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India and China

based on the

Economic Freedom of the World 2006

Annual Report

Economic Freedomin

Comparative Perspective on performance ofIndia and China

based on the

Economic Freedom of the World 2006Annual Report

by James D. Gwartney and Robert A. Lawson

with commentaries from

P.D. Kaushik and Mao Yushi

ECONOMIC FREEDOM IN ASIA

4 Economic Freedom in India and China

It has now been almost ten years since the first Economic Freedom of theWorld (EFW) report was published. The roots of the EFW index go back to aseries of conferences hosted by Michael Walker of the Fraser Institute andNobel Laureate Milton Friedman from 1986 to 1994. These conferencesfocused on the development of a clear definition of economic freedom andthe design of a tool for its measurement. Approximately 60 of the world'sleading scholars, including Nobel Prize winners Gary Becker and DouglassNorth, also participated in the series. Eventually the conferences led to thedevelopment of the EFW index.

The EFW index measures the degree to which the policies and institutions ofcountries are supportive of economic freedom. The cornerstones of economicfreedom are personal choice, voluntary exchange, freedom to compete, andsecurity of privately owned property.

This paper focuses on the results of India and China, the two Asian economicgiants. The development of economic freedom since 1970 of each countrywill be shown, as well as a comparative ranking for 2002. The empiricalresult of the EFW study is a significant correlation of economic freedom withhigher income per capita, higher economic growth rates and lowerunemployment rates. Additionally, there is also congruity with manycomponents of human development: Countries with more economic freedomhave a higher life expectancy and lower rates of illiteracy and infantmortality, and the incidence of child labour declines as economic freedomincreases.

Preface

Economic Freedom in India and China 5

Contents

Preface 4

Development of Economic Freedom from 1970-2004ÐOverview

6

Ranking Overview 7

Ranking Economic Freedom Index Asia 2004-by Area 7

Results for China and India 1970-2004 8

Economic Freedom: a Comparison of India and Chinaby P.D. Kaushik 9

Economic Freedom: a Comparison of China and Indiaby Mao Yushi 20

The methods of the Economic Freedom of theWorld Index 26

Economic Freedom Network Asia 28

Members 29

Partners 30


Bangladesh

China

Hong Kong SAR

India

Indonesia

Japan

Malaysia

Myanmar

Nepal

Pakistan

Philippines

Singapore

South Korea

Sri Lanka

Taiwan

Thailand

Vietnam

Development of Economic Freedom from 1970 to 2004 Ð Overview

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

Countries 1970 1980 1990 2000 2001 2002 2003 2004

8.2

4.9

4.8

6.2

6.0

4.3

5.2

7.5

5.4

6.6

5.7

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

5.9

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

5.9

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

5.7

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


Ranking Economic Freedom Index Asia 2004-by Area

109876543210

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2Si

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3Ja

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4Ta

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5So

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Kore

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6M

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7In

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8Th

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9Ph

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10In

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11Sr

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12Vi

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13Ba

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14Pa

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15Ch

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16N

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17M

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reRanking Overview

1. Size of Government: Expenditures, Taxes, and Enterprises2. Legal Structure and Security of Property Rights3. Access to Sound Money4. Freedom to Trade Internationally5. Regulation of Credit (5a), Labour (5b), and Business (5c) have graph

Area

1Countries

Area

2Area

3

Area

4

Area

5

Area

5a

Area

5b

Area

5c

Total

Score

Bangladesh

China

Hong Kong SAR

India

Indonesia

Japan

Malaysia

Myanmar

Nepal

Pakistan

Philippines

Singapore

South Korea

Sri Lanka

Taiwan

Thailand

Vietnam

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

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

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

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

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

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

3.7

3.5

7.4

4.7

3.8

6.8

5.2

4.2

3.6

7.9

5.1

3.9

6.5

4.8

4.2

6.7

4.7

8.6

5.7

5.0

7.0

7.9

7.8

5.0

6.9

4.9

6.4

5.3

7.3

4.8

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


Results for China and India 1970-2004

5.8

3.2

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

2.6

6.2

4.2

3.0

4.0

3.6

5.8

6.5

4.9

3.3

3.2

4.8

3.8

4.9

8.1

7.2

5.0

4.7

4.7

5.6

5.8

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

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

India

3.6

4.1

6.7

5.7

5.3

5.0

4.5

5.8

6.1

4.2

5.7

5.2

5.2

4.4

4.4

6.5

3.9

5.3

5.1

6.3

4.9

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

8.2

6.3

7.0

6.4

5.4

5.9

5.7

4.7

6.7

7.2

6.0

7.0

6.4

5.5

5.8

5.7

4.9

6.4

1. Size of Government: Expenditures, Taxes, and Enterprises2. Legal Structure and Security of Property Rights3. Access to Sound Money4. Freedom to Trade Internationally5. Regulation of Credit (5a), Labour (5b), and Business (5c)

Economic Freedom: a Comparison ofIndia and China

By P.D. Kaushik

India and China are the two fastest growing economies of the world. India and Chinaranked 53rd and 95th respectively in the assessment of Economic Freedom of theWorld, 2006. Personal ownership of self is an underlying postulate of economicfreedom. Essentials of economic freedom are personal choice, voluntary exchangecoordinated by markets, freedom to enter and compete in markets, and protection ofpersons and their property from aggression by others. In other words, it is themeasure of degree of government intervention or coercion in the respective economicarena. In this regard, the comparison outlines a variety of commonalities and

divergences between the two countries.

* Centrally administered Union Territories

China outweighs India in almost all respects, like size, population, economy, humandevelopment indicators, etc., except economic freedom. In terms of personal liberty,India is better placed in overall terms. Government promotes economic freedom byestablishing an independent legal structure for the protection of individuals and theirproperty. But when taxes, government expenditures and regulations are substitutedfor personal choice, economic freedom is reduced. Similarly, restrictions that limit


India and China: Some Facts 2005

Features India China

Area (million sq. km) 3.287 9.596

Population (billion) 1.09 1.36

Provinces 29 + 9 UT* 23

GDP (growth rate) 8.4 % 10.5%

GDP per capita $ 3,400 $ 6,800

Exports ($ 'billion) 76.23 752.2

Imports ($ 'billion) 113.1 631.8

HDI rank (2006) 126 81

EFI rank (2006) 53 95


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

Composite Economic FreedomAs mentioned above the composite index of economic freedom is calculated fromfive areas, where both India and China have shown improvement over the past 15years period. In 1985, both countries were at the same position, which indicatesconsiderable influence of government in respective economic territories. But fromFigure [1] it is evident that economic reforms undertaken by India in the 90's hasimproved India's composite rating. Although external sector reforms in China cameabout much early in the 80's, the dominant role of state enterprises in Chineseeconomy continued. However, in the early 90's, coinciding with India's externalsector reforms, China also surged ahead in terms of economic freedom ratings.

It also needs to be mentioned that the speed of liberalisation and privatisation inIndia was much faster vis- -vis China. Eventhough both economies madeconsiderable progress in terms of economic freedom, India's performance was muchbetter. In the last five years, India has achieved improvement by almost 1 point interms 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 itsrating fell on every alternate year after 2000. In 2004, India jumped 12 places and

China slid 6 places in overall ranking vis- -vis 2003.

Fig. [1] Economic Freedom Composite Ratings for India and China1985-2004

Year

1985 1990 1995 2000 2001 2002 2003 2004

8

7

6

5

4

3

2

1

0

India

China

Com

posi

teEF

IRat

ings


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

COMPARISON ON INDIVIDUAL AREASEconomic freedom is measured in five areas, namely Size of Government, LegalStructure and Security of Property Rights, Access to Sound Money, Freedom to TradeInternationally, and Regulation of Credit, Business and Labour.

Area I - Size of Government: Expenditure, Taxes and EnterprisesThis area indicates the extent to which a country relies on the political process toallocate resources. When the government spending increases relative to spending byindividuals (citizens, households, businesses), government decision making issubstituted for personal choice.

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 90Õs reforms unshackled India from government controls.India undertook a massive disinvestment of state-owned enterprises during the 90Õs,thus reducing the size of government considerably. In fact, Area-1 is solelyresponsible for pushing India to the 53rd position. China, on the other hand, failed toundertake any stringent measures to reduce the size of government. Since 1985, itsrating for Area-1 continues to remain constant. Government consumption andtransfers & 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.

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 2002 2003 2004

India

China

Year

Are

aI-

EFIRat

ings


Year

India outperforms China by a sizeable margin in terms of Size of Government. In2004, India is placed much better, with a rating of 8.2, than the average rating of 7for the top ten countries. While China's rating of 3.8 is even less than the averagerating of 4.4 for the bottom ten countries. Therefore, it can be safely mentioned thathigh government consumption and existence of subsidies distort the Chinese market,which stifles entrepreneurship.

Area II - Legal Structure & Security of Property RightsProtection of persons and their rightfully acquired property is a central element ofeconomic freedom. If individuals and businesses lack confidence in the legal system,their incentive to engage in productive activity will be eroded.

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

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

8

7

6

5

4

3

2

1

0

1985 1990 1995 2000 2001 2002 2003 2004

India

China

Are

aII

-EF

IRat

ings


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 theaverage rating of 8.5 for top 10 countries. China was pulled down in the ratingmainly on account of independence of judiciary and protection of intellectualproperty. On the other side, India was pulled ahead of China on account of judicialindependence, impartial courts and military interference.

One can easily deduct the fluctuations in India's rating over the past years, byreferring to the respective USTR. In the last ten years, India was put on the US 301Watch List on account of violation of intellectual property rights. Likewise, India'spatenting regime became TRIPs compliant as late as 2005. Though being TRIPscompliant, China continues to remain a major violator of copyrights as per theInternational Intellectual Property Association Report-2006.

Area III - Access to Sound MoneySound money is essential for economic freedom. High and volatile rates of inflationdistort relative prices, thus increasing risks on investment decisions. Besides, whengovernment removes barriers against accessing foreign capital, it allows business toprocure capital at lowest cost, thereby improving competitiveness in overall terms.

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

9

8

7

6

5

4

3

2

1

0

1985 1990 1995 2000 2001 2002 2003 2004

India

China

Are

aIII-

EFIRat

ings

Year


Fig. [4] telltales China's success story and provide an insight to India's rigid monetarypolicy. 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 fiveyears (between 2000-2005). In absolute terms, foreign direct investment in Chinabecame a focus of debate in the global financial markets. On the other hand, Indiacontinued to practice a rigid monetary policy thereby improving its rating marginallyby 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 theinflation rate at acceptable levels. But it continued to exercise somewhatprotectionist regime when it came to freedom to own foreign currency. Indianexperience was much better than China in terms of growth in money supply andcontrolled inflation rate within acceptable limits. But there was no freedom forIndians 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 overallrating on Area 3, China is ranked 75, with almost 1.5 points behind the averagerating of top ten countries (9.5). India is ranked 98, with almost 1.8 points higherthan the average rating of bottom ten nations (5.2).

Area IV - Freedom to Exchange with ForeignersFreedom to Trade Internationally is a key ingredient of economic freedom. But morethan that globalisation has become a means of survival for enterprises. Voluntaryexchange is a positive sum activity, gain for both trading partners. Tariffs and quotasare obvious impediments to freedom to exchange with foreigners because theyreduce convertibility of currencies, control the exchange rates, and also retardinternational trade.

Size of trade figures of India and China in the table Some Facts (page 9) exhibitsChina's superiority over India. In terms of exports, China is almost 10 times morethan India. China's imports are also 6 times more than India. Thus, it is safe tomention that China outpaces India in Area 4.Nevertheless, a close look at Area 4 portraysrobustness of India's trade policy and paves way tolook forward. It also needs to be mentioned thatone cannot observe large variations in tradepolicies of both countries due to the influence ofthe World Trade Organisation. However, a morefavourable trade policy of China is obvious becauseof its time of entry within the WTO framework.

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


In 1985, China was 2 points higher than India in its rating for Area 4. However, Indiacloses the gap after the reforms of 1990, as shown in fig. 5. This is the area wherethe difference in rank between China (37) and India (82) is highest. China is betteroff than India on account of taxes on international trade and size of trade sector.Mean tariff rate has experienced downward trend in China, whereas Indiaexperienced almost a consistent mean tariff rate. Even in 2004, the mean tariff ratewas higher in India vis- -vis China. In terms of variability of tariff rates, Chinaperforms 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 inChina is relatively less than in India, which improves China's rating. It is obvious thatdifference in the size of trade sector pulls China in the overall Area 4 ratings. Bothcountries received identical ratings for official versus black market exchange rate.

Convertibility of respective currencies remains a major issue for both countries. Bothcountries exercise restrictions on capital markets. China in 2000 and India in 2002lifted certain restrictions on access to foreign capital. The capital accountconvertibility 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 interms of overall rating. India, however, has taken no initiative to move towards fullconvertibility of Rupee, thus restrictions on capital transactions continue.

8

7

6

5

4

3

2

1

0

1985 1990 1995 2000 2001 2002 2003 2004

India

China

Year

Are

aIV

-EF

IRat

ings


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

Area V - Regulations on Credit, Business and LabourIn the event that government regulations interfere with the freedom to engage involuntary exchange, it reduces economic freedom. Regulations also mean compliancecost for business. Restrictions on credit stifle the expansion of economic activity andinflexible labour regulations distort labour market.

Both countries remain heavily regulated, but China exhibited considerableimprovement during the 90's. In 1985, India was almost 3 points higher than Chinain its Area 5 rating. However, liberalisation of the Chinese economy started showingresults by closing the gap between the two countries. Since 2001, India and Chinacontinues 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 worthappreciation because of its system of governance. Being a communist regime, itsforay with the market economy is no easy task.

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

8

7

6

5

4

3

2

1

0

1985 1990 1995 2000 2001 2002 2003 2004

India

China

Year

Are

aV

-EF

IRat

ings


Area 5 is also one of the reasons for pulling down both countries in the overallcomposite rating of economic freedom. In fact, it is observed that both countrieshave yet to adopt a more liberal view with respect to regulation of credit, businessand labour.

In terms of regulation of credit markets, both countries are poorly placed in terms ofprivate ownership of banks and competition from foreign banks. Financial sectorreforms in India came about in the late 90's. Thus, private ownership of banks is stillgathering a threshold mass to really emerge as competitor before the governmentbanks. Chinese experience is no different. Though number of foreign banks hasincreased in India and China in the recent past, but again these banks are not placedin a situation to show any significant improvement in rating. China performs betterthan India in terms of extending credit to private sector. Indian financial sectorregime exercises less control over the interest rates than China.

China remains a highly regulated labour market as compared to India, which furtherdeteriorates with time. Both countries exercise controls on the labour market, but theimpact of minimum wages is more detrimental on India than China. Similarly, theIndian regime is less flexible in terms of hiring and firing. In collective bargaining,India regulations are slightly better than China. Incentives from unemploymentbenefits are almost identical in terms of rating for both countries. However, militaryconscription pulls down China for compulsory military service. India receives aperfect 10 rating under this category.

Both countries excessively regulate business, India being slightly better off thanChina. Both countries exercise excessively high control over prices. Burden ofregulation is more on the business in India than China. Both countries experienced adownward trend in terms of burden of regulation since 2000. Business environmentin China remains under the control of bureaucracy because for any activity there is aprocess of approvals, permissions, licenses, etc. In other words, an entrepreneurspends more time with government officials in China than India. However, China isbetter 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 beviewed 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 sub-area basis, India ranked 114th in regulation of credit, 48th in regulation of labourmarket and 69th in business regulations. China was worse off in all respects, ranking128th for regulation of credit, 86th in regulation of labour market, and 106th inbusiness regulations. It is a reason for concern for both countries, especially China,


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

Scope for Improvement: Policy PrescriptionAlthough both countries have undertaken considerable measures to free theirrespective economies, there are some significant moves to be made to improve theiroverall rating. Some of the immediate measures both countries need to take are asfollows;

Size ofGovernment

Legal Structure &Security of PropertyRights

Access toSound Money

Freedom toexchange withforeigners

Reduce governmentconsumption further;reduce tax rates - bothincome & payroll tax.

Immediate measures neededfor judicial independence,impartial courts, protection ofIPRs. Curb military interferencein economic activity.

Remove controls onacquiring foreign currency

Reduce taxes as a percentage ofimports and exports; lowertariffs; eliminate non-tariffbarriers; adhere to internationalstandards

Full Convertibility of Rupee

Ease restrictions on imports andreduce costs of importing

Reduce governmentinvestment on PSUs andgovernment consumption;reduce tax rates- bothincome & payroll tax

Immediate measures neededfor judicial independence,impartial courts, protection ofIPRs. Curb military interferencein economic activity.

Remove controls onacquiring foreign currency

Reduce taxes as a percentageof imports and exports;beneficial to further reduceminimum mean tariff rates

Establish transparent systemfor imports and eliminatenon-tariff barriers; reducecosts of importing

Remove restrictions on capitalmarkets, especially restrictionson capital transactions

Areas India China

Regulation ofCredit, Labour &Business

Remove restrictions on privateownership, free entry offoreign banks, remove controlson fixing interest rates.

Undertake labour reforms,especially on hiring & firing ofmanpower.

Remove entry and exit barriers,remove price controls, removegovernment controls onbusiness, make governmentfunctioning transparent andefficient

Remove restrictions onprivate ownership, free entryof foreign banks, removecontrols on fixing interestrates.

Undertake labour reforms,especially on hiring & firingof manpower.

Remove entry and exitbarriers, remove pricecontrols, removegovernment controls onbusiness, make governmentfunctioning transparent andefficient.

Areas India China


Scope for Improvement: Policy Prescription

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 ofscope for improvement for both countries. Any incremental improvement is aconsiderable progress for both countries. It is therefore essential that both countries

must free their respective economies from government controls.

China ndia


India and China are large, low per capita income developing countries with longhistories and celebrated cultural traditions, but they are now lagging behind in socialdevelopment. In recent decades, both countries have set out on paths to rapideconomic development and their growth is leading the world economy. If we look atthe details of their development patterns, we can find many differences, which aredue to different cultures, histories, natural environments and internationalcircumstances. Difference means possibility and opportunity. Without drawingcomparisons, we do not realise that there are other possibilities to development,what is discovered gives us the opportunity to think about and find developmentalternatives.

The Economic Freedom Index in Asia provides a quantitative comparison for Asiancountries. I will focus on the comparison between India and China. India got a scoreof 6.7, and China 5.7 (10 being the highest). India is freer than China. Five areas werecompared and these are discussed in turn as follows:

1. Size of Government: Expenditures, Taxes, and EnterprisesIn this area, India scores 8.2, while China scores only 3.8, this 4.4 points differencesignificantly 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 thesame level overall as India.

China has a much larger government and a higher fraction of tax in GDP, notably, abigger government has resulted in more resources to be distributed not by themarket, but by government, or authorities. Therefore economic efficiency has beenaffected. In the last decade, the growth of tax in China has doubled the growth ofGDP, the percentage of tax revenue grew from 9% in the early nineties to 18% ofGDP in 2006. However, governmental expenditure has not been properly allocated.Education expenditure is one of the lowest in the world, while governmentalbuildings everywhere are luxurious, particularly those built by governmentaldepartments that have direct power and control over people, such as police offices,courts, tax offices and highway administration offices. Since the year 2000, thegovernment'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%.

Economic Freedom : a Comparison ofChina and India

By MAO Yushi


The threshold for income tax in China is RMB1600/month ($207), which is about thesame as the average monthly salary (RMB1530 in 2005, RMB1335 in 2004). WhenChina imposed income tax in 1980, the threshold for income tax was RMB800, andthe average monthly salary was about RMB80. So the threshold for tax income hasfallen by almost ten times and ensures tax collection from people who have anaverage income. The top income tax bracket is 45%, which is applied to monthlyincomes of over RMB100,000. The progressive income tax applies only for salariesand the tax on other than wages is a flat rate of 20%. Companies generally usecreative book-keeping to evade tax, but in China firms are forced by the governmentto alter their books by law to ensure companies pay more tax. For example, labourcosts (employees' salary) are not allowed to be fully classified as costs, only a smallpart (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 collectmore tax from firms. Another problem in China's taxation system is that the cost oftaxation is partly paid for by taxpayers so tax offices wantonly enforce supervisionwithout any concern on its negative results.

Goods and services produced by non state-owned-enterprises (SOE) have grown fromzero in 1978 when economic reform began, to about 65% of total output. Most ofthe small SOEs have changed to private ownership, but the restructuring ofownership for big SOEs have been hampered because of the fear of the loss of Stateassets during transition. The financial sector, in particular, is still monopolised by theState and is only open to foreign capital, but not to domestic market.

Big government is not good, particularly a government without any supervision fromits people. However, it is not true that the smaller the government the better.I believe, that the Indian government is too smalland too weak to provide adequate infrastructureand sufficient public services. There are only a fewkilometres of express highway in India, and even inits capital, New Delhi, the roads are poor andcongested. The airport is outdated and passengershave to wait a long time to get baggage and topass immigration controls

2. Legal Structure and Security of Property ightsThis is a weak area for China, where China scores 4.9, while India scores 6.3. The legalsystem in China was poorly established and maintained. During the CulturalRevolution this system was totally destroyed. After economic reform, no legalprofessionals could be found, and the whole system was established from scratch. Inthe process, the Party has the final word and judges have to consider what the Partylikes. The justice system has lost its neutral position and independence.


The fundamental theory for Communism alleged that public ownership is the way tosolve social contradiction. So when the Chinese Communist Party came to power in1949, there were vast confiscations of private property in rural areas and about twomillion of landlords were executed in a bloody process. Then in 1956 a vastcampaign of public ownership was launched and all private ownership wastransferred to joint ownership. During the Cultural Revolution, personal property ofrich households was confiscated. There is a strong legacy against the protection ofprivate property in China, so it is difficult to enforce the recognition and protectionof property rights. However the People Congress has put a clause in the NationalConstitution regarding the protection of private property.

The most frequently discussed issue in China recently has been land ownership. Dueto rapid development of the urban economy and huge migration from rural to urbanareas, the outskirts of cities that were farmland have become the target of real estatedevelopers. The owners of these farmlands, according to the Constitution, are villagecollectives, not the farmers themselves. These lands are often transacted at a verylow price to commercial developers by force with collusion between local governmentofficials and developers. Farmers don't have any right to speak out about thesetransaction 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 thegovernment confiscate private firms for various reasons, such as environmentalpollution, workers' safety, or inefficient use of energy due to old technology. Theclosure 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 linewith the protection of State interests, so the property rights are violated.

3. Access to Sound MoneyIn this area China scored 8.0, a little better than the Indian score of 7.0. This reflectsquite an accurate picture. Inflation has stayed low in China. Except in 2004 when theCPI (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 foreignreserves, which have amassed to a trillion US dollars as at the end of 2006, and aremostly due to trade surpluses and the inflow of FDI.

China had followed a more flexible foreign exchange system up to the end of the lastcentury. Chinese people can deposit foreign money in banks and withdraw it intact.They can remit foreign money abroad under certain conditions. The big problem isthat 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


has to buy foreign exchange to keep the USD high. To ease the pressure ofappreciation, over the last year and a half, the RMB has appreciated by 7%, and nowit is close to RMB7.8=$1.0. The Chinese government wants to avoid currencyappreciation to protect employment through surplus exports. But as a rule, fordeveloping countries that have embarked economic development, the domesticcurrency must appreciate. So appreciation of RMB is inevitable in the long term aslong 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 ininternational trade. The average annual growth of trade in the past five years hasreached 23%. Since joining the WTO at the end of 2001, China has greatly reducedimport taxes and many of the non-tariff barriers have been removed. China revisednumerous 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 arethousands 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 exportsector. The export sector in particular, has advanced the division of labour, andimproved economic efficiency. For example, small cigarette lighters are produced inhundreds of family factories with each factory making just a single part, or oneprocess of the whole production process. Division of labour increases the productioncapacity, lowers costs and improves quality. It further encourages R&D. This is theexperience of Zhejiang Province, where about 70% of the lighters consumedworldwide were produced and is the major export force in China. China's economy isthree 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 Indiascored 5.9. The banking system in China is lessefficient than in India. The performance of bankingis based upon trust among people, which is poor inChina. Before the founding of the People'sRepublic, social trust was good. Fifty years of aCommunist regime has never upheld basic moralrequirements, such as honesty, responsibility andintegrity. The repeated bloody political struggles

under Mao Zedong's dictatorship have heavily hit these virtues. During the process ofeconomic reform in 1978, money has become the driving force at the expense ofmoral obligation. In addition, the state controlled justice system cannot establish alast defense for justice, so people have lost confidence in social rightness and haveturned to earning quick money. This is why non-performing loans make up more thana quarter of bank loans, and triangle debt is prevailing. Doing commercial business isrisky in China.

Economic reform has been a great success in China, with the exception of the financesector, as the monopoly of this sector has not only worsened the overall economicefficiency, but also damaged the reputation of Chinese currency, RMB. Although inneighbouring countries RMB is accepted as exchangeable, it can never be aninternational currency or a pillar component of the proposed Asian dollar in the longterm unless the huge amount of bad loans can be written off. Since there is littlecompetition in financial sector, the interest rate is not floating according to moneysupply and demand. The main tool for macroeconomic adjustment is not interestrates or money supply, but the control of credit.

On regulation of labour, China scored 4.7, and India scored 5.7. The role of labourregulation is contradictory. One side is to protect the rights of labourers, and theother is to protect market principles on the labour market. In China, the labourmarket is not well regulated and there is little protection for the labourer and fewrestrictions on market performance, so the labour market is quite free. There used tobe many restrictions on labourer movement and job choice, but most of them areobsolete. To fire an employee and employ someone is relative easy compared with thesituation 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. Theproblem here is too little protection for labourers, and labourer are looking for a placewith better protection. For example, untimely payments of salary and job injury arecommon. There is no labour union to speak for labourer's interest, except thoseorganised by the Party.

The free market principle and the highly developed division of labour, havedifferentiated the salary level and caused large income differences.

On regulation of business, China scored 3.5 and India scored 4.7. The basic problem inChina is the government monopoly, which causes inefficiency as expressed byabnormal losses, as in banking business; and abnormal profit, as in power, oil andtelecommunication sectors. It is widely recognised that monopolies causeinefficiency, 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


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


FNFFeFF e d o m

e t w o r k A s i a


The Economic Freedom of the World Index is the result of several indicators which measure thedegree of economic freedom. The index is divided into five main areas:

1. Size of Government: Expenditures, Taxes, and Enterprises2. Legal Structure and Security of Property Rights3. Access to Sound Money4. Freedom to Trade Internationally : Taxes on International Trade (4a), RegulatoryTrade 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 componentand 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 andtheir relationship to economic freedom.

In Area 1: Size of Government: Expenditures, Taxes and Enterprises are four componentsthat measure which countries rely on individual choice and market rather than the politicalprocess to allocate resources, goods, and services.

The first two components address the size of government: Government consumption as a shareof total consumption and transfers and subsidies as a share of GDP. The third componentmeasures the extent to which countries use private rather than government enterprises toproduce goods and services. The last component is based on the top marginal income tax rateand the top marginal income and payroll tax rate and the income threshold at which the topmarginal income tax rate applies. High marginal tax rates that apply at relatively low incomelevels are also indicative of reliance upon government.

A market order is meaningless if there is no rule of law which guaranteed private property. Thesecond Area: Legal Structure and Security of Property Rights focuses on this issue. The keyingredients of a legal system consistent with economic freedom are rule of law, security ofproperty rights, an independent judiciary, and an impartial court system. Componentsindicating how well the protective function of government is performed were assembled fromtwo primary sources: the International Country Risk Guide and the Global CompetitivenessReport.

Money oils the wheels of exchange. High rates of monetary growth caused by the FederalReserve Bank invariably lead to inflation. Similarly, when the rate of inflation increases, it alsotends to become more volatile. High and volatile rates of inflation distort relative prices, alterthe fundamental terms of long-term contracts, and make it virtually impossible for individualsand businesses to plan sensibly for the future

The methods of the Economic Freedomof the World index

Since sound money is essential to protect property rights Area 3: Access to Sound Moneymeasures the currency stability in a country with four components. The first three are designedto measure the consistency of monetary policy with long term price stability. The othercomponent is designed to measure the ease with which other currencies can be used viadomestic and foreign bank accounts. In order to earn a high rating in this area, a country mustfollow policies and adopt institutions that lead to low (and stable) rates of inflation and avoidregulations 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. Area4: Freedom to Trade Internationally wants to estimate these trade barriers. The componentsin Area 4a: Taxes on International Trade are designed to measure a wide variety of restraintsthat affect international exchange: taxes, tariffs, and the variation of tariff rates. Area 4b:Regulatory Trade Barriers measures hidden administrative restraints, quotas, and the costs ofimporting like license fees and the time required for administrative red-tape that raises costsof importing equipment. In Area 4c: Size of Trade Sector an expected size of the trade sectorwas estimated by the population and geographic size of the country and its location relative tothe concentration of world GDP. The actual size of the trade sector was then compared withthe 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 largerthan expected, a freely convertible currency, and few controls on the movement of capital toget a high score.

The final area is Regulation of Credit, Labour, and Business. The first component (5a) reflectsconditions in the domestic credit market. The first two sub-components provide evidence onthe extent to which the banking industry is dominated by private firms and whether foreignbanks are permitted to compete in the market. The final three sub-components indicate theextent to which credit is supplied to the private sector and whether controls on interest ratesinterfere with the market in credit. Countries that used a private banking system to allocatecredit to private parties and refrained from controlling interest rates received higher ratings forthis component of the regulatory area.

Many types of labour-market regulations infringe upon the economic freedom of employeesand 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 theserestraints upon economic freedom are present across countries.

The sub-components of 5c are designed to identify the extent to which regulatory restraintsand bureaucratic procedures limit competition and the operation of markets. In order to scorehigh in this portion of the index, countries must allow markets to determine prices and refrainfrom regulatory activities that restrict entry into business and increase the cost of producingproducts.



Economic Freedom Network AsiaOn the initiative of the Nobel prize winners MiltonFriedman and Gary Becker, the Fraser Institute inVancouver, Canada framed a series of indicatorsmeasuring the level of freedom granted by the legaland economic system and the practical economic,finance, tax and currency policies in nationaleconomies. Based on these indicators the EconomicFreedom Index was developed, providing acomparison between all countries ranking them bytheir level of economic freedom. More than 70economic research institutes and liberal think tanks

joined the initiative of the Fraser Institute, including the Liberal Institute of theFriedrich Naumann Foundation in Berlin which publishes the Economic FreedomReport annually in Germany.

Based on findings in the report published by the Fraser Institute in Vancouver, theFriedrich Naumann Foundation has supported and facilitated the development ofthe "Economic Freedom Network Asia" to enable a wider discussion of necessarypolicies and framework for economic growth. Since 1998 annual conferences,organised by the Friedrich Naumann Foundation together with member and partnerhosts, allow for the opportunity to evaluate and discuss the methods and indicatorsof the Economic Freedom Index from an Asian perspective and to intensify thestrategic cooperation between the members.

The Network and its members aim to promote individual liberty in the economicsphere that will lead to both human development and economic growth. It doesthis by providing a platform for dialogue, academic exchange and public education.In addition, members cooperate to further develop the Economic Freedom Index inAsia; analyse the economic development, strengths and weaknesses of Asianeconomies in comparison with other regions.

The Network includes Asian organisations and think-tanks, as well as individualssuch as policy makers, academics, journalists and corporate representatives. It alsoseeks partnerships with organisations outside Asia.

For further information about the network please visit:

www.fnfasia.org/efn


MembersCambodiaCambodian Institute for Development Studies www.smeresearch-cids.org

ChinaUnirule Institute of Economics www.unirule.org.cnMr. Feng Xingyuan www.jiuding.orgMr. Yao ZhongQiu www.jiuding.orgDr. Liu Junning www.jiuding.orgDr. Jianxun Wang www.cupl.edu.cn/en

Hong Kong SARThe Lion Rock Institute www.lionrockinstitute.org

IndiaCentre for Civil Society www.ccsindia.orgLiberty Institute www.libertyindia.orgDr. P.D. Kaushik www.rgfindia.com

IndonesiaFreedom Institute www.freedom-institute.orgThe Indonesian Institute www.theindonesianinstitute.comDr. Muhammad Chatib Basri www.lpem.orgDr. Arianto Patunru www.lpem.org

MalaysiaMalaysian Institute of Economic Research www.mier.org.my

PakistanThe Federation of Pakistan Chambers ofCommerce & Industry www.fpcci.com.pkAlternate Solutions Institute www.asinstitute.orgMr. Farhan Bokhari

www.fnfasia.org/efn

Members

Partner

PhilippinesFoundation for Economic FreedomFoundation for Enhancement of Revenues

South KoreaCentre for Free Enterprise www.cfe.org

ThailandInstitute of Future Studies for Development www.ifd.or.thDr. Kriengsak Chareonwongsak www.kriengsak.com

VietnamMr. Nguyen Minh Cong

The Fraser InstituteFriedrich Naumann FoundationInternational Policy NetworkAtlas Economic Research Foundation


www.fnfasia.org/efn

www.fraserinstitute.cawww.fnfasia.orgwww.policynetwork.netwww.atlasusa.org

India-China Overviewbased on the

Economic Freedom of the World 2006

Annual Report

ECONOMIC FREEDOM IN ASIA

www.fnfasia.org/efn

efn india china

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