By Lawrence J. McQuillan

Thomas Jefferson and Alexander Hamilton, though bitter political rivals, appreciated the importance of economic freedom, a founding principle of our country. Thomas Jefferson wrote: "A wise and frugal government shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned." In defense of economic freedom, Alexander Hamilton warned: "Power over a man's subsistence is power over his will." In our times, President Ronald Reagan advanced this message.

In his famous Berlin Wall speech, President Reagan observed: "Prosperity can come about only when the farmer and businessman enjoy economic freedom." In a separate address, he called for "fundamental reform that sees to it that our economic freedom is every bit as protected as our political freedom." Only recently, however, have members of the academy caught up with these champions of liberty by focusing empirical research on this important founding principle.

A search of EconLit, the definitive database of scholarly economics literature, finds 162 publications on economic freedom since 1995; two thirds of these were produced in the past five years. There has been an explosion of academic research on this theme but the bulk of it has examined economic freedom across countries due to data availability.

The Heritage Foundation in Washington, D.C., and the Wall Street Journal have co-published since 1995 an annual report titled Index of Economic Freedom. The Fraser Institute in Vancouver and the Cato Institute in Washington, D.C., have co-published another cross-country annual report since 1996 titled Economic Freedom of the World. Both indexes have received worldwide media attention and spawned many studies, but neither looks at economic freedom across the U.S. states.

The first excursion into U.S. economic freedom was made by John D. Byars, Robert E. McCormick, and T. Bruce Yandle, all of Clemson University, in Economic Freedom in America's 50 States: A 1999 Analysis, published by the State Policy Network. The present study, U.S. Economic Freedom Index: 2004 Report, is an effort to update, refine, and improve on this seminal work. It is hoped that by measuring economic freedom and studying its effects, people will gain a fuller appreciation of the important imprint it makes on the economic and political fabric of America and encourage new legislation in the states that advances economic liberty.

Chapter 1. What Is Economic Freedom?
Economic freedom is the right of individuals to pursue their interests through voluntary exchange of private property under a rule of law. This freedom forms the foundation of market economies. Subject to a minimal level of government to provide safety and a stable legal foundation, legislative or judicial acts that inhibit this right reduce economic freedom.

In a nutshell, economic freedom is the right of an individual to keep what he earns, produce what he wants, and compete in product and labor markets of his choosing, subject to the restriction that he cannot use force or fraud to further his interests. Clearly, this definition is in the tradition of our Founding Fathers' conception of a free and just society and in line with the writings of classical liberals going back to Adam Smith who argued that humans' natural propensity to "truck,barter, and exchange"' will maximize social welfare. This definition, along with the economics literature, guided our judgment as to which variables to include and how to score each variable's freedom effect.

Chapter 2. Methodology and Variables
The methodology consists of four parts: (1) we compiled a set of indicator variables for economic freedom and from that we created various data sets; (2) these data sets were converted into 48 unique indexes using different weighting techniques; (3) we compared each index to the others in terms of its ability to explain, other things equal, human migration; and (4) the index with the greatest statistical link to migration was chosen as the best and we used it to rank the U.S. states in terms of economic freedom.

Variables
We gathered data on 143 variables per state from 1995 to 2003 (data set 1, listed in appendix A). This snapshot included tax rates, state spending, occupational licensing, environmental regulations, income redistribution, right-to-work and prevailing-wage laws, tort reform, and the number of government agencies, to name a few. Next, we cut some redundant variables and averaged similar variables for compactness (appendix B explains this process). This data parsing resulted in five different data sets (data sets 1-5).

Construction of Competing Indexes
For each of the five data sets, we calculated sector scores for each state. For example, data set 1 had 143 variables. We put each variable into one of five sectors: fiscal (51 variables), regulatory (53), welfare spending (10), government size (7), and judicial (22). Each state's sector scores were calculated by ranking each variable within a sector from 1 (most free) to 50 (least free).

Then we averaged the variable rankings within each sector to arrive at a sector score for each state. For example, data set 1 had 51 fiscal-sector variables. A state's fiscal-sector score for data set 1 was calculated by ranking each fiscal variable from 1 to 50 and then calculating an average ranking from these 51-variable rankings. The same process was used to calculate scores for the other four sectors. This process was repeated for each of the five data sets.

After sector scores were calculated for each state over all five data sets, various sector-score weighting techniques were applied ranging from assigning arbitrary weights to using statistical procedures such as principal components analysis to determine weights. Finally, weighted sector scores were added together to arrive at overall index scores for each state. The various combinations of data sets and weighting techniques yielded 48 unique indexes.

The Selection Criterion
These 48 indexes competed with each other to explain net population migration rates across states using regression analysis. In the jargon of econometrics, the index we chose as best yielded the highest R-squared among those equations having an index coefficient t-value significant at the five-percent level or greater. This procedure selects the best, or final, index empirically, and it conforms to the proper statistical methodology for choosing among two or more equally plausible specifications.

We adopt a migration metric for economic freedom. If people are moving from one state to another, other things equal, we assert that this is a market-based response to differences in freedom. Ordinary people, voting with their feet, define freedom. In the end, our index offers the clear advantage that it is evaluated in the marketplace by where people decide to live.

The Best Index
The index having the greatest statistical link to migration was Index40, constructed by weighting data set 3 using first principal components weights. Data set 3 consisted of 47 variables, roughly the same number of variables as in the Heritage Foundation's international index: 13 fiscal, 15 regulatory, eight welfare spending, three government size, and eight judicial variables. Principal components weighting has been used for years in political science.

The technique weights each sector based on the degree of useful information (variation) in the sector, which enables finer distinctions among states to be clearly drawn. The sector-score weights used to compute the final economic freedom score for each state were: Index = (.3486 × Fiscal Score) + (.3422 × Regulatory Score) - (.1260 × Judicial Score) + (.0627 × Government-Size Score) + (.3730 × Welfare-Spending Score) The index score can range from 1 (most free) to 50 (least free), and state rankings were derived from the index scores.

Chapter 3. The Results
Table 1 presents the economic freedom scores and rankings for the U.S. states, 2004. Tenth in 1999, Kansas has assumed the lofty spot as the nation's most economically free state, followed closely by Colorado and Virginia. Idaho, at the top of the 1999 list, remains high at fourth. Rhode Island, Connecticut, California, and New York bring up the rear.

TABLE 1

Turning to the states that made the biggest progress from 1999 to 2004, we found that Arizona advanced 14 places, and Colorado, Maine, Oklahoma, and Oregon each jumped 12 places. In contrast, Mississippi fell 19 places, Alabama 14, and Illinois, Kentucky, Ohio, and South Dakota each sank 10 spots. Note that three of the biggest decliners were in the South. Kansas has assumed the lofty spot as the nationís most economically free state . . . Rhode Island, Connecticut, California, and New York bring up the rear.

FIGURE 1

Figure 1 plots economic freedom from coast to coast, and a distinct pattern emerges. The Great Plains and Rocky Mountain states, shaded the lightest, have the most economic freedom. New Hampshire persists in defying the pattern in the Northeast. Maybe there is something to their motto "Live Free or Die." Virginia stands as a citadel of economic freedom in the South. The darkest regions, reflecting the least amount of economic freedom, are the Northeast and Midwest, excluding Indiana, and California. Many of the nation's most densely populated states are also some of the least economically free. This is consistent with leading economic theories of the determinants of regulation.

Chapter 4. The Relation Between Economic Freedom and Income
An important test of any index is showing relevance and usefulness. An index is valid, in a statistical sense, if it helps to explain the past or predict the future. To this end, we present statistical evidence of the impact of economic freedom on annual income per capita across the U.S. states.

We expect economic freedom to be positively linked, on average, to state 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.

We constructed an economic model that explains the level of state annual income per capita in 2000 as a function of the following state-level variables: education level (a proxy for human capital as measured by the proportion of the population with a high-school education or more); average temperature (a proxy for the work/leisure tradeoff); population density (a proxy for the size of the market and level of transaction costs as measured by the number of residents per square mile); stock of wealth (endowments as measured by annual income per capita in 1990); average age of the population (a proxy for the earnings life-cycle); church membership rate (a proxy for the work ethic); and the institutional environment as measured by the state's economic freedom score.

The regression results (see table 6), robust across specifications, show that more economic freedom is associated with higher income per capita across the U.S. states. The results are virtually identical if economic freedom rankings are substituted for economic freedom scores. The statistical analysis shows that a 10-percent improvement in a state's economic freedom score yields, on average, about a half-percent increase in annual income per capita.

The difference is an estimate of the economic harm caused to individuals in each state from limiting economic freedom relative to the freest state, or, conversely, the value of more economic freedom. We then divided each difference by the actual income level to calculate a state "oppression tax," which measures the percentage decrease in income per capita due to the deterioration in the state's overall incentive system caused by its institutions – as measured by its economic freedom ranking.

Relative to the freest state, Rhode Island residents suffered the largest reduction in annual income per capita due to their loss of economic freedom, $3,607, followed by Hawaii at $2,963, and New York and New Jersey at around $2,400 each (see table 7). The national average was $1,161. This might not sound like much, but over a 40-year working life at a conservative 3 percent interest rate, this translates into $87,541 that would have otherwise gone into the pocket of an average working American.

Rhode Island also had the highest effective "oppression tax," 13.17 percent, followed by Hawaii at 11.36 percent, Maine at 7.61 percent, and New York at 7.45 percent. The national average was 4.42 percent of income. State institutions have a substantial impact on income levels across the U.S. states. Economic freedom matters significantly.

Chapter 5. State Profiles
Chapter 5 presents, in almanac style, a number of important features of each state's economy including personal income per capita, gross state product, and the unemployment rate. It also summarizes the index results for each state, showing the overall 2004 score and rank, and the 1999 rank. For the sector scores, we devised a star system that divided the states into groups of 10. The freest 10 states in each sector received five stars for that sector. The second-freest 10 states received four stars and so on until the least-free 10 states received one star for that sector. This star system provides a quick method of comparing states within each sector.

Conclusion
It has been said that liberty is a whole, and to deny economic liberty is finally to destroy all liberty. In the end, irrespective of our love for freedom, our work was empirical, not romantic. Our goal was to measure economic freedom across the U.S. states and also to measure some of its effects.

The overseers of the Consumer Price Index, one of the oldest indexes in economics, write: "An index is a tool that simplifies the measurement of movements in a numerical series." The U.S. Economic Freedom Index is a tool for measuring economic freedom. Measurement is the first step to understanding, and understanding is required for reasoned discussion and sound policy reform. It is hoped that the U.S. Economic Freedom Index will ultimately contribute to policy reforms that preserve and strengthen economic freedom for all Americans.