In my last post, I mentioned a couple of business climate indices. There is a new paper by Jed Kolko, David Neumark, and Marisol Cuellar Mejia which examines these types of indices in depth. They find that states with high rankings in economic freedom indices tend to have faster job growth, greater wage growth, and greater growth in gross state product.
There are a lot of indexes out there that attempt to rank states in terms of their business climates and the results of their rankings often conflict. As the authors write:
[A]cross all 50 states, every state but one ranks in the top 20 in at least one index, and every state ranks in the bottom half in at least one index.
However, it turns out that when you dig deeper, the indices can be grouped into two general categories and there is actually a lot of consistency within these categories.
Economic Freedom Indices:
The first category examines what the authors call “taxes and costs” and what I might call economic freedom. It includes factors such as the cost of doing business, the size of government, tax rates and tax burden, regulation, litigation, and welfare and transfer payments. The following five indices tend to capture these types of factors:
The economic freedom component of the Freedom in the 50 States Index by Sorens and Ruger would almost certainly fall into this category too, but since the authors focused on indices that have been around for several years, they do not include it.
Productivity and Quality of Life:
The second group of indices tends to measure what the authors call “productivity or quality of life.” These indices include measures of quality of life; equity; employment, earnings and job quality; business incubation; human capital; infrastructure; and technology, knowledge jobs, and digital economy. It appears to me that a number of the indices in this group focus on outcomes (are there a lot of “knowledge jobs in the state”?) while others in this group focus on policy inputs aimed at improving the quality of life (has the government invested in business incubation and human capital?). The indices that tend to fall into this category include:
- The State New Economy Index by the Progressive Policy Institute, the Information, Technology and Innovation Foundation, and the Kauffman Foundation,
- The Development Report Card for the States—Performance by the Corporation for Enterprise Development,
- The Development Report Card for the States—Development Capacity, also by the Corporation for Enterprise Development,
- The Development Report Card for the States—Business Vitality, also by the Corporation for Enterprise Development, and
- The State Competitiveness Index by the Beacon Hill Institute.
The distinction isn’t always clear cut and I’d note that the Beacon Hill State Competitiveness Index, for one, also seems to capture a lot of economic freedom-type factors. The authors categorize an eleventh index, the Fiscal Policy Report Card on the Nation’s Governors by the Cato Institute, as falling somewhere between these two broad groups.
The authors examined the degree to which these indices predicted job growth, wages, and Gross State Product (controlling for other factors that might influence economic growth, including weather and historical industry mix). They found that the quality of life indices generally do a poor job of predicting these positive economic outcomes. In contrast, the economic freedom (aka “low taxes and few regulatory costs”) indices are strong predictors of job growth, wages, and GSP. In particular, the authors found “the corporate income tax structure and base matter for wage and GSP growth, though not necessarily for employment growth.” furthermore, the relationship, “does not appear to be driven by the top marginal tax rate, but rather by other factors such as the simplicity of corporate taxation…” They also found that greater welfare and transfer payment spending was associated with slower economic growth (they have reason to dismiss most concerns about reverse causality; but I’ll leave that to the reader to investigate).
The two indices with the best record for predicting economic progress were the Economic Freedom of North America index by Fraser (“the strongest and most robust evidence”) and the State Business Tax Climate by the Tax Foundation. Looking at the Fraser index, they found that moving a state from the 40th to the 10th place in terms of economic freedom “would increase the rate of growth of employment by 0.317 percentage point.” Given that the mean employment growth rate is 1.15 percent, this amounts to about 30 percent faster employment growth.
Lastly, the authors found that “footloose” industries such as manufacturing that are less-tied to the geography of the state tend to be more responsive to the policies captured by these indices.
Update: I have fixed a broken link to the article. Thanks to alert readers!