggage and to pass immigration controls

2. Legal Structure and Security of Property ights

This is a weak area for China, where China scores 4.9, while India scores 6.3. The legal system in China was poorly established and maintained. During the Cultural Revolution this system was totally destroyed. After economic reform, no legal professionals could be found, and the whole system was established from scratch. In the process, the Party has the final word and judges have to consider what the Party likes. The justice system has lost its neutral position and independence.
Economic Freedom in India and China

21

The fundamental theory for Communism alleged that public ownership is the way to solve social contradiction. So when the Chinese Communist Party came to power in 1949, there were vast confiscations of private property in rural areas and about two million of landlords were executed in a bloody process. Then in 1956 a vast campaign of public ownership was launched and all private ownership was transferred to joint ownership. During the Cultural Revolution, personal property of rich households was confiscated. There is a strong legacy against the protection of private property in China, so it is difficult to enforce the recognition and protection of property rights. However the People Congress has put a clause in the National Constitution regarding the protection of private property. The most frequently discussed issue in China recently has been land ownership. Due to rapid development of the urban economy and huge migration from rural to urban areas, the outskirts of cities that were farmland have become the target of real estate developers. The owners of these farmlands, according to the Constitution, are village collectives, not the farmers themselves. These lands are often transacted at a very low price to commercial developers by force with collusion between local government officials and developers. Farmers don't have any right to speak out about these transaction and serious clashes often follow. A loud voice to change the ownership, or privatisation of land can be heard. Other clashes on ownership happen when the government confiscate private firms for various reasons, such as environmental pollution, workers' safety, or inefficient use of energy due to old technology. The closure of firms usually causes complicated problems regarding employment, liability, contract enforcement, etc. Many lawsuits are related to these governmental actions. But as the courts in China are not independent, the judges give their verdicts in line with the protection of State interests, so the property rights are violated.

3. Access to Sound Money

In this area China scored 8.0, a little better than the Indian score of 7.0. This reflects quite an accurate picture. Inflation has stayed low in China. Except in 2004 when the CPI (consumer price index) went up 3.9%, the highest inflation rate has been 1.8% over the past nine years. China has an extraordinary high savings rate of 45% of GDP, so China has never been short of capital. What bothers China are the huge foreign reserves, which have amassed to a trillion US dollars as at the end of 2006, and are mostly due to trade surpluses and the inflow of FDI. China had followed a more flexible foreign exchange system up to the end of the last century. Chinese people can deposit foreign money in banks and withdraw it intact. They can remit foreign money abroad under certain conditions. The big problem is that the RMB is valued too low and the pressure for currency appreciation is growing. As the Central Bank of China wants to keep an almost fixed exchange rate, the CBC

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has to buy foreign exchange to keep the USD high. To ease the pressure of appreciation, over the last year and a half, the RMB has appreciated by 7%, and now it is close to RMB7.8=$1.0. The Chinese government wants to avoid currency appreciation to protect employment through surplus exports. But as a rule, for developing countries that have embarked economic development, the domestic currency must appreciate. So appreciation of RMB is inevitable in the long term as long as China can continue its high growth rate.

4. Freedom to Trade Internationally: Taxes on International Trade (4a), Regulatory Trade Barriers (4b), Size of Trade Sector (4c)
In this area, China scored 8.0 and India scored 7.0. China has been very successful in international trade. The average annual growth of trade in the past five years has reached 23%. Since joining the WTO at the end of 2001, China has greatly reduced import taxes and many of the non-tariff barriers have been removed. China revised numerous laws and regulations, which were not in line with WTO requirements. Institutional arrangements on international trade have changed, for example, individuals were not allowed to engage in international trade but now there are thousands of private companies trading internationally. The strong trade sector is supported by strong infrastructure connections inland, which can integrate production factors, such as labour and land, to serve the export sector. The export sector in particular, has advanced the division of labour, and improved economic efficiency. For example, small cigarette lighters are produced in hundreds of family factories with each factory making just a single part, or one process of the whole production process. Division of labour increases the production capacity, lowers costs and improves quality. It further encourages R&D. This is the experience of Zhejiang Province, where about 70% of the lighters consumed worldwide were produced and is the major export force in China. China's economy is three times as big as India's, but the trade sector is eight times bigger.

5. Regulation of Credit (5a), Labour (5b), and Business (5c)

On regulation of credit, China scored 4.5 and India scored 5.9. The banking system in China is less efficient than in India. The performance of banking is based upon trust among people, which is poor in China. Before the founding of the People's Republic, social trust was good. Fifty years of a Communist regime has never upheld basic moral requirements, such as honesty, responsibility and integrity. The repeated bloody political struggles
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under Mao Zedong's dictatorship have heavily hit these virtues. During the process of economic reform in 1978, money has become the driving force at the expense of moral obligation. In addition, the state controlled justice system cannot establish a last defense for justice, so people have lost confidence in social rightness and have turned to earning quick money. This is why non-performing loans make up more than a quarter of bank loans, and triangle debt is prevailing. Doing commercial business is risky in China. Economic reform has been a great success in China, with the exception of the finance sector, as the monopoly of this sector has not only worsened the overall economic efficiency, but also damaged the reputation of Chinese currency, RMB. Although in neighbouring countries RMB is accepted as exchangeable, it can never be an international currency or a pillar component of the proposed Asian dollar in the long term unless the huge amount of bad loans can be written off. Since there is little competition in financial sector, the interest rate is not floating according to money supply and demand. The main tool for macroeconomic adjustment is not interest rates or money supply, but the control of credit. On regulation of labour, China scored 4.7, and India scored 5.7. The role of labour regulation is contradictory. One side is to protect the rights of labourers, and the other is to protect market principles on the labour market. In China, the labour market is not well regulated and there is little protection for the labourer and few restrictions on market performance, so the labour market is quite free. There used to be many restrictions on labourer movement and job choice, but most of them are obsolete. To fire an employee and employ someone is relative easy compared with the situation in western countries. So mobility in China's labour market is very high, which is not good for the economy, as firms are always losing skilled labourers. The problem here is too little protection for labourers, and labourer are looking for a place with better protection. For example, untimely payments of salary and job injury are common. There is no labour union to speak for labourer's interest, except those organised by the Party. The free market principle and the highly developed division of labour, have differentiated the salary level and caused large income differences. On regulation of business, China scored 3.5 and India scored 4.7. The basic problem in China is the government monopoly, which causes inefficiency as expressed by abnormal losses, as in banking business; and abnormal profit, as in power, oil and telecommunication sectors. It is widely recognised that monopolies cause inefficiency, so why do the Chinese government want to keep these bad practices? The answer may be the personal interest of governmental officials. To control a

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Economic Freedom in India and China

business can easily turn into personal interest. Up to now, foreigners are allowed to do banking in China, because of WTO requirements, but Chinese citizens are not allowed to operate a bank. Some of the private oil extraction companies have been confiscated; and private power generating companies have difficultly connecting their power to the grid and remaining independent generators. The profits earned by these monopolies have not been passed on to the government treasury but remain their own assets. The average salary of these firms are double or even triple the average salary elsewhere. The government's policy for these big firms is not to give up the monopoly and open the entry to these markets but to change them into public companies to be listed on stock market. However, to go to public does not mean good governance. There is still a long way to go to reform their governance.

F N

eedom etwork Asia

Economic Freedom in India and China

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The methods of the Economic Freedom of the World index

The Economic Freedom of the World Index is the result of several indicators which measure the degree of economic freedom. The index is divided into five main areas: 1. Size of Government: Expenditures, Taxes, and Enterprises 2. Legal Structure and Security of Property Rights 3. Access to Sound Money 4. Freedom to Trade Internationally : Taxes on International Trade (4a), Regulatory Trade Barriers (4b), Size of Trade Sector (4c) 5. Regulation of Credit (5a), Labour (5b), and Business (5c) Within the five major areas, the EFW-index uses 38 distinct pieces of data. Each component and subcomponent is placed on a scale from 0 to 10, whereby 10 is the highest score. Following is a brief explanation of the components incorporated into each of the five areas and their relationship to economic freedom. In Area 1: Size of Government: Expenditures, Taxes and Enterprises are four components that measure which countries rely on individual choice and market rather than the political process to allocate resources, goods, and services. The first two components address the size of government: Government consumption as a share of total consumption and transfers and subsidies as a share of GDP. The third component measures the extent to which countries use private rather than government enterprises to produce goods and services. The last component is based on the top marginal income tax rate and the top marginal income and payroll tax rate and the income threshold at which the top marginal income tax rate applies. High marginal tax rates that apply at relatively low income levels are also indicative of reliance upon government. A market order is meaningless if there is no rule of law which guaranteed private property. The second Area: Legal Structure and Security of Property Rights focuses on this issue. The key ingredients of a legal system consistent with economic freedom are rule of law, security of property rights, an independent judiciary, and an impartial court system. Components indicating how well the protective function of government is performed were assembled from two primary sources: the International Country Risk Guide and the Global Competitiveness Report. Money oils the wheels of exchange. High rates of monetary growth caused by the Federal Reserve Bank invariably lead to inflation. Similarly, when the rate of inflation increases, it also tends to become more volatile. High and volatile rates of inflation distort relative prices, alter the fundamental terms of long-term contracts, and make it virtually impossible for individuals and businesses to plan sensibly for the future

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Economic Freedom in India and China

Since sound money is essential to protect property rights Area 3: Access to Sound Money measures the currency stability in a country with four components. The first three are designed to measure the consistency of monetary policy with long term price stability. The other component is designed to measure the ease with which other currencies can be used via domestic and foreign bank accounts. In order to earn a high rating in this area, a country must follow policies and adopt institutions that lead to low (and stable) rates of inflation and avoid regulations that limit the use of alternative currencies should citizens want to use them. There are different ways to hamper free trade between countries by state interventions. Area 4: Freedom to Trade Internationally wants to estimate these trade barriers. The components in Area 4a: Taxes on International Trade are designed to measure a wide variety of restraints that affect international exchange: taxes, tariffs, and the variation of tariff rates. Area 4b: Regulatory Trade Barriers measures hidden administrative restraints, quotas, and the costs of importing like license fees and the time required for administrative red-tape that raises costs of importing equipment. In Area 4c: Size of Trade Sector an expected size of the trade sector was estimated by the population and geographic size of the country and its location relative to the concentration of world GDP. The actual size of the trade sector was then compared with the expected size for the country. If the actual size of the trade sector is greater than expected, this figure will be positive. Summarised, a country must have low tariffs, a trade sector larger than expected, a freely convertible currency, and few controls on the movement of capital to get a high score. The final area is Regulation of Credit, Labour, and Business. The first component (5a) reflects conditions in the domestic credit market. The first two sub-components provide evidence on the extent to which the banking industry is dominated by private firms and whether foreign banks are permitted to compete in the market. The final three sub-components indicate the extent to which credit is supplied to the private sector and whether controls on interest rates interfere with the market in credit. Countries that used a private banking system to allocate credit to private parties and refrained from controlling interest rates received higher ratings for this component of the regulatory area. Many types of labour-market regulations infringe upon the economic freedom of employees and employers. Among the more prominent are minimum wages, dismissal regulations, centralised wage setting, extensions of union contracts to non-participating parties, unemployment benefits that undermine the incentive to accept employment, and conscription. The labour market component (5b) is designed to measure the extent to which these restraints upon economic freedom are present across countries. The sub-components of 5c are designed to identify the extent to which regulatory restraints and bureaucratic procedures limit competition and the operation of markets. In order to score high in this portion of the index, countries must allow markets to determine prices and refrain from regulatory activities that restrict entry into business and increase the cost of producing products.

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Economic Freedom Network Asia

On the initiative of the Nobel prize winners Milton Friedman and Gary Becker, the Fraser Institute in Vancouver, Canada framed a series of indicators measuring the level of freedom granted by the legal and economic system and the practical economic, finance, tax and currency policies in national economies. Based on these indicators the Economic Freedom Index was developed, providing a comparison between all countries ranking them by their level of economic freedom. More than 70 economic research institutes and liberal think tanks joined the initiative of the Fraser Institute, including the Liberal Institute of the Friedrich Naumann Foundation in Berlin which publishes the Economic Freedom Report annually in Germany. Based on findings in the report published by the Fraser Institute in Vancouver, the Friedrich Naumann Foundation has supported and facilitated the development of the "Economic Freedom Network Asia" to enable a wider discussion of necessary policies and framework for economic growth. Since 1998 annual conferences, organised by the Friedrich Naumann Foundation together with member and partner hosts, allow for the opportunity to evaluate and discuss the methods and indicators of the Economic Freedom Index from an Asian perspective and to intensify the strategic cooperation between the members. The Network and its members aim to promote individual liberty in the economic sphere that will lead to both human development and economic growth. It does this by providing a platform for dialogue, academic exchange and public education. In addition, members cooperate to further develop the Economic Freedom Index in Asia; analyse the economic development, strengths and weaknesses of Asian economies in comparison with other regions. The Network includes Asian organisations and think-tanks, as well as individuals such as policy makers, academics, journalists and corporate representatives. It also seeks partnerships with organisations outside Asia. For further information about the network please visit:

www.fnfasia.org/efn
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Economic Freedom in India and China

Members
Cambodia
Cambodian Institute for Development Studies www.smeresearch-cids.org

China
Unirule Institute of Economics Mr. Feng Xingyuan Mr. Yao ZhongQiu Dr. Liu Junning Dr. Jianxun Wang www.unirule.org.cn www.jiuding.org www.jiuding.org www.jiuding.org www.cupl.edu.cn/en

Hong Kong SAR

The Lion Rock Institute www.lionrockinstitute.org

India
Centre for Civil Society Liberty Institute Dr. P.D. Kaushik www.ccsindia.org www.libertyindia.org www.rgfindia.com

Indonesia
Freedom Institute The Indonesian Institute Dr. Muhammad Chatib Basri Dr. Arianto Patunru www.freedom-institute.org www.theindonesianinstitute.com www.lpem.org www.lpem.org

Malaysia
Malaysian Institute of Economic Research www.mier.org.my

Pakistan
The Federation of Pakistan Chambers of Commerce & Industry Alternate Solutions Institute Mr. Farhan Bokhari www.fpcci.com.pk www.asinstitute.org

www.fnfasia.org/efn
Economic Freedom in India and China

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Members
Philippines
Foundation for Economic Freedom Foundation for Enhancement of Revenues

South Korea
Centre for Free Enterprise www.cfe.org

Thailand
Institute of Future Studies for Development Dr. Kriengsak Chareonwongsak www.ifd.or.th www.kriengsak.com

Vietnam
Mr. Nguyen Minh Cong

Partner
The Fraser Institute Friedrich Naumann Foundation International Policy Network Atlas Economic Research Foundation www.fraserinstitute.ca www.fnfasia.org www.policynetwork.net www.atlasusa.org

www.fnfasia.org/efn
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Economic Freedom in India and China

ECONOMIC FREEDOM IN ASIA

India-China Overview
based on the

Economic Freedom of the World 2006

Annual Report

www.fnfasia.org/efn