Workers gain from freedom

by John Hood, John Locke Foundation and NC SPIN panelist, September 15, 2014.

When governors and state legislatures make their economies freer — through tax relief, regulatory relief, and labor-market reforms — who stands to benefit?

According to labor unions and other left-wing pressure groups, the answer is obvious. Only business owners and wealthy people prosper under smaller government. Confiscatory taxes, redistributive spending, and pro-union laws are needed for everyone else to enjoy real gains in income and living standards, they say.

Unfortunately for them, their claim is empirically testable. Furman University economist Jeffrey Yankow has just done so in a new study for the Journal of Regional Analysis and Policy. His conclusion is that, all other things being held equal, states with greater economic freedom experience higher average wage growth than states with less economic freedom do.

Yankow’s study tracks wage trends over the last two decades of the 20th century using a cohort of 12,868 workers tracked by the National Longitudinal Survey of Youth. The sample includes men and women of all ethnic groups and skill levels. To rank the states by their economic policies, Yankow uses the Fraser Institute’s Economic Freedom of North America (EFNA), which includes tax, spending, and regulatory variables.

According to the simplest models in the study, state economic freedom has a statistically significant, moderately positive effect on worker wages. That is, for every standard-deviation increase in a state’s EFNA score, wages are 2.3 percent to 2.5 percent higher. However, when Yankow constructs a more complex model to control for a wide range of state-specific factors, the effect grows far stronger. For every standard-deviation increase in economic freedom, worker wages rise by 8.6 percent.

This effect, by the way, cannot be simply the result of workers with greater motivation or earnings potential moving to states with lower taxes or other attractive amenities, because Yankow controlled for that, too. The effects also differ by ethnicity in an interesting way. While the benefits of economic freedom for white and black workers are roughly comparable, Hispanics derive significantly higher wage gains from it.

How does economic freedom boost wage growth? There are several possible explanations. One is that when states lower tax burdens on businesses, a significant share of the money saved flows to workers in the form of higher compensation. This is the flip side of the well-known inverse relationship between corporate income taxes and employee compensation. Only silly people believe that the cost of a state tax on corporate income falls entirely on corporate shareholders. There are three potential taxpayers in this case: shareholders getting lower dividends or capital gains, customers paying higher prices, and workers getting less pay. Different studies yield differing allocations of taxes among these three groups, but workers do end up getting less pay in nearly all of them — and workers shoulder the largest tax burden of the three groups in most studies, given that they are the least able to respond to tax increases by going elsewhere.

Another possible explanation, one that Yankow discusses in his study, is that in freer states, both employers and employees have stronger incentives to investment in capital — be it plants, equipment, or training — that make work more productive, and thus better paid. In addition, states with lower tax and regulatory burdens tend to attract more entrepreneurs and job creators. The more employers compete for workers, the higher their wage offers will be. Less-restrictive labor markets allow for a better fit of workers to jobs requiring their individual skills, also boosting productivity and wages.

If Yankow’s study were the only one establishing a relationship between state economic freedom and state economic performance, that wouldn’t be much to go on. As it happens, however, peer-reviewed academic journals have since 1990 published some 33 other studies of state economic freedom . Three-quarters of them have found positive, statistically significant links to such measures as income growth, GDP growth, and job creation.

State governments certainly provide valuable services. But there is a point of diminishing returns to state taxes, spending, and regulation. By the beginning of the 21st century, most states — including ours — had exceeded it. The good news for North Carolina workers is that our legislature has been correcting the problem.

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