What makes some places grow and some places stagnate or decline? There are many politicians, economic development specialists, and regional planning experts who claim they hold the keys to economic growth, and yet there is great persistence in the strength of local economies over very long time periods. The five states with the lowest labor productivity in 1974 were Mississippi, South Carolina, Vermont, Arkansas, and Maine. By 2015, all of these states were still ranked among the bottom six states. As wages follow labor productivity, these states also ranked among the bottom ten in average earnings per job over the 41-year period. Surely if there were some magic elixir that spurred economic growth, at least one of these states would have broken out from the bottom of the pack. Perhaps the only ones benefiting from the development advice are the advisers.
So why is economic activity so persistent over time? We opted to investigate this question by looking at firm entry, firm exit, and relative employment between adjacent counties on either side of a state border. These counties should share the same labor market, the same access to credit, the same customer market, and the same locational and geo-climatic amenities. If, over time, more economic activity occurs on one side of the border than the other, it must be driven by greater anticipated profitability in one state rather than the other. We examine whether these systematic patterns of firm location are related to state tax or expenditure policies, or if they are driven by locational advantages that are not influenced by government policies.
Our choice of measures of the strength of the local economic environment are informed by the long-term pattern of growth by size of local economy. In this century, virtually all of the employment growth has occurred in the metropolitan and large urban markets. As shown in Figure 1, since 1999, employment grew 14% in metropolitan areas and 5% in large urban markets, and shrank or stagnated everywhere else, suggesting that the factors favoring economic growth are concentrated in more populated markets.
Since Marshall’s (1890) pioneering book, economists have known that firms are more productive when they are in close proximity to suppliers or customers, when they are clustered among similar firms that share a pool of skilled workers and technologies, when they have a ready supply of educated workers, and when their customers have disposable income. All of these agglomeration factors give firms a productive advantage from locating in cities. However, Artz et al. (2016) showed that these same factors matter for firm entry and survival in less-densely populated markets as well. Therefore, we focus on these factors as descriptive of the local economic environment. If agglomeration matters for employment, firm entry, and firm exit, then we would expect the border county with the better economic environment would dominate its neighbor.
Governments may try to make up for these disadvantages by adjusting their tax rates and subsidies to try to counteract these naturally occurring disadvantages attributable to weaker economic environments. We include controls for the highest state marginal tax rate on property, sales, income, capital gains, corporate income, and unemployment insurance. High marginal tax rates should reduce economic activity. On the other hand, tax revenue is used to produce public goods, which should improve the economic climate, and so we include per capita state government expenditures as a factor.
Agglomeration Effects at State Borders
In Table 1, we present regression coefficients that show how industry employment, firm entry, and firm exit are affected by these factors at state borders. All measures react strongly to our market agglomeration measures. One finding may seem surprising—many of the agglomeration factors that encourage firm entry also generate more firm exits, due to the strongest local markets attracting entrants who may need to displace incumbent firms. Even marginally profitable firms may opt to sell to new entrants willing to pay a price high enough to justify exit.
|Variables||Log(Employment)||Birth rate||Death rate|
|Firm Cluster|| 0.05***|
|Industrial Diversityb|| 7.52***|
|Population with high school degree or above|| 0.07***|
|ln(Per Capita Income)||0.05|
|Taxes and Expenditures|
|Combined Tax Effect|| -0.02*|
|Government expenditure per capita|| 0.26***|
Looking at the first two columns of Table 1, the county with the stronger agglomeration measure had more employment and more firm entry, although not every coefficient is statistically significant. Having a better local source of upstream suppliers attracts more entry and employment on that side of the border. The larger number of downstream customers attracts more entrants on that side of the border. A larger number of firms in the same industry cluster increases industry employment. More firm entry and employment occurs on the side of the border with the more educated local labor supply and the more diverse mix of industries. Firms entered more readily on the side of the border with the higher per capita incomes.
It is perhaps surprising that agglomeration in the own county matters so much compared to agglomeration one county removed. Because these effects are so strong, they drive the location of economic activity on one side of the border and the effects are too large to allow government policy to reverse the advantage. As we will see, taxes and government spending matter, but not enough to counteract the impact of the economic environment.
State Government Taxes and Expenditures
We present the accumulated effect of a unit increase in each of the six taxes. Taxes do not have a significant effect on firm entry, but they do have a small but significant effect on employment, which is greater on the side of the border with lower marginal tax rates. The bigger, but still modest, effect is accelerating firm exits on the side of the border with higher taxes. Having a one-unit higher marginal tax rate in each of the six taxes only increases the firm exit rate by 0.5%. A 10% higher level of per capita state government expenditures raises employment by 2.6% on that side of the border, but it hastens the firm death rate as well.
Which States Have the Worst Tax Structure?
While the effect of the relative tax rates is modest on average, there are some states with substantial effects on employment and firm death rates. The adverse effects of tax rates differ by the type of economic outcome. In Table 2, we list the states with the worst economic outcomes as measured by the summed effect of their 2015 marginal tax rates on their own employment and on their firm survival rates. Only three states, Maine, Rhode Island, and New Jersey, are on both lists. In Oregon, the combined effect of the six tax rates lowers employment by over 25%. Effects on firm death rates are more modest. The most damaging tax policy inducing firm deaths is in Iowa, where the six tax rates raise the firm exit rate by just over 1%.
|Lost Employment||More firm death|
|New Jersey||-18.0%||New Jersey||0.88%|
Borders with the Greatest Differences Due to Marginal Tax Rates
It is interesting that having a bad tax structure does not necessarily disadvantage firms at the border if their neighbors have even higher marginal tax rates. Hence, New York’s relatively high marginal tax rates do not cost it as much because its neighbors, Vermont and New Jersey, have even higher marginal tax rates.
In Table 3, we list the ten borders with the greatest differences in employment and in firm death rates attributable to differences in marginal tax rates. While the average effect of taxes may be modest, some of the differences at state borders are quite large. However, the effects differ depending on the measure of economic performance used, as the correlation between the two measures is only 0.06. Using induced employment differences as the gauge, the greatest cross-border employment difference due to marginal tax rates is the 32% employment advantage Nevada and Washington have over Oregon at their respective borders. Nevada, Washington, and Wyoming are on the favorable side of 8 of the 10 biggest border employment gaps. However only two of these borders, Wyoming-Idaho and Nevada-Idaho were also among the 10 largest gaps in terms of firm death rates. The largest percentage point advantage in firm survival attributable to tax policy is South Dakota’s 0.7 percentage point advantage over Iowa and Minnesota. Two of the 10 largest border differences in firm death rates, Colorado-Utah and Wisconsin-Iowa, actually have reversed advantages in employment levels.1 When examining differences in firm exit rates, Iowa is on the disadvantaged side of five borders, a consequence of an atypically high marginal tax on corporate income.
|A. Tax-induced percent difference in employment levels at state borders|
|Advantage||Disadvantage||Employment Advantage||Death Rate Advantage Rank|
|B. Tax-induced percentage point difference in firm death rates at state borders|
|Advantage||Disadvantage||Death Rate Advantage||Employment Advantage Rank|
|South Dakota||North Dakota||0.489||33|
The Implication for Firms in Rural Markets
In Figure 2, we show what has happened to firm birth and death rates in urban and rural markets. Both firm birth rates and firm death rates have fallen over time in both the most and least agglomerated markets. However, in metropolitan markets, the firm birth rates exceed the firm death rates, thus the net number of firms increased 11.9% since 1999. In rural markets, firm death rates are higher than firm birth rates, and so there has been a net 2.8% decrease in the number of firms. Lacking the advantages of agglomeration, rural markets cannot attract enough entry to replace their exiting establishments. And that is why metro and large urban markets are the only ones to have experienced average employment growth in Figure 1.
Artz, G.M., Y. Kim, and P.F. Orazem. 2016. “Does Agglomeration Matter Everywhere? New Firm Location Decisions in Rural and Urban Markets.” Journal of Regional Science 56(1): 72–95.
Bartik, T.J. 2017. “A New Panel Database on Business Incentives for Economic Development Offered by State and Local Governments in the United States.” Upjohn Working Paper.
Marshall, Alfred. 1890. Principles of Economics. London: Macmillan.
Artz, G., Y. Chen, L. Ma, and P. Orazem. 2019. "What Affects Firm Location and Firm Employment at State Borders?" Agricultural Policy Review, Spring 2019. Center for Agricultural and Rural Development, Iowa State University. Available at www.card.iastate.edu/ag_policy_review/article/?a=93.