With the implosion of its storied investment banks and the future of Wall Street in doubt, New York will suffer the effects of the financial crisis more acutely than many states. But the crisis reaches epicenters outside of Manhattan as well. Chief among them is the world’s eighth-largest economy: California.
Several key economic indicators point to grim news for the Golden State in the aftermath of the Wall Street meltdown. The state’s unemployment rate has jumped to 7.7 percent, its highest rate in 12 years and the third-worst in the United States. In Riverside County, 40 percent of homes sold in the past year are in foreclosure. Unfortunately, California’s government doesn’t seem interested in solving the state’s economic problems.
California continues to be burdened with high taxes, punitive regulations, huge wealth-transfer programs, out-of-control spending, and lawsuit abuse. And there’s no end in sight to the state’s fiscal madness. The “balanced budget” signed only a few weeks ago by Governor Arnold Schwarzenegger already runs a deficit of as much as $5.5 billion. Last week, to cover state expenditures for the rest of the fiscal year, the state sold $5 billion in short-term notes. Schwarzenegger bought $100,000 worth himself.
Analysts already project that next fiscal year’s budget will be billions in the red. State spending has increased at a faster rate under Schwarzenegger than under his predecessor, Gray Davis. Every year, California puts taxpayers on the hook for yet more spending without any reform of the government’s boneheaded economic policies. It’s not surprising, then, that California ranks fourth-to-last in the Pacific Research Institute’s 2008 U.S. Economic Freedom Index, published in association with Forbes. The Index measures how friendly or unfriendly each state’s government policies are toward free enterprise and consumer choice. Its rankings derive from a comprehensive evaluation of fiscal, judicial, and regulatory indicators such as tax rates, state spending, occupational licensing, environmental rules, income redistribution, tort reform, and prevailing-wage laws.
When he arrived in Sacramento, Schwarzenegger promised to end government overreach. He pledged to “blow up” boxes in the state’s organizational chart, “tear up the credit card” for state legislators, and curtail taxes. Thus far, though, any “Schwarzenegger effect” on state governance has been difficult to discern. Since 2004—Schwarzenegger’s first full year in office—California’s economic-freedom ranking in the PRI index improved only two places, from an abysmal 49 to 47. And $5 billion of new debt will do nothing to bolster the Governator’s self-proclaimed reputation as a fiscal hawk.
By contrast, Nevada, California’s neighbor to the east, boasts a much more favorable economic environment. Nevada ranked sixth among the states in economic freedom, an improvement from 2004, when it placed twelfth. But the model of economic freedom among the states is slightly further east—South Dakota. The Mount Rushmore State imposes no corporate-income tax, no personal-income tax, no personal-property tax, no business-inventory tax, and no inheritance tax. States in the Great Plains and Rocky Mountains tend to be the most economically free. States in the Northeast tend to be the least free. (New York has ranked dead last since 1999.)
Americans vote with their feet, and strong economic freedom draws workers and businesses. According to United Van Lines, South Dakota ranked seventh in inbound migration in 2007. That’s one way of saying that lots of people are moving there. Nevada ranked second. By contrast, California tallied more outbound shipments than inbound. People are fleeing California partly because of economic aggravation. For every one-place improvement in a state’s Index ranking of economic freedom, its net migration per 1,000 people typically increases by one person. This means that for Michigan, the top-ranked outbound state, a one-spot improvement in economic freedom would result in a net increase of about 10,000 people moving into the state—resulting in much-needed new consumers, workers, entrepreneurs, and investors.
Economic freedom—or the lack thereof—affects states in multiple ways. Migration alters the political map through congressional apportionment. Current projections suggest that California’s mass exodus will deprive it of a seat in the U.S. House of Representatives after the 2010 census. Economic freedom also impacts pocketbooks. In 2005, per-capita income in the 15 most economically free states grew 31 percent faster than in the 15 states with the lowest levels of economic freedom. Policies friendly to economic freedom help states shore up their finances, too. The 15 freest states saw their general-fund tax revenues grow at a rate more than 6 percent higher than the 15 states with the least economic freedom. California lawmakers should keep these figures in mind as they grapple with the state’s yawning budget deficit.
In short, economic freedom is not an academic exercise or a zero-sum game. It benefits workers, businesses, and governments alike. When one state expands economic freedom, it puts pressure on its neighbors also to improve, or risk competing at a disadvantage for people and capital. With luck, Nevada’s example will spur California to embrace serious reforms. Otherwise, a stagnant economy brought on by the financial crisis will plague the Golden State far longer than necessary.
Lawrence J. McQuillan is director of business and economic studies at the Pacific Research Institute and coauthor of the 2008 U.S. Economic Freedom Index.