Growing State Economies: A Policy Framework - National Governors ...

The recent naonal recession has pushedjob creaon to the top of everygovernor’s policy agenda. What can bedone to create more high-wage jobs in our stateeconomies? The short answer is this: focus onbusinesses that are growing the fastest.Taxes and regulaons at the federal, state andlocal governments have a significant impact onbusiness creaon and development. The inialdecision by a business about where to locate andthe rate at which they grow is affected byeconomic, tax and regulatory policies.Many owners of startups and small businessesreported during meengs held as part of theNaonal Governors Associaon Chair’s IniaveGrowing State Economies that fulfilling inial filingand perming requirements can be a daunng andsomemes insurmountable task. Even aer a newbusiness becomes a going concern, the burden ofregulaon affects growth and employment.Reducing and streamlining the regulatory process isespecially helpful for startups and small businesses.Similarly, the structure of each state’s tax systemand overall tax burdens affect the creaon andgrowth of business. High state taxes can reduce astate’s economic growth. Improving the quality of astate’s educaonal system can have a posiveimpact on economic growth.Each state must decide on its tax, spending andregulatory policies. Within that framework,however, this report highlights six issues andacvies that can be refined to improve thecondions for job creaon. The six drivers ofgrowth are:• Entrepreneurs, the individuals who seed,grow and renew businesses;• Educaon and skills, the concentraon ofhighly educated, highly skilled individualswithin economies;• Innovaon and technology, the new ideasand technologies that enter the economyand change what is produced, how it isproduced and the way producon itself isorganized;• Private capital, the sufficiency andavailability of debt and equity financingat all stages of company formaon;• Global markets and linkages, the businessescompeng successfully in global markets;and• Industry clusters, the firms embedded inregional clusters supported by instuonsproviding educaon, training, finance andmarkeng services, which experiencehigher rates of job and wage growth thancomparable firms not embedded in suchclusters.The challenge for state policymakers is tostrategically combine the factors that supportand sustain the businesses that have propelledgrowth into a policy agenda.The central theme of this report is that, together,these six factors demonstrate the road for UnitedStates businesses to compete in the 21st centuryand frame the terms within which states can helpbusinesses move down that road. Althoughbusinesses must make the decisions and takeacons to grow and compete, the condions thatmake it possible can be directly influencedby the acons of policymakers at all levels ofgovernment. State policies can assert a posiveinfluence in each of the six areas and be mosteffecve when they take advantage of thecomplementaries among them. For example,entrepreneurship brings innovaon to markets,which increases producvity and leads to bothgrowth and high-wage jobs.Growing State Economies: A Policy Framework \ 3 \

INTRODUCTION“The Iron Law of the ModernEconomy”: Leadership inProductivity GrowthProducvity drives both prosperity and economic growth. Producvity growth (outputper worker) is the basis for rising real wages for workers, increasing returns toshareholders, and increasing per capita income for a state and the naon.Businesses and workers without high levels of producvity and who do not connuallywork to improve themselves find it increasingly difficult to thrive and compete. Themodels that economists use to examine economic growth describe the relaonshipbetween outputs of goods and services; inputs of people’s me and effort; andfactories and offices in which they work, including all equipment necessary to do theirjobs. More can be produced when more workers or capital—factories, equipment, andthe like—are added to the mix.Innovaon also is important to producvity growth. The value of goods and servicesincreases not only as more workers are employed and as investors create more capital,but also because of new technologies and innovaon in products, processes, andmanagement. Increasingly, it is innovaon-driven producvity growth that is the basisfor rising real wages for workers, increasing returns to shareholders, and increasing percapita income for a state and the naon.

The key to state economic growth, then, is tohave as many innovave, producve, and globallycompeve businesses and workers as possiblereside within a state’s borders. As Michael Portersaid in a speech before the Naonal Governors Associa-on: “Producvity determines wages. Producvity setsjobs. Producvity determines the standard of living. Thisis the iron law of the modern global economy. The morewe’re open to the rest of the world, the more businessescan invest anywhere; it’s producvity that determineswhether your parcular state is going to succeed.”(Porter, 2011).A Policy FrameworkIf producvity is the key, parcularly that generated by innovaon,what role does public policy play in fostering it?This report highlights the following six factors and considershow state policies can influence progress in each area:• Entrepreneurs, the individuals who seed, grow,and renew businesses;• Educaon and skills, the concentraon of highlyeducated, highly skilled individuals withineconomies;• Innovaon and technology, the new ideas andtechnologies that enter the economy and changewhat is produced, how it is produced, and theway producon itself is organized;• Private capital, the sufficiency and availability ofdebt and equity financing at all stages of companyformaon;• Global markets and linkages, the businessescompeng successfully in global markets; and• Industry clusters, the firms embedded in regionalclusters supported by instuons providingeducaon, training, finance, and markengservices, which experience higher rates of joband wage growth than comparable firms not embeddedin such clusters.The central theme of this report is that, together, the sixfactors demonstrate the roadmap for U.S. businesses tocompete in the 21st century (see text box).It also frames the terms within which states can helpbusinesses move down that road. Although businessesmust make the decisions and take acons to grow andcompete, the condions that make it possible can be directlyinfluenced by the acons of policymakers at all levelsof government. State policies can assert a posiveinfluence in each of the six areas and be most effecvewhen they take advantage of the complementariesamong them. For example, entrepreneurship brings innovaonto markets, which increases producvity and leadsto both growth and high-wage jobs.The report describes each of these six factors in detail:• It defines the components of each factor;• It describes the theorecal reasons why the factormaers; and• It marshals evidence showing how the factor influencesstate economic success.The report also provides ideas on how state policies caninfluence progress in each area and emphasizes that,used together, these six factors can serve as an effecveframework—or policy map—for growing stateeconomies.WHAT IS COMPETITIVENESS?“Competitiveness”is a phrase with manyvarying meanings. Having the correctdefinition and strategy is increasinglyimportant, Michael Porter and Jan Rivkinargue in the March 2012 Harvard BusinessReview. They provide this guidance forpolicymakers and corporate managers:The United States is a competitive location tothe extent that companies operating in theU.S. are able to compete successfully in theglobal economy while supporting high andrising living standards for the averageAmerican. A competitive location producesprosperity for both companies and citizens.Whether a nation is competitive hinges[instead] on its long-run productivity—that is,the value of goods and services produced perunit of human, capital, and natural resources.Only by improving their ability to transforminputs into valuable products and servicescan companies in a country prosper whilesupporting rising wages for citizens.Increasing productivity over the long runshould be the central goal of economic policy.This requires a business environment thatsupports continual innovation in products,processes, and management.Growing State Economies: A Policy Framework \ 5 \

PRODUCTIVITY IS THE KEY TOGROWING STATE ECONOMIESWhat is the Evidence?Producvity is a key driver of long-term economicgrowth. One study esmates that risingproducvity accounted for about 80 percent ofrecent gross domesc product (GDP) growth(Malhotra & Manyika, 2011). Becomingsteadily more producve enables Americanworkers to compete effecvely with those inother countries. And higher producvity levelsenable these workers to keep their jobs, evenin the face of lower wage compeon (becausehigher producvity helps offset the compevedisadvantage of higher wages).Producvity is highly correlated with incomesat the state level. States with higher levels ofaverage producvity, as measured by output percapita, generally have higher levels of per capitaincome (Figure 1 ). Harvard economist, ElhananHelpman notes in his book, The Mystery ofEconomic Growth (2010), that differences inproducvity explains significant cross-countryvariaons in per capita income. He cites thatWho Says?MIT economist Robert Solow won theNobel Prize in Economics in 1987 for hiswork on the role of productivity andeconomic growth. He developed a seriesof measures to track the contributions ofworkers, capital investment, andtechnology to improving productivity.Solow’s work shows that our long-termgains in income and living standards can betraced directly to improving productivity.differences in producvity accounts for 90 percentof the variaon in cross-country differencesin the growth rate of income per worker.American workers are now more than twiceas producve, on average, as they were fourdecades ago. In 1967, the average Americanworker produced about $29 in output per hourworked (valued in 2010 dollars). By 2010, aver-FIGURE 1. Productivity Strongly Correlated with Per Capita Income60,000 ________________________________________________________________________________________________________________________________55,000 ________________________________________________________________________________________________________________________________CTPer Capita Income50,000MA________________________________________________________________________________________________________________________________NJMDWYNY45,000 ________________________________________________________________________________________________________________________________NHVAWAAKCO ILCA40,000 ________________________________________________________________________________________________________________________________VT NDPA MNKS NEHIRISD FLTXDELAMEWI IAMOOROHNVOK MI35,000 ________________________________________________________________________________________________________________________________NCMTTN GASCIN AZAL NMIDAR WV KYUT30,000 ________________________________________________________________________________________________________________________________MS40,000 50,000 60,000 70,000 80,000 90,000 100,000 110,000 120,000GDP Per Worker/ 6 / Growing State Economies: A Policy Framework

FIGURE 2. Breaking Down Productivity Changes(change in output per hour)3 ______________________________________________________2.5 ______________________________________________________2 ______________________________________________________1.5 ______________________________________________________1 ______________________________________________________0.5 ______________________________________________________0 ______________________________________________________1973-1995 1995-2000 2000-2007Source: Gordon, 2010■ Labor Quality ■ Capital Investments ■ Technical Changeage output in the United States had doubled to$61 per hour worked (The Conference Board,2011). Those improvements in producvity enabledhigher worker incomes and increasedhousehold purchasing power.The basis for producvity growth is increasinglyinnovaon. As figure 2 shows, economicgrowth in the United States was held back byweak producvity growth in the 1970s and1980s. With the advent of informaon andcommunicaon technology in the 1990s,United States labor producvity grew muchmore rapidly (Gordon, 2010).What Have We LearnedRecently?There are sll ample opportunies to improveproducvity simply by beer aligning lowerperforming firms and industries with bestpracces. There is obviously wide variaon inproducvity across different industries andamong firms within those industries. Overme, producvity grows for a variety of reasons—moreproducve firms grow faster, raisingaverage producvity; inefficient firms goout of business; and businesses learn or imitatethe “best pracces” in their industries. Es-mates by McKinsey and Company show that asignificant poron of needed U.S. economicgrowth can be propelled by more widely applyingestablished best pracces across the economy(Malhotra & Manyika, 2011).It is parcularly important to focus on improvementsin the producvity of the servicesector of the economy. Although much of thefocus is on producvity in manufacturing, it iseven more important to focus on producvityimprovements in service industries—servicesare about three to four mes larger than manufacturingas a share of the U.S. economy. TheMckinsey Global Instute (2011) points outthat public and regulated sectors such ashealth care and educaon can benefit fromproducvity improvements.Growing State Economies: A Policy Framework \ 7 \

The Role of EntrepreneursMost new jobs occur when entrepreneurs start companies. Some open businesses toemploy themselves. Some start small businesses that fill a niche and never growbeyond it. Others launch firms with the intent of significantly growing theircompanies—and succeed at it. All of those models are important. But it is important todisnguish among types of entrepreneurs, because some have more impact thanothers. Entrepreneurs who build high-growth ventures are a parcularly importantsource of job growth.High-growth entrepreneurs usually pursue the commercializaon of a radicallyinnovave idea—a new process, product, or service—that can wind up transformingenre global markets. Fred Smith devised the idea of overnight package delivery andbuilt the global giant Federal Express, which revoluonized logiscs. Steve Jobs andBill Gates founded Apple and Microso, two companies that have defined the idea ofpersonal compung and have touched almost everyone’s lives. In addion to thosewell-known examples, there are entrepreneurs in almost every state who have creatednew businesses, which play important roles naonally and internaonally.

What is the Evidence?Firms younger than five years create most of the newjobs each year. Even though small firms are oen describedas the engines of job growth, the more accurateview is that new, small firms—frequently referred to asstartups—are a parcularly important source of jobgrowth. (Congressional Budget Office, 2012). Evidence ofthe greater job-creaon rates associated with new, smallfirms includes a Kauffman Foundaon study, which foundthat job creaon by very small firms (those with fewerthan 20 employees) and newly formed firms (establishedwithin the past five years) account for a majority of overalljob creaon in any given year (Stangler, 2010).As important as startups are, some of the greatest returnsto the economy come from those businesses thatsurvive the dynamics of startup and advance to subsequentstages of growth. New ventures have relavelyvolale growth paths, leading them to both create andeliminate jobs at higher rates than larger firms. By oneanalysis, nearly 40 percent of new startup firms shutdown within the first three years (Spletzer, 2000). Anotherstudy, based on recent data released by the U.S.Census Bureau’s Business Dynamics Stascs (BDS), reiteratesthat firms aged one to five years generate approximately43 percent of new jobs; it also finds that many ofthese young firms experience employment loss due toclosure (nearly 20 percent job destrucon) in their firstyear (Halwanger, Jarmin, & Miranda, 2010).FIGURE 3. Failure Rate by Business AgeSurviving the first 5 years is a key indicator ofbusiness longevityFailed New Establishments, by Age (1990-2008), indicates thatSurvivabilty Improves Markedly Aer 5 Years% of New establishments60.0% ______________________________________________________50.0% ______________________________________________________Survived at least 5 years40.0% ______________________________________________________30.0% ______________________________________________________20.0% ______________________________________________________10.0% ______________________________________________________0.0% ______________________________________________________1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Establishment AgeSource: Don Walls, 2011As figures 3 and 4 show, surviving the first 5 years is a keyindicator of business longevity and underscores thatsome of the greatest job creaon can come from expansionsof exisng (surviving) firms. Firms surviving the 5-year mark may not grow beyond their inial startup employmentsize, however (Reedy & Litan, 2011).A relavely small group of high-growth firms are par-cularly important. A study of high-impact firms by theU.S. Small Business Administraon shows that relavelyfew high-growth firms account for a disproporonateshare of job creaon in almost every state (Acs, Parsons,& Tracy, 2008). The study defines high-growth firms asthose that expand employment by 15 percent or moreannually for five consecuve years. High-growth firmscan be any age; it is not necessarily the case that thosefirms are always newly formed. Naonally, such firmsmake up approximately 5 percent to 6 percent of all ofthe businesses, but virtually all of net new job creaon.There are high-impact firms in every state.FIGURE 4. The Accumulation of High-GrowthYear 0:500,000 firm births243,500 (48.7%) will survive to age 5Revenue & EmploymentGrowthAccumulaon ofHigh-Growth FirmsNumber of FirmsYear 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9Source: Stangler, 2010Year 1:500,000 firm births234,500 (48.7%) will survive to age 5Growing State Economies: A Policy Framework \ 9 \

Who Says?More than 70 years ago, Harvard economistJoseph A. Schumpeter famously coined theterm“creative destruction,”a somewhat selfcontradictoryshorthand for how capitalistsystems constantly replace existing ways ofdoing business with new ones and for emphasizingthe critical role that entrepreneurs playin economic progress (Schumpeter, 1934).In his view, economic advances don’t happenby the smooth transition of existing firms orindustries into new ones, but by the creationof entirely new businesses and businessmodels that move the economy to a newlevel of productivity and living standard.Immigrants play a key role in fueling technology firms.America’s tradional openness to immigrants has contributedsubstanally to entrepreneurial acvity. Onestudy found that a quarter of the new computer and informaontechnology firms formed between 1995 and2005 had one or more immigrants among their founders.By 2006, these firms included more than 450,000 employeesand reported more than $50 billion in revenue(Wadhwa, Jasso, Rissing, Gereffi, & Freeman, 2007).Business relocaons typically play a minor role in contribungto state job growth. In fact, relavely few businessesever move outside the area in which they areestablished. Over a three-year period, approximatelythree-tenths of 1 percent of U.S. businesses made an interstatemove; many of these were to locaons in adjacentstates within a single metropolitan area (Brandow,1999). In Silicon Valley—a region of famously high costsand the frequent target of industrial recruiters promonglower cost alternave locaons—relavely few businessesmove away. Over a 10-year period, fewer than 3percent of all of Silicon Valley’s high-tech establishmentsrelocated outside of the region, and of these, less than athird le the state of California (Zhang, 2003).What Have We LearnedRecently?The U.S. entrepreneurial engine is showing serioussigns of weakness. Considerably fewer new businessesare formed today than in the past, creang fewer newjobs. A 2012 U.S. Department of Commerce study showsthat the business formaon rate has been trending downsince 1980 and fell at a parcularly sharp rate during themost recent recession (Figure 5). Another analysis by theKauffman Foundaon shows that job creaon in startupshas fallen from an average of 3.5 percent of total U.S.jobs annually in the 1980s to 2.6 percent of total U.S.jobs in the 2000s (Reedy & Litan, 2011).FIGURE 5. U.S. Private Business Startup Rate, 1980–2009______________________________________________________________14______________________________________________________________13______________________________________________________________12______________________________________________________________11______________________________________________________________10______________________________________________________________ 9The aenon in thepopular media is oenfocused on layoffs atexisng firms. Yet a remarkableslowdown inthe number of newbusinesses beingstarted, and the consequentdecrease in newjobs being created, hasbeen an important factorin the sluggish recoverythe UnitedStates has experiencedin the past few years.______________________________________________________________ 8______________________________________________________________ 71980 1984 1988 1992 1996 2000 2004 2008Source: U.S. Census Bureau, Center for Economic Studies, Business Dynamics/ 10 / Growing State Economies: A Policy Framework

DESIGNING POLICIES TO FACILITATEENTREPRENEURIAL ACTIVITIESPolicy Questions andDirectionThe following quesons and points provide some basicguidelines for a policy agenda:• Does your state devote most of its aenon andresources to growing its own entrepreneurs? Or,are most of the aenon and resources devotedto recruing firms from elsewhere?• Define entrepreneurship clearly, and disnguishits various forms in contrast to relatedsubjects like innovaon or the economic role ofsmall businesses. Efforts are likely to have amuch greater impact by focusing on high-impactmodels and by linking efforts to your state’s exisngand emerging industry cluster strengths(Monitor Group, 2009).• Make sure state policies and efforts make use ofthe insights gained directly from entrepreneursand those who work with them. Some of themost frequently recommended policy measuressignificantly contradict what entrepreneurs saythey need and what they fail to get as it relates tothe crical factors that maer most at differentstages of growth. Working with high-growth entrepreneursis different than working with startups.For example, during the startup phase,entrepreneurs strive to develop products and findinial customers. Second-stagers struggle withnew issues, such as strategic planning, market diversificaon,and operaonal efficiencies.• Are your iniaves coordinated to take advantageof complementaries between policies?For example, since entrepreneurial acvity is correlatedwith commercializaon of research anddevelopment, providing the right policy measures—taxincenves, credits for commercializa-on, and smooth pathways for entrepreneurs toconnect with university researchers and venturecapitalists—are likely to have a much greater impactif pursued in a coordinated plan.• Is it easy or difficult to file the necessary paperworkand obtain licenses and permits to startand operate a business in your state? Makingsure that regulatory and administrave requirementsthat each new firm must comply with aretransparent, simple, and meet straighorwardtests for good customer service is basic publicpolicy that supports entrepreneurship.Economic change is a ubiquitous,ongoing, incremental process that is aconsequence of the choicesindividual actors and entrepreneurs oforganizations are making every day(North, 1993).Growing State Economies: A Policy Framework \ 11 \

The Role of Educationand SkillsEducaon and skills are increasingly important to economic success. For individuals,the correlaon between an individual’s educaon, lifeme earnings, and probabilityof avoiding unemployment has grown stronger over me. What is true for individualsalso holds for states. States that have higher average levels of educaon tend to havegreater levels of economic success. Educaon and skills are central to nearly every issueof economic growth today: rising levels of producvity, innovaon, entrepreneurshipand prosperity.Specialized educaon and skills are especially vital. It is individuals with specific training,abilies and characteriscs—for example, sciensts, engineers, entrepreneurs, andmanagers—who provide the principal mechanisms through which economies evolveand thrive. A crical mass of high-powered minds and specialized knowledge is ingreat demand, not just in the United States but around the world, as corporaonslook for new sites for a parcular cung-edge industry and young sciensts andengineers want to be where other highly-skilled people are. Like aracts like,and that magnesm has greatly accelerated in recent years.

What is the Evidence?Educaon and skills are important to improving produc-vity. A greater level of educaon results in higher laborproducvity (Goldin & Katz, 2008). For example, one studyfinds that higher educaonal aainment has led to improvementsin the quality of the labor force that haveadded between one-quarter of 1 percent to one-third of 1percent to overall producvity growth rates annually overthe past two decades (Gordon, 2010).States with beer educated populaons have significantlyhigher per capita incomes. Figure 6 shows the correlaonbetween the fracon of the adult populaon with a fouryeardegree or higher level of educaon and the percapita income in each of the 50 states in 2010.Moreover, places with higher levels of educaon havefaster rates of income growth. Beer educated metropolitanareas showed substanally higher incomes andfaster income growth than the least well-educatedmetropolitan areas (Figure 7: Golieb & Fogarty, 2003).Educaon seems to bring higher returns to places, notWho Says?Gary Becker,the Nobel Prize–winning economistfrom the University of Chicago,coined theterm“human capital”to describe the importanceof education and skills to economic performance(Becker, 1964). Since he published a bookunder that title in 1964, economists havefocused on the connection between educationalattainment and economic success.FIGURE 7. Better Educated MetropolitanAreas Have Faster Rates of Income Growth2.0% ______________________________________________________1.8% ______________________________________________________1.6% ______________________________________________________1.4% ______________________________________________________1.2% ______________________________________________________1.0% ______________________________________________________0.8% ______________________________________________________0.6% ______________________________________________________0.4% ______________________________________________________0.2% ______________________________________________________0.0% ______________________________________________________Ten Best EducatedSource: Golieb & Fogarty, 2003Ten Least Educatedjust to the parcular individuals who possess those skills.Economist Enrico More, for example, found that a1 percent point increase in the college-educated popula-on of a metropolitan area raises everybody else’saverage wages by 0.6 to 1.2 percent (More, 2004).Entrepreneurs tend to be highly educated. Highlyeducated persons are disproporonately likely to startsuccessful high-growth firms and to develop new ideasthat are economically valuable (See Figure 8).Science and technology firms are even more likely to bestarted by well-educated founders. As figure 9 shows,ninety-two percent of U.S.-born technology and engineeringfirm founders had at least a bachelor’s degree and 48percent had a master’s or higher degree (Wadhwa, Freeman,& Rissing, 2008).FIGURE 6. Per Capita Income Strongly Correlated with Education LevelsAnnual Per Capita Income, 2010CT$50,000 ____________________________________________________________________________________________________________________________________NJMANYMDWY$45,000 ____________________________________________________________________________________________________________________________________AKVAWANHRI IL CACOPAMN$40,000 ____________________________________________________________________________________________________________________________________NDHIDEVTKSLAFL TX NEIANVSD WI$35,000 ____________________________________________________________________________________________________________________________________IN TN OK OH MO MEORMI NC GA MTAZALAR KYSCNMWVIDUTMS$30,000 ____________________________________________________________________________________________________________________________________$25,000 ____________________________________________________________________________________________________________________________________10% 15% 20% 25% 30% 35%Percent of Populaon with a 4-Year College Degree, 2000Sources: BEA (income), Census (educaon)Growing State Economies: A Policy Framework \ 13 \

FIGURE 8. Entreprenuership by Age and EducationUnited StatesBY AGE100% ________________________________________________________________90%65 or over________________________________________________________________80% ________________________________________________________________55 to 6470% ________________________________________________________________60% ________________________________________________________________50%45 to 54________________________________________________________________40% ________________________________________________________________30% ________________________________________________________________20%35 to 44________________________________________________________________10%25 to 34________________________________________________________________0 ________________________________________________________________Under 202002 2007Source: Survey of Business Owners, U.S. Census Bureau; Analysis Collaborave EconomiesBY EDUCATIONAL ATTAINMENT________________________________________________________________100%Graduate or________________________________________________________________90%Professional Degree________________________________________________________________80%________________________________________________________________70%Bachelor’s Degree________________________________________________________________60%Associate’s Degree________________________________________________________________50%Some College________________________________________________________________40%________________________________________________________________30%Technical School________________________________________________________________20%High School Graduate________________________________________________________________10%Less than High School________________________________________________________________ 0%2002 2007FIGURE 9. Terminal Degree Completed byU.S.-Born Tech FoundersMaster’s30%Associate’s DegreeCerficaon, Same College2%PhD10%MD4% JD4%Bachelor’s44%High SchoolDiploma6%areas with residents possessing an above-average educa-on had lower unemployment rates, not only for thosewith a college educaon, but also for those with lowerlevels of educaon (Glaeser, 2010).Job losses connue to grow for the less educated, evenin the recovery. Over the past year, the number of jobsfor those with a high school diploma or less educaonhas been declining, and all of the net increase in jobs hasbeen for people with at least some college educaon(Figure 10). The greatest job growth has been for thosewith a college degree (Rampell, 2012).FIGURE 10. Change in Number of EmployedWorkers Age 25+, from Dec. 2010 toDec. 2011, by Education (seasonally adjusted)1200 ____________________________________________________________1068Source: Wadhwa, Feeman, and Rissing, 2008What Have We LearnedRecently?Returns from educaon have connued to increase. Thedata suggest that the trends building for more than half acentury are connuing to play out. The most recent datashow higher than ever returns on investment for a collegeeducaon: a person holding a four-year college degreenow earns 84 percent more than a person with justa high school diploma (Carnevale, Rose, & Cheah, 2011).Places with more educated populaons have fared betterin the face of the recent naonal recession. In 2010,Thousands of Workers1000 ____________________________________________________________800 ______________________________________________________________600 ______________________________________________________________400 ______________________________________________________________384200 ______________________________________________________________1260 ______________________________________________________________-200______________________________________________________________-400______________________________________________________________-600______________________________________________________________-551-800 ____________________________________________________________Source: Rampall, 2012Less than a HighSchool DiplomaHigh SchoolGraduates, NoCollegeSome College orAssociateDegreeBachelor’sDegree andHigher/ 14 / Growing State Economies: A Policy Framework

DESIGNING POLICIES TO BOOSTEDUCATION AND SKILLSPolicy Questions andDirectionsThe data provide important insights into policy acons inseveral areas:What are you doing to increase college aainment inthe state?• What state policies are in place to encouragestudents to complete a degree or cerficate,parcularly students from groups historically atgreater risk of not compleng degrees? Reviewthe state’s financial aid program and instu-onal funding mechanisms to determine if thereare incenves for compleon.• Are public postsecondary instuons producingenough degrees in high-growth fields to meetthe state’s current and future demand? Establishgoals for increasing college aainment inthe state (if they do not already exist) and linkthe goals to current/projected workforce needs.What are you doing to provide the educaon andtraining to prepare the next generaon of entrepreneursand would-be business owners?• How can state educaon efforts encourage studentsto think about invenng their first jobs,not applying for them? Educaon is not simplyabout training workers for exisng businesses. Itis about geng students ready to start companiesand become chief execuve officers of theirown businesses.• Is the state’s educaon system fully engagedwith your industry clusters? Every state has itsown disncve industry sectors (see the discussionof clusters, later). A key opportunity forstrengthening your economy is making sure thatthere are good connecons among leading industryclusters, parcularly in defining educaonalneeds, assuring that curricula are mely and relevant,and providing workers with training and retrainingto manage the very real challenges oftechnological change and global compeon.• A state’s immigrant populaon is likely to makea disproporonately large contribuon to entrepreneurialacvity. Do relevant programsrecognize this opportunity?The enormously tight connectionbetween skills and unemploymentshould remind us of the importanceof investing in human capital. Skillsdrive the success of individuals, cities,and nations.America’s future rests onthe human capital of its population(Glaeser, 2009).Growing State Economies: A Policy Framework \ 15 \

The Role of Innovationand TechnologyInnovaon has always been a key driver of economic success. Its importance has evengrown in recent years, as those who create and apply new knowledge capture moreand more of the value generated in the economy. As the economy has globalized andentrepreneurs from anywhere are eager to figure out how to replicate techniques andtechnologies at lower costs and even at faster speeds, the real challenge is increasinglythat of connuous innovaon. Today, it is important that everyone at every level of acompany is enlisted as a potenal innovator, that economic and social ecosystemssupport creavity and adaptability, that there is rapid knowledge transfer, and thatmore places experience the founding and growth of new firms.Although the focus is oen on major scienfic breakthroughs and technology fields—which are crical types of innovaon—innovaon actually takes many forms, frombeer ways to sew a shirt, to improved customer service, to the use of informaontechnology to improve inventory management. Businesses across all sectors that donot change, that stand sll, find that they face increasing compeon. As MichaelPorter told the naon’s governors in 2011, “If a company in your state is doing thesame thing that it did 10 years ago—using the same producon processes, producingthe same products—it’s going to be very hard to succeed” (Porter, 2011).

What is the Evidence?Innovaon is by far the most important factor in economicgrowth. As menoned earlier, MIT economistRobert Solow won his Nobel Prize for showing that in theUnited States technological innovaon was the most important“factor of producon.” Subsequent studies of theU.S. economy during the 1990s concluded that technologicalchange and innovaon (especially in the areas ofinformaon technology, supply-chain management, androbocs) accounted for the largest share of U.S. produc-vity gains over the period (Mckinsey & Company, 2001).Innovaon is strongly correlated with business successand local economic vitality. Cross-country, country-level,and company-level studies show that innovaon, as measuredby research and development or patenng, has aposive associaon with economic producvity and enhancesmarket share and profitability at the companyWho Says?The insight that companies innovate forgrowth has led economists to retool theirtheories of what drives long-term economicexpansion. For decades, economic theoristsfollowed the work of Nobel Laureate RobertSolow, who developed the means forattributing increases in the growth ofeconomic activity to a combination ofimprovements in physical capital and humancapital (Solow, 1957). But those calculationsshowed that a significant amount of growthcame not from either of these sources, butfrom a residual, which economists attributedto steady improvements in technology.In the 1980s, several economists, led by PaulRomer, formulated the New Growth Theory,which attributed growth to the economy’sability to create and deploy new ideas(Romer, 1986).The critical implication of thistheory is that national economic success isdetermined by how successful a nation’seconomic system is in creating incentives andrewards for creating new ideas.The criticalrole of institutions—the kinds oforganizations and rules that we create toguide economic activity, and especiallyknowledge creation—was also a central partof the work that earned Douglass North theeconomics Nobel award (North, 1990).level (Atun, Harvey, & Wild, 2006). Differences in innova-ve acvity, along with educaon aainment, also accountfor much of the income differenals between ciesand states.The benefits of innovaon tend to be regional. Innova-on tends to be clustered in parcular places, andknowledge spills over from research instuons to andamong firms. Put another way, innovaon acvity is seldomconfined to a single company or research instuon.And because knowledge spillovers are fundamentally aphenomenon of human interacon, they are also stronglylocal in character. This is especially true in recently createdknowledge, where the knowledge is embodied in the intellectualcapital of the discovering scienst, for example,and only can be transferred to other pares through ac-ve working relaonships with the scienst. Companiestend to locate R&D centers near research universies becauseof the talent and knowledge pools that are locallyavailable (Naonal Academy of Sciences, 2010).What Have We LearnedRecently?Increased innovaon, as evidenced by patents issued, isposively correlated with higher state per capita income.Research connues to confirm that differences inthe stock of knowledge among states play a key role inshaping economic performance (see Figures 11 and 12).A study prepared for the Federal Reserve Bank of Clevelandfound that a state’s stock of patents had a measureableimpact on per capita income, aer controlling forthe effects of differences in tax burdens, public infrastructure,size of private financial markets, rates of businessfailure, industry structure, and climate (Bauer, Schweitzer,& Shane, 2011).FIGURE 11. Change in Estimated Effects ofPatents on Income, 1989–2004(seasonally adjusted)Percent5 ______________________________________________________________4 ______________________________________________________________3 ______________________________________________________________2 ______________________________________________________________1 ______________________________________________________________0 ______________________________________________________________-1 ______________________________________________________________-2 ______________________________________________________________ID SC NC AZ VT GA NM UT TX LA MS NH KY WV PA OHSource: Bauer, Schweitzer, & Shane, 2011Growing State Economies: A Policy Framework \ 17 \

FIGURE 12. A State’s Stock of Knowledge is the Main Factor Explaining its Relative Level ofPersonal Income (Cumulave Effects of Explanatory Variables)3 ______________________________________________________________________________________________________________________________________________________2 ______________________________________________________________________________________________________________________________________________________Relave Income1 ______________________________________________________________________________________________________________________________________________________0 ______________________________________________________________________________________________________________________________________________________-1 ____________________________________________________________________________________________________________________________________________________-2 ______________________________________________________________________________________________________________________________________________________-3 ______________________________________________________________________________________________________________________________________________________MS WV AR NM UT ID SC KY LA AL MT OK AZ ND NC GA TN ME IN MO OR SD TX IA KS OH FL VT MI WI NE PA NV RI WY IL WA CA DE VA CO MN NH NY MD NJ MA CT■■■ Patents ■■■ Educaon ■■■ Industry Structure ■■■ OtherSource: Bauer, Schweitzer, & Shane, 2011The ability to innovate in fast-growing fields and to beable to deploy research locally has the greatest economicimpact. The states that had the greatest returnfrom innovaon were not necessarily those with thelargest stock of patents, but those that grew their patentacvity the most, especially in fast-growing technologieslike semiconductors and informaon technology(Mukherji & Silberman, 2011).As the world becomes more andmore closely integrated, the featurethat will increasingly differentiate onegeographic area (city or country)from another will be the quality ofpublic institutions.The mostsuccessful areas will be the ones withthe most competent and effectivemechanisms for supporting collectiveinterests, especially in theproduction of new ideas(Romer, 1992)./ 18 / Growing State Economies: A Policy Framework

DESIGNING POLICIES TO BOOSTINNOVATIONPolicy Questions andDirectionsThe importance of innovaon for growth calls on statesto strengthen the innovaon capabilies and processeswithin their boundaries. Consideraons for designingpolicies to meet that challenge include the following:• Does your state have a policy and a strategythat guides your state research investmentsand university acvies? Research at instu-ons of higher educaon is one of the most obviousways that public policies influenceinnovaon. The federal government is the keypublic sector funder of research and development(R&D), but states are increasingly creangtheir own R&D funds and using them to:– Make investments to gain talent, build topnotchresearch enterprises, and compete forfederal dollars in those focused areas wherethe state can be world class;– Encourage, even mandate, collaboraonamong universies, the private sector, andother instuons;– Push the applicaon of technology and commercializaonof research; and– Hold the recipients (e.g., universies, companies)of public investments accountable fordelivering on promised benefits (Waits, 2007).• Are university missions aligned with the localeconomies’ compeve strengths and industryneeds? The growth of high-technology complexesin places like Boston, the San FranciscoBay area, and Raleigh-Durham is oen aributedto the localized knowledge spillovers associatedwith university research. Put anotherway, the growth of high-technology innovaonhubs is oen aributed to the smooth pathwaysthat allow intellectual and human capital associatedwith university research to flow to enterprisesin local economies. And although theterm “technology transfer” is oen taken tomean that ideas flow from researchers to industry,it is oen the reverse: private-sector firmscan alert researchers to praccal problems andmarket opportunies, enabling them to focus onresearch with real commercial potenal.• Does your state have effecve public–privatecollaboraons? Enhancing the links and collaboraonamong universies, research instuons,entrepreneurs, venture capitalists, supply chains,and other actors can enrich the innovaon ecosystemthat oen benefits all pares, and generatesreal economic benefits, as indicated by the experienceof organizaons like UCSD-Connect, a SanDiego-based organizaon that promotes university-industrynetworking in biotechnology.• Are universies encouraged to work with smalland medium-size businesses? Similarly, are taxcredits and tax incenves for investment in researchand/or for commercializaon of researchavailable specifically to entrepreneurs andyoung firms? Entrepreneurs and small firms canplay a key role in introducing new technologies,new products, and new industries.• Do you have private-sector firms with the capabilityto take advantage of your research? Research,although oen intrinsically valuable,doesn’t automacally translate into local economicadvantage. Unless there is a strong localecosystem of businesses (and especially entrepreneurs)that can capitalize on an idea, and agood network connecng research establishmentsto private firms, research ideas may notget developed locally.• Does your state’s intellectual property managementpolicies encourage the greatest use ofstate-funded research? Since the passage of theBayh-Dole Act in 1979, universies have beenable to obtain patents for ideas developedbased on federally funded research. That has ledmany more academic instuons to patent theirwork and to establish technology transfer officesto try to license these patents and recoup somefinancial return from the research. Despite a fewnotable financial successes—New York Universityhas earned several hundred million dollarsin royales for its role in the development of thepharmaceucal Remicade, for example—big returnsare generally rare. One concern is that bylooking to sell their intellectual property, universiesmay limit potenally fruiul interaconsbetween their researchers and private firms.Growing State Economies: A Policy Framework \ 19 \

The Role of Financial Capitaland InvestmentThe importance of financial capital for long-term economic growth in a free marketeconomy is obvious. Businesses and consumers depend on the availability of capital topurchase long-lived assets that improve producvity (new plant and equipment),allow for job retenon and growth, and provide a stream of benefits (like a collegeeducaon or a new house). Absent effecve capital markets, businesses and consumerscannot undertake the kind of long-term investment strategies that facilitate growth.There is strong evidence that the development of financial instuons and intermediaries(banks, stock markets, leers of credit, etc.) played a crical role in enabling modernindustrial economies (Levine, 1997). And it is sll the case that a key factor liminggrowth in underdeveloped countries is the absence of effecve financial instuons.When capital markets suddenly seize up in developed naons like the United States—as they did in the fall of 2008—growth quickly comes to a grinding halt.For most kinds of consumer and business investment in the United States, capital iswidely and, in most cases, equally available across the naon. Accordingly, capital playsonly a limited role in explaining variaons in long-term state growth rates. Two keyexcepons to the limited effect of variaons in capital availability would seem to be,one, risk capital for new and high-growth businesses, and, two, lack of adequate accessto debt and equity for businesses in rural and economically distressed areas.

What is the Evidence?A key characterisc of capital markets in the early 21stcentury is their fluid and interlinked character. With theintegraon and globalizaon of finance in the past threedecades, businesses face similar terms (interest rates andmaturies) and underwring standards in every state, indicangthat variaons in state long-term growth ratesare not likely explained by variaons in the health of thestate financial system. One recent empirical invesgaonof the relaonship between bank deposits per capita—aproxy for private capital and the size of a state’s financialmarkets—has a stascally insignificant relaonship withstate economic growth. This finding is consistent with thepublished literature on the subject (Bauer, Schweitzer, &Shane, 2011).The picture changes when considering venture capitaland seed capital—sources of financing for young, riskyventures. Although convenonal business lending forproperty and equipment is widely available on similarterms naonally, venture capital—equity investments instartups or new firms with few assets—is very concentratedin just a few regions of the country (Figure 13).Seventy-five percent of venture capital investments in2010 were made in five states. New York, the San FranciscoBay area, and the Boston area have accounted for amajority of naonal venture capital investment over thepast several decades (Lerner, 2010). This kind of equityinvestment is actually very me-consuming. Venture capitaliststend to invest in firms that are located nearby or inwell-developed clusters.Venture capitalists provide much more than financingbusiness growth at the crical early stages. VentureFIGURE 13. 2009 Venture Capital Fundingby Geography (# of Deals)10.9%40.5%33.7%6.4%8.4%■ New York ■ Southern California ■ Silicon Valley ■ Massachuses ■ Rest of U.S.Source: www.cbinsights.comcapitalists assist business plan development, becomeboard members, lend management skills, suggest strategicpartnerships and alliances, assist in expansion plans,and can bring in key talent where needed.Although venture capital is crical for the growth ofnew businesses, it is early stage and seed capital thatulmately determine whether they are formed in thefirst place and whether they survive the “Valley ofDeath.” (See figure 14 for the capital connuum andValley of Death.) The Monitor Entrepreneurship BenchmarkingSurvey suggests that venture capital is failing toFIGURE 14. Firms Can Get Stranded in “Death Valley” without Seed and Angel CapitalSources ofCapitalDeal StageFirmFunconsCumulave Cash FlowGrantsSpecializedprograms,friends/familyVentureformaonPre-seedSpecializedinvestmentfunds and/orangelsEarly seedstageventurecapitalFunds with sideagreements tosource locally“Naonal” funds basedlocally and their2nd roundventurecapitalsyndicate partnerselsewhereMezzannineVenture capitalpre-IPOor salePosive cash flowBreakEvenSource: BaelleGrowing State Economies: A Policy Framework \ 21 \

cover a crucial financing gap at the earliest stages of thestartup cycle. On average, 52 percent of respondentsworldwide said there is a sufficient supply of equity capitalfor growing firms, but only 37 percent said there issufficient supply for starng them. In the United States,45 percent of respondents say there is a sufficient supplyof venture capital to grow high-risk firms, but only 32 percentthink there is sufficient supply of seed capital to startthem (Monitor Group, 2009).More oen than not, entrepreneurs invest considerablepersonal resources (both cash and sweat equity) beforethey seek addional funds. It’s not uncommon for entrepreneursto take out a second mortgage on their homesand “max out” their credit cards in the early stages oflaunching a company. Moreover, angel investors (wealthyentrepreneurs, family members, or friends invesng$25,000 to $50,000 at a me), along with governmentprograms, such as funding from Small Business Innova-on Research (SBIR) and the Small Business Administra-on, provide the early stage funding before venturecapital steps in (Sohl, 2012).What Have We LearnedRecently?Following a considerable contracon in investment dollarsin 2008 and 2009, U.S. angel investments are on anupward trend. Angel investors shelled out $22.5 billionin investment dollars during 2011, up just over 12 percentfrom the previous year’s total, according to the2011 Angel Market Analysis. Forty two percent of 2011angel investments were in the seed and startup stage(Sohl, 2012).Venture capital funds are increasingly concentrated intop-er funds. In the United States, fewer funds areraising more capital. U.S. venture funds during 2011 had5 percent more capital than those in 2010, hing $16.2billion. However, the number of funds plummeted 12percent, to 135 funds, and, for the first me in threeyears, the median fund size rose to $140 million(Ernst & Young, 2011).Small business credit markets have improved, and thedemand for small business loans started to increase in2010. Banks ghtened the loan credit standards duringthe recession, but since 2009, business credit marketshave improved. Most senior loan officers report thatthey are no longer ghtening their lending standard forsmall business, according to the Federal Reserve Board.However, the Federal Reserve Board also notes thatlending standards “remain quite stringent following theprolonged and widespread ghtening that took placeover the past few years” (Dilger and Gonzales, 2011). Accordingto the Federal Reserve and the Naonal Federa-on of Independent Business (NFIB), anecdotal evidenceshows that supply is not meeng demand for small businesscredit from the borrower’s perspecve (Booze AllenHamilton, November 2011).Who Says?The concentration of venture capital firmsmay be a rational allocation of scarceresources. Many venture capital investmentsare in industries where geographicallylocalized knowledge spillovers are likely tobe important (Lerner, 2010)./ 22 / Growing State Economies: A Policy Framework

DESIGNING POLICIES TO IMPROVEACCESS TO CAPITALPolicy Questions andDirectionsFrom a public policy standpoint, every state has a strongstake in a well-funconing system of finance. But most ofthe key policy decisions influencing finance are made na-onally (and in households) rather than in state capitals.The special challenge of finding venture capital and angelinvestments for startup and high-growth firms has ledstates to experiment with capital formaon soluons. Indesigning policies to improve access to capital, answersto the following three quesons are crical:• What does the connuum of capital look like inyour state? It is not always clear which kind offinancing is most necessary at a given me or ina parcular environment. It is also somemeshard to determine how accessible the financingis to local entrepreneurs and businesses. Isthere a sufficient supply of debt and equitycapital for growing firms, a sufficient supply ofseed capital to start companies, and a sufficientsupply of proof-of-concept funds for researchersand inventors? State finance is not needed inmarkets that are well-served by exisngbusinesses or investors.• Is your state taking advantage of federalfinancing programs, such as the State SmallBusiness Credit Iniave (SSBCI) and severalU.S. Small Business Administraon (SBA)programs? Most states and territories that wereeligible have applied for their share of the U.S.Treasury Department’s $1.5 billion SSBCIallocaon, which provides direct support tostates to increase small businesses’ access tocredit. The SSBCI provides an opportunity forstates to develop programs in response tounique gaps in local markets. According to theU.S. Government Accountability Office (GAO),many states are using the funds for venturecapital programs, both to fill perceived gaps andas a means of retaining exisng businesses asthey expand (GAO, GAO–12–173, December2011). The Small Business Innovaon Research(SBIR) and Small Business Technology Transfer(STTR) programs provide funding for early stagetechnology ventures that are sll too high-risk toaract funding from private investors. Bothprograms are coordinated by the SBA and offerapplicants a three-phase development cycle.• One of the most important policyconsideraons is deciding on the structure andgovernance of public investment capital funds.For example, SSBCI funds can be used for astate-run venture capital fund (which mayinclude other private investors) that investsdirectly in businesses. It can also be a fund-offunds,which is a fund that invests in otherventure capital funds that in turn invest inindividual businesses. Research and stateexperience revealed that the followingcondions are important for success:– Set clear objecves and devise performancemeasurements that relate to those objecves;– Emphasize return on investment (fund managersinvest only in companies with goodprospects for a posive rate of return onequity capital);– Use skilled and experienced management tohelp realize return on investment;– Let the market provide direcon and discipline(require that a substanal amount offunds be raised from nonpublic sources or usematching funds to determine where publicinvestments go);– Pay aenon to deal flow (put significant resourcesinto generang deals from the localacademic and business scienfic and researchbase); and– Realize that programs need creavity andflexibility (Lerner, 2010).Growing State Economies: A Policy Framework \ 23 \

The Role of Global MarketsThe dominant fact of economic life is the globalizaon of a wide range of acvies.Although the transion to global compeon is oen difficult, it is a challenge thatevery state faces, and must deal with directly, to prosper and create jobs.Globalizaon is in part about exporng goods, but is increasingly becoming more complexand pervasive. Goods like agricultural commodies, pharmaceucals, electronics, andindustrial machinery are items we commonly think of as exports. More and more though,growth is coming from the sales of a diverse range of services, including tourism (servicesprovided to foreign visitors to the United States), movies, music, soware, and financialservices. The process of exporng is becoming deeply enmeshed in a range of majorcorporaons. Many leading U.S. firms—like Nike, Coca-Cola, and General Motors—nowget a majority of their sales outside the United States. These mulnaonal firms produceand sell their products on a global basis, and U.S. jobs are oen part of a complex chain ofvalue-adding acvies, from innovaon and design to manufacturing, distribuon, andservice. Exporng, in all these complex forms, typifies modern industrial economies.Exporng is a hallmark of what economists call “traded sectors” or “traded clusters” ofthe economy. Broadly speaking, the economy can be divided into two parts—tradedand local. The traded sector consists of firms that sell their goods and services into thebroader naonal and global marketplace. The local sector consists of firms that selltheir goods and services primarily or exclusively to local residents. Most manufacturersfind themselves in the traded sector—cars, planes, oil, and electronics are all sold in aglobal marketplace. Most retail acvity and many services are essenally local, in thatthey exist to serve the needs and market provided by local customers.Traded sector businesses, the ones that export and face compeon from imports fromother countries, are crically important to state economies. The fact that they faceforeign compeon head-on sharpens their skills to perform at the forefront of theglobal economy. They are also the businesses that provide most high-wage jobs.

What is the Evidence?Global markets provide job opportunies. Many Americanfirms sell a large fracon of their products to customersoutside the United States, and these sales directlycontribute to domesc employment. According to one recentstudy, exporng supported 11.8 million jobs in theUnited States in 2008 (Istrate, Rothwell, & Katz, 2010).Selling to global markets is associated with higherworker wages. Each addional increase in exports of $1billion was associated with a 1 percent to 2 percent increasein worker wages (Istrate et al., 2010).Who Says?The importance of exporting and tappingglobal markets has been long established ineconomics.The doctrine of comparativeadvantage, developed by the classicaleconomist David Ricardo in the 19th century,outlined the argument for comparativeadvantage: when each country specializes inthe production of the goods and services inwhich it is most adept, this maximizes thetotal value for all the parties involved in trade(Ricardo, 1817).This fundamental insight has been augmentedin the past two decades by the development ofthe“NewTradeTheory,”which added furthercomplexity (and realism) to Ricardo’s model byaccounting for the benefits associated with thegreater variety of products that are available toconsumers because of well-developed bidirectionaltrade between industrializednations. Paul Krugman shared the Nobel Prizefor Economics in 2008 for helping developthese insights (Krugman, 2008).Nobel Prize–winning economist MichaelSpence points out the importance ofexpanding the export sector of the economy.Over the past two decades, we haveincreased the value-added per worker and theearnings of workers in our export industries,but have added very few net jobs in thesesectors (Spence, 2011).Exporng is important because it forces U.S. businessesto compete against the best in the world and, in theprocess, improve their performance. Global markets area great tesng ground. By compeng in the global marketplace,businesses are exposed to internaonal bestpracces, new knowledge and ideas and technology thatlead to innovaon, further producvity improvementsand economic growth. Exporters are consistently foundto out-perform non-exporters using a variety of measuresof success, including profitability, producon, wages andsales volumes.Tapping the large global marketplace also enables firmsto spread the high fixed costs of technological and capitalinvestments. Costs are spread over a larger number ofcustomers, thus providing goods and services at lowercosts to everyone else and enabling connual product andtechnological improvement (Jones & Romer, 2010).What Have We LearnedRecently?Most of America’s recent economic growth has comein the non-traded sectors of the economy—parcularlyretailing, government, and health care—where valueaddedgrowth and wages have stagnated. As shown inFigure 15, between 1990 and 2008, the traded sectorof the U.S. economy added just 600,000 jobs, whilenon-traded businesses added 26 million (Spence &Hlatshwayo, 2011). The challenge is therefore two-fold:first, to increase export acvity (where high-wage jobsare disproporonately found) and, second, to improvethe value-added of the non-traded sector (a topicaddressed earlier in this report under producvity).Global markets are growing faster than the domescmarket and there are parcularly large opportuniesin the so-called emerging economies. The overall valueof world trade is growing more than twice as fast as theoverall U.S. economy. The Organisaon for EconomicCo-operaon and Development projects that real worldtrade will grow 4.8 percent in the coming year, but U.S.GDP will grow only about 2 percent. The difference isFIGURE 15. Total Change in Jobs, 1990–2008,and by Tradable and Non-tradable Sectorsof the Economy30.0 ________________________________________________________________27.326.6820.0 ________________________________________________________________10.0 ________________________________________________________________0.620.0 ________________________________________________________________Total Tradable Non-TradableSource: Spence & Hlatshwayo, 2011Growing State Economies: A Policy Framework \ 25 \

expected to widen in 2013 (Organisaon for EconomicCo-operaon and Development, 2011).Less than 5 percent of U.S. small and midsize companies(SME) export, even though 95 percent of the world’scustomers live beyond U.S. borders. In 2012, nearly 60percent of all SME exporters only exported to one foreignmarket. There is evidence, however, that U.S. SMEs thatexport are more producve and generate more revenuethan SMEs that do not export. A recent InternaonalTrade Commission survey found that exporng small andmedium sized manufacturers in 2009 had more thantwice the total revenue of their non-exporng counterparts.They experienced revenue growth of 37 percentbetween 2005 and 2009, while total revenue declined by7 percent for non-exporng SME manufacturers over thesame period. (United States Internaonal Trade Commission,2010).DESIGNING POLICIES TO BOOST GLOBALLINKAGES AND BUSINESSPolicy Questions andDirections• Does your state have an integrated approachto the global marketplace? Although the policyfocus of a state economic development programmay be on increasing exports, it is important torecognize that export promoon takes place inthe framework of a state’s broader posioningin a global economy. With a goal of connecngmore cizens and businesses to opportuniesaround the globe, states will likely need to instutethe following three policies to be successful(Conway & Nothdur, 1996):– Develop a vigorous trade developmentsystem that deeply integrates the publicand private sectors;– Create a capacity to manage the state’sforeign affairs; and– Foster a supporve civic capacity forgoing global.Within the context of the larger internaonalframework, there are a number of specific tac-cs states can undertake to encourage exports,including supporng established traded sectorexporters, helping small-scale exporters expand,and judiciously working with non-exporters toevaluate export markets.• Are the state’s principal traded sector industriesengaged globally? It is likely that thelargest source of exports from any state comesfrom the established traded sector clusters thatmake up a state’s economic base. The best opportuniesto expand exports generally comefrom working to improve the compeveness ofthese clusters. Industry-wide efforts to advanceproducon technology, improve worker skills,increase producvity, or reduce costs can helpencourage export growth.• Is there support for small-scale exporters to expandtheir efforts? Although larger firms andthose in clusters will oen have well-developedstrategies for pursuing exports, many small-scaleexporters are primarily passive parcipants inthe global market. In these cases, targeted stateefforts to help firms more acvely examine andpursue export markets will be effecve.• Are non-exporters encouraged to realiscallyexplore the global marketplace? Most businesses,especially smaller business, will not haveexperience in exporng, for good reason: mostbusinesses lack the scale and resources to successfullypursue an export strategy, have products orservices not suitable for foreign markets, or are notcost-compeve. Many businesses may be strugglingto find a niche in the domesc market andwould be ill-advised to lose focus by seeking to export.But some small businesses that are non-exporterstoday may be good candidates to exporttheir products. The policy challenge here is to iden-fy those businesses with real export potenal./ 26 / Growing State Economies: A Policy Framework

• Does the state support a wide range of meansfor businesses to tap the global market? Althougha focus may be on exports, it is importantto recognize that internaonal trade is acomplex, mulfaceted process. Imports, immigraon,cultural exchanges, internaonal educa-on, and inward investment are also componentparts of any state’s internaonal posion. Mostof the infrastructure for internaonal trade inany state is in the private sector of the economy;building effecve partnerships with thosewho are already deeply involved is the key to effecveness.• Are you leveraging broader social and culturalrelaonships to foster trade and globalizaon?Many, perhaps most, firms—even in the tradedsectors of the economy—will be ill-equipped, orwould be ill-advised to pursue an export-drivenstrategy. Exporng is not for everyone. Somefirms may find it more sensible to pursue alternavestrategies for parcipang in global markets.Rather than exporng, many U.S.businesses license their goods and services orbusiness models to firms in other naons, generangincome from their intellectual property,while leaving the complexity, cost, and financialrisk of working in a foreign market to firms morefamiliar with the terrain.With pressure on government budgetsat all levels,rapidly rising health carecosts,a fragile housing market,thepost-crisis effort to curb excessconsumption and boost savings,andthe risk of a second economicdownturn,it is highly unlikely that netemployment in the non-tradablesector of the U.S.economy willcontinue to grow as rapidly as it hasbeen. Therefore,the United States willneed to focus on increasing jobgrowth in the tradable sector(Spence, 2011).Growing State Economies: A Policy Framework \ 27 \

The Role of Industry ClustersClusters are geographic concentraons of similar and related firms, their workers,and supporng instuons. Every state economy has clusters of firms—regionalspecializaon is one of the hallmarks of advanced economies. Clustering is commonin both high- and low-tech industries.Clusters are important because a business’s success depends not just on its capabilies,but on those of the firms, workers, and instuons in its nearby environment.A concentraon of firms aracts a concentraon of workers and encourages themto develop their skills. This also aracts supplier industries.Clusters also advance knowledge as specialized informaon about markets, technology,compeon, and best pracces is developed and spreads more quickly in such clusters.The health of a state economy depends on the compeveness and producvity ofits principal industry clusters.

What is the Evidence?There have been extensive studies of exemplary clusters—placeslike Hollywood, Silicon Valley, or New York’sfinancial district. In the case of industries ranging frommoon pictures (Sco, 2004), to carpet manufacturing(Krugman, 1991), to electronics (Saxenian, 1994), a strongconcentraon of businesses in a relavely small geographicarea creates a strong dynamic of compeon andinnovaon, aracts and develops competent workers,and leads to successive generaons of new startup businessesthat create jobs.In addion to these case studies, there is good economicevidence that clustering helps improve producvity, promoteinnovaon, and increase value-added, which enablefirms to pay higher wages. Here is a sampling of thatstascal evidence:Clustering improves worker producvity. Vernon Hendersonlooked at employment, producvity, and wages ina series of manufacturing industries across the naonover a period of two decades (Henderson, 1997). His resultsshowed that same-industry concentraon—a measureof clustering—was posively correlated with highermanufacturing producvity. Workers in clusters weremore producve than similar workers in the same kind offirm that was not located in a cluster.FIGURE 16. The Composition of RegionalEconomies, United States, 2008Share of EmploymentEmployment Growth Rate,1998 to 2008Average WageRelave WageWage Growth Rate,1999 to 2007Relave ProducvityPatents per 10,000 EmployeesTradedNaturalResource-BasedLocal27.4% 0.9% 71.7%0.3% 0.6% 1.6%$57,706 $40,142 $36,911135.2% 94.1% 86.5%3.9% 2.9% 3.3%144.1 140.1 79.321.5 1.6 0.3Source: Prof. Michael E. Porter, Cluster Mapping Project, Instute for Strategy and Cmpeveness, Harvard Business School;Richard Bryden, Project DirectorStrong clusters pay higher wages. One study invesgatingthe effects of industrial and occupaonal specializaonon manufacturing wage levels across 220 metropolitanareas found that for the typical metropolitan area, adoubling in employment concentraon in a parcularindustry is associated with a 2 percent increase in wages(Wheaton and Lewis, 2002). Another study by Gibbs andBernat (1998) invesgated the effects of industry clusteringon wages, finding posive and significant cluster wagepremiums for 14 of 18 manufacturing industries naonally.Overall, wages for workers in industry clusters wereabout 6 percent higher than for workers in the same industrywho were not part of a cluster. Figure 16 comparesthe wages in Traded Sectors, Local Sectors and NaturalResources Sectors in the U.S. Economy.Clusters promote innovaon. It is now broadly affirmedthat strong clusters foster innovaon through dense networksof trust and cooperaon that reaches across firms,colleagues, rivals, and knowledge instuons like universiesin close proximity (Audretsch& Feldman, 2004).Who Says?The idea of industry clustering is well established.Alfred Marshall, an English economist writing at theend of the 19th century, outlined the key rationale for clusters when he described the economicadvantages to businesses that were located in industrial districts (Marshall, 1920). More recently, PaulKrugman, winner of the 2008 Nobel Prize for Economics, developed a formal theory of howincreasing returns—the additional economic benefits that firms get from being in a place where thereare other similar firms—encourage the concentration of economic activity in particular places(Krugman, 1991).Growing State Economies: A Policy Framework \ 29 \

FIGURE 17. Clusters and New Business FormationClusterThe stonger the cluster, thehigher the survival rate of newbusinessesSurvival Rates ofNew Businesses +New Industries +The stonger the cluster, the morelikely new industries within thecluster are to emerge➡New Business Formaon +➡➡The stonger the cluster, the moredynamic is the process of newbusinesses formaonJob Growth InNew Businesses +Source: Porter, The Economic Performance of Regions, Regional Studies, 2003; Delgado, Porter & Stern, Clusters and Entrepreneurship,Journal of Economic Geography, 2010; Delgado, Porter & Stern, Clusters, Convergence, and Economic Performance, 2010.The stonger the cluster, thehigher the job growth of newbusinessesWhat Have We LearnedRecently?• Strong clusters help accelerate job growth inlocal economies. Michael Porter and his colleaguesinvesgated the relaonship betweencluster strength and economic performance fora series of regional economies across the UnitedStates for the period 1990 to 2005. They foundthat employment growth was stronger in a region’sindustries if they were part of a strongcluster (Delgado, Porter, & Stern, 2010).• Strong clusters promote entrepreneurship.Michael Porter and his colleagues also foundthat industries located in regions with strongclusters (i.e., a large presence of other relatedindustries) experience higher growth in newbusiness formaon and start-up employment(Figure 17). Strong clusters contribute to startupfirm survival as well. (Delgado et al., 2010).The dramatic spatial unevenness ofthe real economy—the disparitiesbetween densely populatedmanufacturing belts and thinlypopulated farm belts, betweencongested cities and desolate ruralareas, between the spectacularconcentration of particular industriesin Silicon Valley and Hollywood—issurely the result not of inherentdifferences between locations, but ofsome set of cumulative processes,necessarily involving some form ofincreasing returns, wherebygeographic concentration canbe self-reinforcing(Krugman, Fujita, & Venables, 1999)./ 30 / Growing State Economies: A Policy Framework

DESIGNING POLICIES TO SUPPORTINDUSTRY CLUSTERSPolicy Questions andDirections• Do you understand your state’s disncve clusterstrengths? Every state has its own disncveset of industry clusters. Understanding yourstate’s clusters is a crical step in fashioning aneconomic strategy. In addion to using the clusterconcept to understand a state’s economy,governors can use clusters as a way to communicatewith businesses and organize economicdevelopment efforts. The typical state economyconsists of tens of thousands of independentbusinesses. Using clusters as an organizingtool—grouping businesses according to commonindustry interests and similar technologiesand markets—is a logical way to idenfy policypriories and simplify the task of understandingand communicang with large numbers of firms.• Does your state make use of clusters to organizeits economic development efforts? Clustersalso turn out to be the logical units for organizingpraccal efforts to address a range of economiccompeveness issues. For example,clusters oen have common interests in supporngindustry-related research or developingspecialized programs to train workers in neededindustry skills. Clusters also turn out to behotbeds of innovaon and entrepreneurial acvity.A deep prior knowledge of an industry—itsmarkets and technology—is oen a prerequisiteto starng a new firm or devising a new productor process. The people with the necessary skillsand insight to be entrepreneurs or innovatorsare much more likely to be found in placeswhere there are strong clusters. As states lookto generate new businesses and encourage innovaon,working with clusters is frequently thebest source of opportunies.• Is your state realisc about its clusterstrengths? You cannot create a cluster fromnothing. In their review of the genesis of clusters,Feldman and Braunerhjelm (2006) notethat “clusters are born and develop on the basisof specific combinaons of capabilies, incen-ves, and opportunies.” The presence of capabilies—includingthe presence of localizedknowledge, a skilled workforce, and the availabilityof capital—creates opportunies for entrepreneurshipand collaboraon, where theseopportunies can be realized in the presence ofappropriate incenves. Public policies can play arole in developing the necessary capabilies, opportunies,and incenves for the development ofclusters. The key is to be strategic in making publicinvestments and to have a long-term strategy.• Are you prepared to deal with stable or decliningclusters as well as growing ones? There is noguarantee that just because you have an industrycluster, even a long-established one, that it willconnue to grow, or even exist indefinitely. Clustersare subject to compeon and decline, justlike the businesses that make them up. Althoughsome clusters do decline, most evolve over me.Having a robust and acve engagement with allyour clusters is the best way to cope with this ongoingprocess of economic change.• Does your state adapt its response to the differentneeds of each cluster? One of the key conceptsunderlying clusters is the noon that everycluster is different, has different problems, andpresents different opportunies for state policyto influence cluster economic success. A successfulstate cluster development effort has to allowfor these differences. Some clusters may behighly organized and ready to work with the stateon a wide range of specific issues; others may beless organized or interested, or have only a fewnarrow interests. A good cluster strategy meetseach industry on its terms and works from there.Growing State Economies: A Policy Framework \ 31 \

CONCLUSION

For all the tough issues states face today,economic growth is one of the mostimportant and most perplexing toaddress. Addressing that issue includes, and goesbeyond, creang a compeve tax and regulatoryenvironment. This report is designed to providegovernors and other state policymakers with someanswers to the key queson: What can be done tocreate more good jobs in our state economies?It highlights six factors for state policymakers toconsider in their agenda:• Entrepreneurs: the individuals who seed,grow, and renew businesses;• Educaon and skills: the concentraon ofhighly educated, highly skilled individualswithin economies;• Innovaon and technology: the new ideasand technologies that enter the economyand change what is produced, how it isproduced, and the way producon itself isorganized;• Private capital: the sufficiency andavailability of debt and equity financing atall stages of company formaon;This list of growth factors is certainly not exhausve.But it includes the basics—the widely agreed uponessenals—for creang good jobs and promongeconomic growth. The report emphasizes theinsights of respected economists—including NobelPrize winners—in each area and includes the latestdata and evidence about how the six factorspromote economic growth.Finally, the report considers how state policies caninfluence progress in each area, emphasizingparcular things states can do to help more:• Startups launch and grow;• Companies find skilled labor andinnovaons;• New ideas and new technologies gainacceptance in the marketplace;• Firms navigate private capital markets;• Firms compete globally; and• Firms and workers capture benefits bybeing embedded in regional clusters.• Global markets and linkages: the businessescompeng successfully in global markets;and• Industry clusters: the firms embedded inregional clusters supported by instuonsproviding educaon, training, finance, andmarkeng services, which experiencehigher rates of job and wage growth thancomparable firms not embedded in suchclusters.Growing State Economies: A Policy Framework \ 33 \

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