Economic freedom and net business formation.

• Author: Campbell, Noel D.

Economic freedom indexes, especially the Fraser Institute/Cato Institute Economic Freedom of the World (EFW) index and the Heritage Foundation/Wall Street Journal Index of Economic Freedom, are becoming increasingly important as researchers seek to explore the link between economic freedom and prosperity. The consistent finding is that nations with more economic freedom--as indicated by security of property rights, free trade, limited government, low marginal tax rates, and so forth--enjoy higher per capita incomes and general living conditions compared with countries that are less free. (1)

In a less aggregated study, Karabegovic et al. (2003) find that differences in economic freedom across U.S. states and Canadian provinces are significantly and positively related to differences in the level and growth of economic activity across states and provinces. Various researchers have used the Economic Freedom of North America (EFNA) index, published by the Fraser Institute (Karabegovic, McMahon, and Mitchell 2005), to address questions of income differentials between states, income growth, and entrepreneurship. (2) Scholars have also used the EFNA index to study migration. Ashby (2007), not surprisingly, finds that people tend to move from less free to more free areas.

In this article, we apply the EFNA index to the question of business formation, similar to Kreft (2003) and Kreft and Sobel (2005). Specifically, we ask whether the governmental, judicial, and social activities observed in the index are significantly related to net business formation among the states. We posit that greater economic freedom results in higher income levels for state residents because such freedom increases the opportunities to pursue entrepreneurial activities. Thus, such freedom should be positively and significantly correlated to net business formation, as measured by the net change in the number of businesses as a percentage of total businesses by state.

Consistent with our expectations, we find that there is a strong positive relationship between economic freedom in a state and net business formation, after controlling for state population, income, median age, federal intergovernmental revenue, minority percentage in the population, and commercial lending.

Our results are qualitatively consistent with the arguments advanced by Sobel, Clark, and Lee (2007), Clark and Lee (2006), and Kreft and Sobel (2005): When economies become politicized, effort is channeled away from wealth creation and into securing protection from market forces. Consistent with our empirical results, states with less economic freedom--and therefore more intrusive government--experience a lower rate of business formation because the benefits of private, for-profit entrepreneurial activity decline relative to other forms of economic and political activity.

Entrepreneurship, Economic Freedom, and Economic Performance

Promoting entrepreneurship has emerged as a significant policy tool for regional economic growth and job creation (Friar and Meyer 2003; Laukkanen 2000; Rosa, Scott, and Klandt 1996). Indeed, Maillat (1998) argues that economic development policy has shifted to promoting endogenous economic growth via entrepreneurship and away from competitive growth via attracting businesses from elsewhere.

The relevant policy question becomes how best to promote entrepreneurship. One answer repeatedly championed in the literature is to increase economic freedom, conceptualized as follows:

Policies are consistent with economic freedom when they provide an infrastructure for voluntary exchange, and protect individuals and their property from aggressors seeking to use violence, coercion, and fraud to seize things that do not belong to them. However, economic freedom also requires governments to refrain from actions that interfere with personal choice, voluntary exchange, and the freedom to enter and compete in labor and product markets [Gwartney and Lawson 2002: 5]. There is now strong evidence that economic freedom promotes economic prosperity and growth. (3)

Most of the work using economic freedom indexes emphasizes differences in economic freedom across countries. Those indexes emphasize that differences in institutions largely create the observed differences in economic freedom. It is interesting to consider whether similar differences in institutions exist among the U.S. states. Under a federalist system each state has its own constitution, and there are significant differences in economic rules and regulations. For example, the costs of doing business in Colorado and West Virginia are markedly different.

Kreft and Sobel (2005: 604) forcefully state the argument that ties together economic freedom, entrepreneurship, and growth:

Underlying economic freedoms generate growth primarily because they promote underlying entrepreneurial activity.... In areas with institutions providing secure property rights, a fair and balanced judicial system, contract enforcement, and effective limits on government's ability to transfer wealth through taxation and regulation, creative individuals are more likely to engage in the creation of new wealth through productive market entrepreneurship. In areas without these institutions, creative individuals are more likely to engage in attempts to capture transfers of existing wealth through unproductive political entrepreneurship. Neither the literature nor policymakers have consistently defined either the differences or the overlap between entrepreneurship and business formation. Kreft and Sobel (2005) follow the Bureau of Economic Analysis and proxy entrepreneurial activity with the number of sole proprietorships. Indeed, in popular parlance, entrepreneurship and business formation are used nearly synonymously. Correspondingly, we choose to focus on business creation and business destruction as a proxy for entrepreneurship.

Economic Freedom of North America

We observe the EFNA index as a panel of all U.S. states from 1990 to 2001. Karabegovic et al. (2003) choose to group 10 variables--usually expressed as ratios of gross state product (GSP)--into three categories: size of government, takings and discriminatory taxation, and labor market freedom. For size of government, the authors measured general consumption expenditures by government as a percentage of GSP, transfers...