April 13, 2016

Are State Business Climate Indices Really Helpful?

Adam Millsap

Assistant Director, L. Charles Hilton Jr. Center for the Study of Economic Prosperity and Individual Opportunity, Florida State University
Summary

The usual policies of tax expenditures, subsidies and other government handouts to businesses are generally ineffective at spurring economic growth, so states have little to lose by foregoing such strategies and focusing on simplicity and stability when it comes to economic policy.

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Many organizations publish indices purporting to measure some aspect of a state’s business climate. A few examples are the Tax Foundation’s State Business Tax Climate index, the Fraser Economic Freedom of North America Index and the State New Economy Index. And while these and other indices provide a snapshot of some aspect of a state’s business climate, very few studies have been conducted that test whether a better ranking on these indices actually leads to better economic outcomes.

A new study recently published in the Journal of Regional Science examines 11 business climate indices and tests whether they can predict relative economic growth across state borders. The authors look at economic outcomes such as total income, average wage per job, and total employment in counties on either side of a state border, which is where the differences due to policies rather than geographic factors should be strongest. They find that most of the indices fail to predict changes in relative economic outcomes and that some of the indices are even negatively correlated with some outcomes.

The best predictive index was the Grant Thornton Index, which was last produced in 1989 and focused on the cost of doing business in a state. The Tax Foundation’s index also fared relatively well. In fact, the authors note that the best performing indices emphasized relative tax policy as a component of their index. Most of the other indices were better at explaining previous economic growth than predicting future growth.

This research doesn’t mean that the non-predicative indices aren’t valuable. Each index provides useful information about the relative position of states at a point in time on a variety of topics, from economic freedom to labor market skills, and policy makers may want to improve their state’s position on any of these rankings for reasons other than economic growth.

But if economic growth is the goal, policy makers should be cautious about chasing any particular ranking, especially the poorly performing rankings that focus on infrastructure or local labor market skills. Instead, they should focus on structural reforms that foster innovation and entrepreneurship, such as simpler taxes and the removal of complicated and burdensome regulations, like occupational licensing, which limit opportunity.

Firms invest in areas that provide the largest expected return on their investment. States with simple tax and regulatory structures lower firms’ compliance costs and, perhaps most importantly, reduce uncertainty, since they are devoid of ambiguities and hidden penalties. Because investment decisions rely on projected outcomes, reducing uncertainty is an effective way to attract firms to a particular state.

The usual policies of tax expenditures, subsidies and other government handouts to businesses are generally ineffective at spurring economic growth, so states have little to lose by foregoing such strategies and focusing on simplicity and stability when it comes to economic policy. And more importantly, the evidence suggests that strategy works.