Growth in the Number of Firms and the Economic Freedom Index in a Dynamic Model of the U.S. States

Article excerpt


Freedom indices of the world have established themselves as fixtures in the social sciences literature, especially in the economic growth literature. (e.g., Atukeren, 2005; Berggren and Jordahl, 2005; Gwartney, Lawson and Clark, 2005; Powell, 2005; Gwartney, Holcombe and Lawson, 2004; Nieswiadomy and Strazichich, 2004; Cole, 2003; Gwartney and Lawson, 2003; Gwartney, Block and Lawson, 1996) Across the literature, the consistent finding is that economic freedom, as measured by the various indices, is significantly and positively related to economic well-being. Citizens of nations with more economic freedom enjoy higher incomes, and as an economy becomes freer, incomes rise. Of course, some may object that the term "economic freedom" is not value neutral. Though true, the advocacy component of the indices creators does not alter the indices' proven research usefulness in summarizing a broad variety of government activities. One could choose to think of the indices in terms of "market liberalism," or "government economic non-interventionism."

Karabegovic, Samida, Schlegel and McMahon (2003) introduced a conceptually similar index, the Economic Freedom of North America index (EFNA) featuring economic freedom differences among U.S. states and Canadian provinces. Karabegovic, et al, used their index to explain income differences among the states, offering evidence that the EFNA is significantly, positively related to state levels and growth of economic activity.

Various researchers have used the EFNA (e.g., Ashby, 2005; Kreft and Sobel, 2005; Wang, 2005) to address questions of income differentials between states, income growth, entrepreneurship, and other research questions. Similar to Kreft and Sobel (2005), Gohmann, Hobbs & McCrickard (2008), Sobel (2008), and others, we apply the EFNA to questions of entrepreneurship. Specifically, we ask whether the political outcomes summarized by the EFNA are significantly related to growth in the number of businesses. Karabegovic, et al, argue that the EFNA measures economic freedom in states; furthermore, they argued that greater economic freedom results in higher income levels for state residents because greater economic freedom consists of greater opportunity to seek and exploit economic opportunities; that is, to pursue entrepreneurial activity. Freedom to exploit economic opportunities is also the freedom to create new businesses, so economic freedom should lead to more business births. However, such freedom is a double-edged sword. The freedom to start a business is also the freedom for that business to fail. Indeed, it is business births that create the "raw material" for business failures. Therefore, the impact of economic freedom on growth in the number of businesses is ambiguous, although the impact on society--higher incomes--is not.

This paper contains two innovations not found elsewhere in this stream of the literature. The first is the dependent variable, the measure of businesses. We use the annual growth rate in the number of firms, approximated by the annual difference in the natural log of the number of firms. Therefore, this measure implicitly includes firm births and firm deaths, and captures the full range of firm launches, whether partnership, corporation, etc. The second innovation is the use of a particular dynamic panel data estimator (Arellano and Bond, 1991) not found in this literature outside of a working paper. (1)


Promoting entrepreneurship has emerged as a significant policy tool for regional economic growth and job creation. The relevant policy question becomes which policies best promote entrepreneurship. A literature has developed around the concept that the appropriate policies are those will increase economic freedom. "Economic freedom" may be conceptualized as:

"Policies are consistent with economic freedom when they provide an infrastructure for voluntary exchange, and protect individuals and their property from aggressors seeking to use violence, coercion, and fraud to seize things that do not belong to them. …