Recent Research: Are State Business Climate Indices Meaningful?

State business climate indices are a common tool in economic development policymaking and marketing. These indices allow analysts to bundle sets of business-friendly policies, quantitative metrics and subjective rankings into a single index to compare one state's business environment to another's. A recent paper by Jed Kolko, David Neumark and Marisol Cuellar Mejia suggests that many of the factors that are sometimes included in business climate indices have little or no predictive power. While factors related to taxes and costs have some correlation with economic growth, productivity-related variables have no bearing on growth, according to the authors. The factors that are most significant tend to be outside of the control of state policies, such as industry mix and population density.

Kolko, Neumark and Mejia compile data from 11 business climate indices for all available years from 1992 to 2008 to test their correlation with economic growth. For the study, economic growth is defined by employment, total wages and gross state product. Each of the indices has a different focus and definition of what constitutes a state business climate. For example, the Tax Foundation's State Business Tax Climate Index is strongly focused on tax rates and business tax burdens. The Beacon Hill Institute's State Competitiveness Index has a more diverse range of factors, including infrastructure, knowledge jobs and quality of life.

Variation in the types of factors taken into account by different indices has led states to highlight studies that focus on their strengths. A state with generally low tax rates might use a more tax-oriented study, such as the Tax Foundation's, in their promotional materials. However, even within a single index or an index category, a state may have divergent scores. Because combining many different metrics makes it difficult to evaluate the effectiveness of policies, state business indices are often not the best way to choose policy options. Also, since states tend to select studies and scores that paint a complementary picture of their business environment, these indices can be a misleading source of information for entrepreneurs making decisions about where to move their company.

Despite these concerns, the authors do find merit in using business climate indices as a way to predict state economic growth, at least with indices that focus on taxation, costs of doing business and factors unrelated to public policy. After testing the 11 indices, the authors find that the indices that emphasize taxes and costs can effectively predict economic growth, particularly within the manufacturing sector. Factors unrelated to policy that have been included in these indices have an even greater predictive ability. These include industry mix, population density and weather. The authors find that factors related to productivity, including quality of life, infrastructure, human capital and business incubation, do not correlate with economic growth.

Download Public Policy, State Business Climates and Economic Growth ($5) at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1820080.