Thursday, February 27, 2014

Is Our Economic Freedom Slipping Away, and Can Competitive Federalism Reverse the Slide?


Less Free

Somewhere In Between

The Heritage Foundation recently released its annual "Index of Economic Freedom" for 2014, developed in partnership with the Wall Street Journal.  (See here).  Authors of the index measure each country's performance in ten different variables grouped into four different categories.  Here are the four different categories along with the variables assigned to each category.

1. Rule of Law (Property Rights and Freedom from Corruption);

2.  Limited Government (Fiscal Freedom and Government Spending);

3.  Regulatory Efficiency  (Business Freedom, Labor Freedom and Monetary Freedom);

4.  Open Markets   (Trade freedom, Investment Freedom and Financial Freedom)

Here are the top fifteen, along with their scores on the index in question.

1) Hong Kong:         90.1

2)  Singapore:         89.4

3)  Australia:           82.0

4)  Switzerland:        81.6

5)  New Zealand:      81.2

6)  Canada:              80.2

7)  Chile:                 79.7

8)  Mauritius:           76.5

9)  Ireland:               76.2

10) Denmark            76.1

11) Estonia               75.9

12)  USA                   75.5

13) Bahrain               75.1

14)  UK                     74.9

15)  Netherlands        74.2

The United States, which ranked number 6 in 2009, fell out of the top ten this year, continuing a slide that began several years ago.  (See here for the 2013 rankings, here for the 2011 rankings, and here for the 2009 rankings.)  The US now ranks 12, with a score of 75.5.

It should be noted that such national rankings can be imperfect proxies for the extent of economic freedom that individual citizens enjoy in political systems, like the United States (and Canada), characterized by competitive federalism.  By limiting the power of a national government and devolving power to individual states or provinces, federalism may result in varying degrees of economic freedom throughout a nation, as states embrace and implement different philosophies on taxes, spending and regulation.

Take the category of limited government, which the Index equates with low government spending and low taxes.  While the US national government taxes and spends more per capita than any individual state, there are significant differences between the states on these variables, differences with important implications for economic freedom as measured by the Heritage index.    In California, for instance, the top income tax rate is over 13 percent.  By contrast, some states (Washington, Nevada, South Dakota and Florida) have no income tax at all, and some states (New Hampshire and Tennessee), only levy income taxes on so-called "unearned" income, i.e., interest and dividends.  (For a visual representation of how top tax rates differ between the states, see here.)  Of course, the gap between top income tax rates can overstate the difference in tax burdens between various states, as some states might rely more heavily upon sales taxes than others, for instance.   Still, no one doubts that, as previously explained on this blog, states like California generally tax and spend more per capita than states with lower top income tax rates.

The category of regulatory efficiency, which includes labor freedom, provides another example.    As previously explained on this blog, Federal Labor Law once allowed companies and unions to agree to compel individuals to provide financial support for unions they do not wish to join as a condition of pursuing their chosen vocation.  Fortunately, the 1947 Taft-Hartley Act allows states to opt out of this law by declaring themselves "Right to Work" states.   Moreover, while federal law sets a minimum wage applicable to most employees in the United States, several states mandate even higher wages, further reducing the liberty of employers and employees to strike bargains in their mutual best interest.   As a result, the extent of "labor freedom" differs significantly from state to state.    Some states (e.g. Georgia, Louisiana and Tennessee) have no minimum wage at all and have declared themselves "Right to Work" states, thus maximizing labor freedom to the extent possible given federal law.  (See here for a summary of minimum wage laws in the 50 states and here for a list of Right to Work states.)    Other states, e.g., New York and California, have imposed minimum wages that are higher than the Federal minimum and also declined to recognize their citizens' right to decline to support a union.  Some states are "in between," having declared themselves "Right to Work" states while still imposing a minimum wage.  Virginia is one example of such a state.  The Commonwealth is a Right to Work state but also imposes a minimum wage on employers not subject to federal law (with numerous exceptions) equal to the federal minimum.  Ditto for South Dakota.

It therefore appears that the extent of economic freedom varies significantly among various American states. Indeed, some have attempted to document this variation, albeit with somewhat different metrics than those employed by the Heritage Foundation Index.  For instance, the Mercatus Foundation affiliated with George Mason University has published the results of a study of "Freedom in the 50 States."  The report assesses various aspects of freedom on a state-by-state basis, including "economic freedom," "regulatory policy," "tax burden," and "fiscal policy."  It is no surprise that states like California and New York do quite poorly in these measures.  New York (whose flag is pictured above), for instance, is tied for last in economic freedom, 48th in regulatory policy and tied for last in both tax burden and fiscal policy.  By contrast, states like South Dakota, Virginia, and Tennessee perform very well on all such metrics.

As a result, the Heritage Index  likely overstates the extent of economic freedom enjoyed by Americans who live in states such as California and New York, while understating the extent of such freedom in states like Virginia, South Dakota and Tennessee, to name a few.

Some may wonder why, if economic freedom is so valuable, states such as California and New York are able to maintain their freedom-reducing policies in the face of competition from states such as Virginia, South Dakota and Tennessee.  Put another way, why has competitive federalism not prevented America's slide from 6th to 12th in the Heritage survey?  The answer is simple.   Competitive federalism requires limits on the scope of national power and an appropriate division of responsibility between states and the national government.  Where, by contrast, the national government exceeds its authority, imposing uniform solutions to local problems, states face distorted incentives, thereby undermining to some extent the operation of competitive federalism and unduly restricting economic freedom.

Take the minimum wage as an example.  Absent a national minimum wage, states would internalize the benefits of deregulating wage rates, attracting businesses that create jobs and individuals who want them.  However, in the United States, the national government has imposed a minimum wage that governs purely local businesses, so long as they generate sales of $500,000 annually, produce goods or services for interstate commerce, or handle, sell or work on goods that have moved in interstate commerce.  (See here for a description of the reach of the national minimum wage.)  Thus, a state that eliminates its own minimum wage will impact only a fraction of actual or potential business within its boundaries.  By contrast, states that maintain minimum wages equal to or slightly higher than the national minimum wage will risk losing very few employers to other states.   In the same way, the National Labor Relations Act, which authorizes the formation of labor cartels known as unions in purely local commerce, presumably preempts state laws that would treat such collective bargaining as unlawful price fixing.  Here again, national law discourages would-be state efforts to remove restraints --- in this case private restraints --- from the labor market so as to attract capital and productive citizens from other states. 

Federal tax policy also distorts competitive federalism.  In particular, the federal tax code allows citizens to deduct state taxes from their federal taxable income, thereby offsetting, in part, the impact of increased state income taxes.  As my colleague Nate Oman has explained, this provision allows states to export a portion of their costs to other states.  Moreover, as previously explained on this blog, the ability to export such costs insulates high tax states from the rigors of interstate rivalry.  After all, citizens in states such as California receive all of the benefits of new state spending while only paying part of the cost.  As a result, these citizens are less likely to exit such states despite what appear to be oppressive tax policies.  By contrast, states that reduce their taxes internalize only a portion of the benefits of doing so, as their citizens must pay higher federal taxes as a result.  Thus, when it comes to fiscal policy, the national government has distorted the "rules of the game" in a way that advantages high tax states vis a vis those that exercise fiscal restraint, thereby biasing the results of interstate competition against economic freedom as measured by the Heritage Foundation Index.

To be sure, basic principles of political economy teach us that states lack the appropriate incentives to address economic activity that produces significant and direct harmful or beneficial impacts on more than one state.  We should not, for instance, rely upon individual states to pass upon mergers between interstate railroads or set the rates for interstate carriage of goods.  See Northern Securities Co. v. United States, 193 U.S. 197 (1904) (holding that merger to monopoly between interstate railroads violated the Sherman Act regardless of the transaction's legality under state law); Wabash, St. Louis and Pacific Railway Co. v. Illinois, 118 U.S. 557 (1886) (voiding one state's attempt to regulate interstate railroad rates).  However, as the examples discussed in the previous paragraph demonstrate, much national legislation greatly exceeds this justification, regulating private conduct that produces few if any interstate spillovers or subsidizing purely local spending.    (For instance, it's not clear how low market wages in, say, Virginia produce harmful "spillovers" into other states.)   Unfortunately, the Supreme Court has often upheld such legislation, giving undue deference to the political branches' determination that the regulated conduct has significant impact negative impact in more than one state.  Until the national government confines its legislation to those activities beyond the regulatory competence of individual states, competitive federalism will not realize its potential to promote the economic freedom of the nation's citizens.