Innovative States Aren't Low-Tax States

Lists are fun. The 10 best places to live. Top cities for the creative class. Most affordable cities for retirees.

No one except maybe local boosters take rankings like these seriously. They’re Web-based photo streams ideal for grazing during a break at work.

Some rankings, however, are much more ambitious. Specifically, the creators of state rankings use economic and fiscal criteria in an attempt to shape public perceptions and public policy. A case in point are the lists produced to push a low-tax agenda, such as the Tax Foundation’s 2014 State Business Tax Climate Index. The top five tax-friendly states are Wyoming, South Dakota, Nevada, Alaska, and Florida. The bottom five? Rhode Island, Minnesota, California, New Jersey, and New York.

The conservative American Legislative Exchange Council offers a more comprehensive ranking system comprising 15 policy variables in its economic competitiveness ranking, Rich States, Poor States. Utah, North Dakota, South Dakota, Wyoming, and Virginia are head of the class, and Minnesota, California, Illinois, New York, and Vermont are at the bottom.

It’s intriguing to compare the fiscally conservative lists with those designed to highlight science, technology, human capital, and innovation. A very different story emerges. Take the Milken Institute’s State Technology and Science Index 2012 (pdf). Massachusetts, Maryland, California, Colorado, and Washington are its top five, while Wyoming, Nevada, West Virginia, Arkansas, and Mississippi rank lowest. The 2010 State New Economy Index, by the Kauffman Foundation, praises Massachusetts, Washington, Maryland, New Jersey, and Connecticut, while South Dakota, Wyoming, Alabama, Arkansas, West Virginia, and Mississippi are in last place.

The two kinds of state rankings don’t exactly overlap. Still, going through the various lists, it’s striking how low-tax states such as South Dakota and Wyoming hold a place of pride in fiscal rankings, while such states as California and Minnesota dominate innovation lists.

A spurious correlation? Probably not. In general, low-tax states have historically been dependent on natural resources or on mass production industries, relying on low costs rather than innovative capacity to gain a competitive advantage. “But innovative capacity (derived through universities, R&D investments, scientists and engineers and entrepreneurial drive) is increasingly what drives competitive success,” write the Kauffman study scholars.

A similar insight informs an economic analysis into how New York City developed one of the nation’s largest and most vibrant tech/information sectors, second only to finance as an engine of economic growth in the city. Among the public policies that contributed to growth in the tech/information industry are the “funding of multiple tech incubators and training programs for entrepreneurs and small businesses; the rapid extension of broadband access throughout the city, including free Wi-Fi in key public spaces; NYC’s broad-reaching Open Data initiative; and the Applied Sciences competition, which has put Cornell-Technion on track to open a 2 million-square-foot campus on Roosevelt Island plus the expansions at Columbia University and NYU-Poly in Brooklyn,” observes Michael Mandel of South Mountain Economics in a report (pdf) prepared for the Bloomberg Technology Summit last September. Going through the report, taxes aren’t even mentioned.

Of course, New York City is anything but a low-tax regime, yet the metropolitan area is thriving in the global economy. The same goes for Minnesota and California. The lesson isn’t that high taxes are good or lead to dynamic growth, but that investment in human capital, technology, science, and knowledge matter in an intensely competitive global economy. The Milken Institute scholars hit the right note. “Technology and science are important to states and by extension the nation because innovation drives economic growth and bolsters the ability to compete in the global economy,” the Milken Report says. “State governments must recognize this and adopt policies that maximize their ability to innovate.”

So must Washington, D.C. The federal government’s deficit and debt are well on their way to taking care of themselves. According to the Treasury Department, the federal deficit as a percent of gross domestic product was at 4.1 percent for 2013, down from more than 10 percent in 2009. The House and Senate budget negotiators should noisily declare victory. Then Congress should focus on bolstering the kinds of investment that nurture innovation, learning from the experience of such states as Massachusetts and cities such as New York. Back basic science and fundamental research. Invest in human capital and rapidly expand next-generation broadband. Tear down walls impeding immigration, especially for entrepreneurs and students. Overhaul the patent system to encourage greater competition and, therefore, innovation.

Don’t get me wrong. Comprehensive tax reform is a worthwhile goal. The individual and corporate income tax systems have evolved into a byzantine mess, and everybody would benefit from simplification. Still, when it comes to ginning up growth, an emphasis on fiscal reform is a mistake, reminiscent of proposals to increase savings to boost growth.

Yes, saving is important for households, but savings aren’t a driver of economic growth. “It has been usual to think of accumulated wealth of the world as having been painfully built up out of the voluntary abstinence of individuals from the immediate enjoyment of consumption which we call thrift,” noted economist John Maynard Keynes in 1931. “But it should be obvious that mere abstinence is not enough by itself. … It is enterprise which builds and improves the world’s possessions. … If enterprise is afoot, wealth accumulates whatever may be happening to thrift, and if enterprise is asleep, wealth decays whatever thrift may be doing.”

You can substitute fiscal reform for savings in the quote. Innovation-nurturing policies are what the doctor ordered for what ails the U.S. economy.

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