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States, Economic Freedom, and Wealth Creation

Lawrence W. Reed

Montesquieu once observed that “Countries are well cultivated, not as they are fertile, but as they are free.” The 1999 Index of Economic Freedom, published by the Heritage Foundation and the Wall Street Journal, examined 161 countries and came to the same conclusion: “Countries that have the most economic freedom also tend to have higher rates of long-term economic growth and are more prosperous than those that have less economic freedom.” Unequivocally, the numbers show that “countries with the lowest levels of economic freedom also have the lowest standards of living.”

One would expect that within a country the same pattern would be evident. Indeed it is, and now we have a comprehensive analysis that proves it: Economic Freedom in America’s 50 States by economists John Byars, Robert McCormick, and Bruce Yandle. Commissioned by the State Policy Network, an association of some three dozen state-based free-market think tanks, the report argues that “states with relatively more economic freedom enjoy higher rates of growth . . . because individuals in those states are allowed to keep more of their income, and thus the marketplace can more efficiently determine the allocation of resources.”

There are profound lessons here for state governments. Their actions and policies do make a difference in the material welfare of their citizens. People respond to incentives and disincentives, and they tend to migrate, taking their skills and capital with them, to those locales where those skills and capital are relatively safe from the depredations of high taxes and regulation. Governors and state legislators who want to accumulate power and centralize resources while proclaiming a desire to spur growth are trying to have their cake and eat it too.

Economic Freedom Defined

From the start, the report assumes a definition of “economic freedom” that comports with the ideas of classical-liberal thinkers. The individual is a sovereign entity that the state respects by minimizing its intrusions and providing for a common defense. Economic freedom is expanded when governments limit “encroachments on opportunities for individuals to engage in voluntary exchange.” It is contracted when states interfere with voluntary exchange through an array of costly impositions.

Every state provides its own “bundle” of costs and benefits. The tax burden may be low in a state at the same time the regulatory burden is high. A state may have low tax and regulatory burdens that are at least partially offset by a judicial system that encourages frivolous lawsuits or bestows abnormally large damage awards that overcompensate harmed parties and thereby exposes individuals to higher risks of property confiscation and redistribution. A relatively high level of welfare spending indicates a state is engaged in more income redistribution than others, a violation of economic freedom, and this may offset an otherwise friendly regulatory environment. In any event, the report agglomerates all this information in about as scientific a fashion as is possible.

It assembles data on more than 200 indicators, grouping the resulting measurements under five key categories: fiscal, regulatory, judicial, government size, and welfare spending. Each state is then assigned a rank, from 1 to 50. Idaho turned in the best score as the state with the greatest degree of economic freedom, while New York came in dead last. The five states with the most economic freedom (Idaho, Virginia, Utah, Wyoming, and South Dakota) boasted growth in personal income from 1990 to 1997 that was a spectacular 59 percent higher on average than the five states with the lowest levels of economic freedom (New York, Rhode Island, New Jersey, Massachusetts, and Connecticut).

Just as the human traffic around the world tends to move from the less free to the more free countries, migration patterns within the United States show similar movement. The report confirms that “people are moving into states with high levels of freedom and out of states with low freedom.” Birth rates are not markedly different from state to state, so changes in population are heavily influenced by the movement of people. The difference in population growth between the top and bottom of the freedom scale is especially dramatic: Idaho—the freest state—saw its population soar by 16.8 percent from 1990 to 1997, while New York—the least free state—barely held its own with a paltry growth rate of just 0.8 percent.

Per capita personal income in Idaho in 1996 was a low $19,539 when compared to New York’s $28,732—a fact which by itself might suggest a conclusion diametrically opposite of the report’s general finding. Having lived in Idaho in the mid-1980s, however, I can certify that $19,539 goes a lot further than the same amount of income in a high-cost-of-living state like New York. Indeed, Byars and colleagues show that residents of New York pay twice the state and local taxes than residents of Idaho: $3,858 versus $1,955.

You’re also more likely to be working if you live in Idaho rather than in New York. The unemployment rate in Idaho was 3.7 percent below the national average in 1996, while New York’s was 15 percent above. In the 1990s, both per capita income and gross state product boomed in Idaho at almost twice the respective rates of New York.

Business Incentives

The strong, positive correlation between economic freedom and economic growth that the report demonstrates has implications for the states in an increasingly controversial area of policy: “incentive” packages designed to lure businesses. Almost every state is now engaged in a tit-for-tat war of selective tax abatements and direct subsidies. For example: To attract a new factory for Ohio and prevent it from locating in neighboring Michigan, Ohio politicians may offer to forgive several years of taxes due and even give the company millions of dollars for job training and infrastructure.

The report does not directly address this form of competition among the states, but its bottom line certainly points in one particular direction. If states want to cultivate growth and prosperity, they should focus on the forest and the trees will take care of themselves. To the extent that these incentives are targeted at a few at the expense of the many, they rearrange wealth and politicize it—which works against an improvement in overall economic freedom. State governments would be better advised to reduce burdens on everyone and foster a policy of “a fair field and no favor.” Economic freedom, not political redistribution, is what makes a state—and indeed, a nation—prosper.

Byars, McCormick, and Yandle have done us a favor by proving beyond a shadow of a doubt what we all should have instinctively known. Freedom works, and more of it works even better.

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