Political capitalism: The interaction between income inequality, economic freedom and democracy

•We investigate panel data of 100 countries for the 1971-2010 period.•Income inequality Granger-causes economic freedom, but not vice versa.•The effect of income inequality on economic freedom is negative.•Democratic institutions do not prevent economic freedom from eroding.•Our findings correspond to ideas of political capitalism or captured democracy.

We study the relationship between income inequality and economic freedom for a panel of 100 countries for the 1971-2010 period. Using a panel Granger non-causality approach, we reject the null hypothesis of Granger non-causality running from income inequality to economic freedom, but not vice versa. From a series of dynamic panel estimations we show that the effect of income inequality on economic freedom is negative and robust to the inclusion of additional controls. In particular, inequality is negatively associated with those components of economic freedom related to international trade, domestic market regulation as well as the rule of law and property rights protection. We argue that the negative effect of inequality on economic freedom is due to the economic elite converting its economic power into de facto political power to defend its economic interests; these interests run counter to economic freedom, discouraging innovation and competition as well as protecting the elite's rents. Finally, we show that economic freedom decreases with income inequality even in democratic countries, suggesting that democratic institutions do not prevent economic freedom from eroding. We argue that the latter finding corresponds to a system of political capitalism or captured democracy, where a powerful economic elite can nevertheless exercise de facto political power by cooperating with politicians and other decision-makers for their mutual benefit.