Darryl Cramer
January 25th, 2005
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  1. Before delivering this essay to Mr. McQuillan, asking him to comment, I sent him an email
    in an attempt to better understand the process he used to get states with low per capita
    income to positively correlate with high EFI scores. "What am I missing?," I inquired. Here
    is his reply: "What you are missing is a basic understanding of linear multiple regression
    analysis. I suggest that you take a course in it at your local university or discuss it with a
    professor at a university. Or, if you feel bold enough, read a textbook on it.
    Unfortunately, I don't have the time to teach you the basics but it is worth knowing if you
    plan to do economic research." Perhaps he has a point.
  2. Mr. McQuillan has yet to respond to the essay.
  3. In all fairness, and much to my chagrin, Mr. Frank has also not responded.
  4. On March 9th, 2005, The Wall Street Journal reported that the Republican-dominated
    Kansas legislature, in defiance of the Kansas Supreme Court which set an April 12th
    deadline for a plan to boost eduction funding, voted down an amendment which
    proposed a moderate increase in funding for poor students. They apparently intend on
    working hard to keep their #1 position on the EFI.

Kansas: Model of American Capitalism

In November, the Pacific Research Institute (PRI) released its latest edition of the U.S. Economic
Freedom Index (EFI). As the name implies, it is an attempt at the laudable goal of measuring,
state by state, the relative friendliness toward free enterprise and consumer choice – “economic
freedom” – by applying statistical rigueur to such things as tax rates, government spending,
litigation, regulations and welfare. The report culminates by attempting to demonstrate a
relationship between economic freedom, as defined by the PRI, and financial prosperity, as
measured by per capita income.

The results are startling. When thinking of economic freedom, perhaps the first place that
comes to mind is Wall Street, the financial capital of the world and the nexus of Capitalism,
where every day millions of investors channel billions of dollars to the businesses that, through
efficiency and resourcefulness, produce the greatest returns on capital. Or, if focusing more on
the Left Coast, perhaps Silicon Valley, with its intrepid entrepreneurs, battling at the vanguard
of science and technology, striving to go from rags to riches, and venture capitalists, striving to
go from riches to more riches, is more exemplary as the model of economic freedom. As the
PRI’s EFI indicates, however, both could not be farther off the mark: New York and California
finished, respectively, out of all 50 states, last and next to last.

If that is not enough, consider who is
numero uno: Kansas. Yes, Kansas, with its… not sure
what. Nothing against Kansas, but perhaps the only person who was not surprised by that
result was the Governor of Kansas herself, Kathleen Sebelius, as she indicates in the Forward
to the report. Lawrence McQuillian, a co-author, offers some explanation by pointing out that
Kansas won the top spot “largely due to its respect for property rights: It engages in less
income redistribution and attracts less tort litigation than most states.” Okay.

Then, however, the PRI attempts the Herculean task of making Kansas look like the most
financially prosperous state in the country while simultaneously moving California and New York
to the bottom. By means of linear multiple regression analysis, PRI creates an economic model
that determines, not surprisingly, that economic freedom, as they have defined it, is in fact
positively associated with per capita income. The ultimate outcome, they conclude, is that, if all
states were as economically free as Kansas, the annual income of the average American worker
would increase by $1161, or 4.42%.

Of course, all of this smacks of right-wing financial gymnastics designed to misinform the
general public: it did not escape anyone’s attention that 8 of the top 10 economically free
states are “red” and that 9 of the bottom 10 states are “blue,” with the one exception at the
bottom being the decisive swing state of Ohio. In the interest of intellectual curiosity and, in
this case, entertainment, let us take a look at the results. Besides, after reading conservatives’
gloat in The Wall Street Journal, something had to be done!

The graph below compares the 2004 EFI with 2003 per capita income figures provided by the
Bureau of Economic Analysis (2004 data is not yet available). The result seems to indicate a
significantly negative correlation between the two parameters, as highlighted by the black least-
squares trend line: the less economically free the state, the higher the per capita income. While
this un-American conclusion seems to fly in the face of the PRI’s findings, it does not, however,
account for differences in cost of living: as the argument goes, higher taxes and stricter
regulations will drive up the cost of living and, in order to compensate, require employers to
pay more for their employees.

To account for this, the income levels in the following graph have been adjusted for differences
in cost of living, as provided by the
Missouri Economic Research and Information Center. The
least-squares line has now tipped in the other direction, implying that, in effect, maybe there is
a correlation between economic freedom and per capita income, as suggested by the PRI.

Unfortunately, this analysis is hardly fair either. Hawaii, all the way to the left, is the first
indication as to the reason. Why would anyone want to live in a place where the per capita
income, adjusted for cost of living, is so much lower than the rest of the U.S.? The obvious
answer is, of course, because it is a beautiful, tropical island paradise. Which leads us to an
important element that has not been reflected in the prior analysis: non-pecuniary benefit.

While taxes and regulation certainly play a role, one of the reasons that some states have such
a high cost of living is because, everything else being equal, they are beautiful, wonderful places
to live and thus more people want to live there. Demand drives up prices. Hawaii did not do
horribly on the EFI, coming in 35th place, but has the highest cost of living in the country by
far: 68% above the average and 17% greater than the number 2 state, California. Are
California and New York also being "penalized" the same way? California is a large state,
however, people like to pack themselves in along some of the most picturesque coastline in the
country, driving up, among other things, real estate prices. Silicon Valley and Wall Street, as
mentioned previously, as well as Hollywood, all attract people from around the world as they
offer unparalleled opportunities to generate fame and fortune. (Richard Karlgaard, publisher of
Forbes magazine, derides this as a “myth” in the Forward.) This, too, will push up the cost of
living. Conversely, while there certainly must be some examples, one does not often hear of
people crowding into Kansas seeking their fortunes.

It is not clear how one would adjust cost of living measurements for non-pecuniary benefits,
and perhaps costs, such as over-crowding, pollution and crime, as well. Domestic tourism
revenue as a percentage of gross state product could be used as a proxy, but those results
are skewed by places like Orlando and Las Vegas and it is not clear to what extent the per
capita incomes should be modified. Then again, even if nothing is done, the data is hardly
compelling: visually the dots are not tight against the least-squares line, which is moreover
born out in a very low R-squared value of 0.023.

The authors of the study say, “intuitively, we expect economic freedom to be positively linked,
on average, to annual income per capita. Economic freedom expands the opportunities for
individuals to use their knowledge and resources to their best advantage and to keep the fruits
of their labor for personal consumption and future productive investment.” Anyone who
believes in Capitalism and Freedom would have a difficult time disagreeing with that statement.
So where is the problem? Perhaps it is time to call the EFI itself into question.

If one worked at an unabashedly conservative think tank that received funding from right-wing
organizations and individuals and that liked to liberally quote Regan, Thatcher and Friedman,
and one was then asked to put together an index of economic freedom, how hard would one
work to engineer the results so that the red states came out on top? Let it be said that there
is no evidence that the PRI did anything to manipulate the results. Nevertheless, while
attempting to steer clear of impugning the intellectual integrity of the organization and its
researchers, it should be noted that they do, at some point in their analysis, use average
temperature as a proxy for the tradeoff between work and leisure time and, even better,
church membership as a proxy for work ethic. It is unclear how much all of this helps the Bible
belt, but hardworking secularists in New England and the Great Lakes states might take offense.

Otherwise, to what extent are states that spend more on education, and subsequently have
higher taxes, punished by this study? While not always the case, conservatives generally paint
taxes with a pretty broad brush: taxes are bad. (The report colorfully defines the percentage
decrease in per capita income due to low EFI ratings as the “oppression tax.”) Yet it can be
argued, though perhaps not here, that increased education results in a better trained
workforce that is more equipped to compete in today’s high-technology, service-oriented
economy and that will ultimately enjoy a higher living standard in spite of the elevated taxes.

In all fairness, the PRI model does take education, as a proxy for human capital, into account,
but they only look at the proportion of the population with at least a high-school education.
This is surprising given that Sally Pipes, President and CEO of the PRI, is quoted declaring “the
American K-12 education system… has become a vast collective farm of ignorance, run by
reactionaries, and a play-ground for the Nanny State.” Nice. That being said, she is not too
fond of universities either, which she accuses of “inflicting propaganda on their captive audience
of students [while] failing to do their job,” which is to produce “highly qualified software
engineers and technology experts.” She does not go on to explain how she expects
universities to accomplish this task when they must to contend with the product of the
ignorance farms.

Be that as it may, to be competitive internationally, this nation needs a college-educated
workforce. Hence, college degrees, as opposed to high school diplomas, would certainly be a
better proxy for human capital. While we will never know, it is interesting to imagine how the
results might have changed if the PRI had looked at the proportion of the population with a
bachelor’s degree. New York and California, and the blue states in general, would have faired
much better.

As a closing thought, one might also wonder if putting Kansas at the top is more than
coincidentally related to Thomas Frank’s bestseller, and perhaps the most insightful social and
political commentary of 2004,
“What’s the Matter With Kansas?” In it, Mr. Frank, a native of
Kansas, describes a state where the capitalism might be unfettered, but the working people are
far from prosperous. A populist and a keen observer, here is how he describes a two-hour visit
to the small, once industrious town of Emporia: “houses made of painted particleboard; a
facade on Commercial Street composed of untreated two-by-fours, nailed one next to the
other; imposing brick homes with every window frame empty and grass three feet high in the
yard; tumbledown apartment buildings with sprayed-on stucco and peeling veneer; bungalows
with porches in midcollapse and flimsy plastic wrap instead of glass; prefabricated steel utility
buildings interspersed with residences; stone-slab sidewalks grown so craggy and broken they
can’t be used; a rain gutter jutting from a house like a bone from a broken arm; a window air
conditioner abandoned in the middle of a weedy lawn.” This is only a solitary anecdote, but Mr.
Frank paints a picture much different than that proposed by the PRI and it is this sort of
representation that it would undoubtedly like to repudiate.

In the final analysis, a legitimate study that statistically demonstrates the positive relationship
between economic freedom and prosperity, for everyone involved, would be more than
welcome. California and New York are potentially over-regulated, and maybe Kansas has some
lessons that can be shared with the rest of the country, but putting partisan politics in front of
an important endeavor such as this is a disservice to the goal of educating and informing
everyone, on the Left and the Right, about the virtues of a free economy. Those who disagree
should perhaps make for Kansas to seek their fortunes, if they have not already.

Darryl Cramer