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“ALTERED STATES”: Economic Analysis Credits Investments in Education and Innovation for Higher State Per Capita Incomes

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“U.S. states share a common set of technologies, and labor and capital are free to locate wherever the return for their services is highest. Over time the movement of labor and capital should reduce differences in the average amount of capital per worker in a state….”

According to the U.S. Department of Commerce, Connecticut ($47,819), Massachusetts ($44,289), and New Jersey ($43,771) had the three highest state per capita incomes in 2005 whereas Louisiana ($24,820), Mississippi ($25,318), and Arkansas ($26,874) had the lowest. But why do residents in some states have higher incomes than individuals in other states? And why have these differences persisted for the past 75 years? In “Altered States: A Perspective on 75 Years of State Income Growth,” an essay included with its 2005 Annual Report, the Federal Reserve Bank of Cleveland addresses these questions and concludes that “knowledge building”—the combined result of education and innovation—is the principal difference maker.

In analyzing per capita incomes over the last 75 years, the report finds real-income growth (inflation-adjusted) for all states, with the most improvement coming from states with lowest incomes. As a result, the gaps between state per capita incomes have decreased dramatically since before World War II.

According to the report, this movement is consistent with “convergence,” an economic term meaning that, over time, the per capita income of states will become closer to average as people and money move to places where they are needed most. As the report reads, “U.S. states share a common set of technologies, and labor and capital are free to locate wherever the return for their services is highest. Over time the movement of labor and capital should reduce differences in the average amount of capital per worker in a state….”

However, most of the movement toward the average was during the 1940s, 1950s, and 1960s. The closest point of convergence—the point at which all states are equal—came in 1976. Since then, the gap between states has started to expand even though economic theory says it should have all but disappeared. For example, Connecticut was the highest-income state in both 1976 and 2004. In 1976, it was 23% above the median, but in 2004, it was 47% above the median.

Knowledge-Building Key to Income Growth

In an effort to explain why the gap between state per capita incomes is expanding rather than contracting, the Federal Reserve Bank of Cleveland studied statistics on high school and college graduation rates, grants of new patents, tax rates, spending on public infrastructure, types of industries, and even climate. Of these factors, it finds that only education, innovation, and industrial specialization have a significant connection, either positive or negative, to per capita incomes between states.

The report notes a tremendous rise in educational attainment among the American population—since 1930, the share of the U.S. population with college degrees has grown from approximately 4% to 27% today—but a noticeable difference across states. Massachusetts has the highest proportion of college-educated adults at 36.7% whereas states such as West Virginia and Alabama have fewer college-educated residents, it finds. Not surprisingly, Massachusetts is near the top of state per capita incomes while Alabama and West Virginia are near the bottom.

In discussing innovation, the report says that differences in research and development activity, which it measures by the number of patents granted, can “create a channel through which per capita incomes diverge.” In fact, when listing the states with the highest levels of patents per capita, Delaware is first, New Jersey is second, and Connecticut is third. (Connecticut has the highest state per capita income and New Jersey is third. Delaware is in the top 10).

The report also notes that industrial specialization can be a reliable indicator of state growth differences. For example, it finds that states with larger-than-usual mining incomes, such as Kentucky and West Virginia, or higher levels of manufacturing, such as Ohio and Indiana, tend to grow slower than states with other specialties. Conversely, it reports that states with larger-than-average service sectors are the ones estimated to have experienced more income growth.

Overall, however, the study emphasizes the role of knowledge building—through research and education—as the biggest tool to aid income growth and suggests that states pursue policies that increase the knowledge base of the region. As it concludes, “This may sound like the mantra of the Internet age, but the results presented here show that innovation has been pivotal to income growth at the state level since the 1930s.”

The complete study is available at http://www.clevelandfed.org/Annual05/PDF/Essay2005.pdf.

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