How inflation affects you and the economy
In June, the Bureau of Labor Statistics (BLS) announced that inflation had increased 5.4 percent in the last 12 months. But even before that announcement, high and increasing prices were…
Beneath the surface Minnesota’s economy shows inherent weakness.
Economic growth in Minnesota
It has become fashionable in recent years to question whether developed countries need more economic growth. “Society” has everything it needs, the argument goes, we just need to bring more “fairness” to how we divide it up and, anyway, the planet could not sustain further economic growth.
But, as the old song goes, “You don’t know what you got till it’s gone.” In his book, The Moral Consequences of Economic Growth, economist Benjamin M. Friedman argues that material growth has non-material benefits. “Economic growth—meaning a rising standard of living for the clear majority of citizens—more often than not fosters greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy ” he writes “[M]any countries with highly developed economies, including America, have experienced alternating eras of economic growth and stagnation in which their democratic values have strengthened to weakened accordingly.”
It is not true, as the Marxists argued, that society is driven by its economics. But it seems unarguable that some element of recent political turmoil stems from the financial crisis of 2008-2009 and the sluggishness of the recovery. Even the rich world needs economic growth.
On some commonly-cited measures, Minnesota’s economy appears to be in good health. Take Gross Domestic Product (GDP) per capita, which simply divides the amount of GDP (goods and services produced) in a given state by the population. On this metric, Minnesota performs better than the nation as a whole. In 2017, our state ranked 15th nationally, with a per capita GDP of $62,962. By comparison, average GDP per capita for the U.S. as a whole was $59,141.
But other signs are less comforting. The growth rate of GDP is one of them. Sine 2000, our state’s economy has grown more slowly that the U.S. In 2017, the United State’s economy was 32.8 percent larger in real terms than it was in 2000. Minnesota’s economy was 30.2 percent larger. If Minnesota’s economy rate had matched that of the nation since 2000, the state’s GDP would be 2 percent higher that it actually is.
It is often argued that Minnesota’s below average growth rate of GDP per capita is a result of its above average level. The economic theory of convergence holds that, all else being equal, poorer economies’ per capita incomes will tend to grow faster rates and catch up with those in richer economies.
Economists found evidence to support this theory. During much of the 20th century, poor states and regions in America caught up with rich ones at a rate of about 2 percent per year, a figure sometimes called the “iron law of convergence.” In 1930, for example, workers in Mississippi earned just 20 percent of the wages of workers in New York. By 1980, the proportion had increased to 65 percent.
Recent research casts doubt on this. Incomes across states converged at a rate of 1.8 percent per year from 1880 to 1980. Since then, however, there has been hardly any convergence at all. Convergence has declined in cities, too. Between 1940 and 1980, poor cities caught up with rich ones at a rate of 1.4 percent a year. Since then, they have lagged behind.
Specifically, research finds that “the convergence rate from 1990 to 2010 was less than half the historical norm, and in the period leading up to the Great Recession there was virtually no convergence at all.” In other words, the “convergence,” which is supposed to explain Minnesota’s slow rate of economic growth relative to the U.S. average, has not been happening over the period covered in the Center’s economy report. Our economic growth is lackluster, and “convergence” does not explain it.
What matters most for long-term growth is productivity. This is the ability to produce more outputs with a given amount of inputs. It is the essence of economic growth. Indeed, as economist Paul Krugman has quite rightly written, “Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”
Here, too, Minnesota performs relatively poorly. One common measure of an economy’s productivity is its labor productivity, the average amount of GDP produced per worker. Minnesota’s per worker productivity has consistently been below the national average since at least 2000. In 2017, Minnesota’s workers produced 7.8 percent less GDP than the national average. The picture is the same when we look at GDP per hour worked. In Minnesota’s goods producing sector, the state’s workers produce 6.8 percent less GDP per hour worked than the U.S. average. It is the same, too, in the service producing sector where Minnesota’s workers produce 6.9 percent less GDP per hour worked. Once again, productivity in this sector has more or less flatlined since 2010. This is bad news for Minnesota, as a growing share of the state’s jobs are to be found in service industries.
How do we square Minnesota’s above average levels of GDP per capita with its below average productivity? The answer is found in Minnesota’s hard working population. At 3 percent in July 2018, our state’s unemployment rate was below the national rate of 3.9 percent. With a Labor Force Participation rate of 68.8 percent, Minnesota ranked second nationally in 2017. Households with two workers account for 34 percent of Minnesota households, but only 28.6 percent of households nationally. Minnesota also has a smaller portion of households with one worker or no workers than the nation as a whole.
This is good in one sense: all else being equal, it is better to have a higher share of your population working. But remember, GDP per capita is calculated by dividing GDP by the state’s population.
Because GDP is produced by the population, even if that population has, on average, relatively low labor productivity, it might still produce above average levels of GDP per capita if a relatively large share of it is working to produce GDP. In other words, Minnesota’s higher-than-average labor force participation is offsetting its lower-than-average per worker productivity and driving up the levels of GDP per capita. But the point of economic growth is not to accumulate inputs, like labor. It is to make them more productive. Minnesota fails here.
Minnesota’s economic future
There are three sources of per capita GDP growth: an increase in the Labor Force Participation rate, a rise in capital per worker, and higher Total Factor Productivity. The first two relate to the accumulation of factors of production and the third to the quality and skill with which they are utilized. We can look at past—and likely future—trends in each of these to get some idea of what might lie ahead for Minnesota.
Labor force participation
The Labor Force Participation rate is the percentage of the population that is either employed or unemployed and actively seeking work.
The outlook here is not good. The Labor Force Participation rate is projected to fall to 64.6 percent in 2035. This will be a negative value in our per capita GDP growth equation. This will be driven by the retirement of Baby Boomers, those born between 1946 and 1964, but recent data reveal other concerning signs. Between 2000 and 2017, Minnesota’s overall Labor Force Participation rate fell by 3.9 percentage points, from 75.1 percent to 71.2 percent. But for workers between the ages of 16 to 19, labor force participation has slumped by 17.5 percentage points since 2000. By contrast, in the two oldest categories, those over age 55, labor force participation has actually increased by 9.9 and 3.5 percentage points, respectively.
Why are younger Minnesotans dropping out of the labor force? One answer is minimum wage legislation. Minnesota is one of 26 states and the District of Columbia to have a state minimum wage above the federal level of $7.25 per hour. For large employers, those with an annual sales volume of $500,000 or more, the minimum wage in Minnesota is currently $9.50. Most empirical studies have found negative effects of minimum wages on youth employment. Other research pinpoints further causes of declining labor force participation, including increased recourse to disability benefits. To soften the blow of the Baby Boomers dropping out of the labor force, harmful policies like these should be abandoned.
Is immigration the answer?
One remedy often suggested for the state’s shrinking workforce is increased immigration. But this relies on two assumptions.
The first is that the new arrivals will have a Labor Force Participation rate at least as high as that of the population already here. If they do not, they will lower the Labor Force Participation rate, exacerbating the very problem they are proposed to solve. The Labor Force Participation rate among Minnesota’s foreign-born population was 72.7 percent in 2016, above the rate for native-born Minnesotans.
The second assumption is that the new arrivals are at least as productive as the workers already here. Considering GDP per capita, immigrant workers add to the denominator (population) as well as the numerator (GDP). If these workers increase the population by a greater percentage than they increase GDP, they will lower GDP per head.
What matters is the skill level of the workers. Of immigrants aged 25 or older, 32.6 percent have bachelor’s degrees or higher, a figure similar to native-born Minnesotans’ 35 percent. However, whereas 34 percent of native-born Minnesotans have attended some college or earned an associate’s degree, that figure is just 21.6 percent for foreign-born Minnesotans and falls to 15.5 percent for foreign-born non-citizens. While 30.8 percent of native-born Minnesotans have a high school diploma or less and only 4.9 percent are not high school graduates, for foreign-born Minnesotans these numbers are 45.8 percent and 27.1 percent, respectively. For foreign-born residents who are not citizens these figures rise to 52.7 percent and 34.4 percent.
Growth in capital per worker
Capital per worker refers to the amount of capital each worker has to work with. Increasing capital per worker makes workers more productive, until the point where diminishing returns set in. By enabling workers to produce more, wages and GDP per capita rise.
Minnesota performs poorly here. The state’s levels of capital per worker have been below the national average since at least 2000. Nationally, in 2015, each American worker had $104,187 of capital behind them. In Minnesota, the figure was $100,129—3.9 percent below that national average. Growth in the capital available to Minnesota’s workers is driven by the amount of investment capital business owners have access to. This will shift with the expected after-tax rate of return on investment, which is a measure of the flow of income generated by an investment in the stock of capital. It is primarily affected by tax rates. Evidence indicates that corporate income taxes have a negative effect on aggregate investment and entrepreneurial activity. They are also an influence in foreign investment decisions.
Minnesota’s taxes are not conducive to capital investment. The Tax Foundation ranks Minnesota 46th out of the 50 states for its business tax climate. Minnesota imposes a deduction schedule for natural resource depletion on top of the federal one, and it is one of only eight states to have an Alternative Minimum Tax on corporations. These add another layer of compliance difficulties beyond the federal requirements. More importantly perhaps, Minnesota’s top rate of Corporate Income Tax is 9.8 percent. This is the third highest in the U.S. Only Iowa (12 percent) and Pennsylvania (9.99 percent) have higher rates. To boost capital per worker, Minnesota’s policymakers need to change course on these tax rates.
Innovation and entrepreneurship
The third source of per capita GDP growth is an increase in Total Factor Productivity (TFP). This is a measure of technological improvement and productivity. The first, technological improvement, simply refers to the improvement in the quality of capital rather than its quantity. A farm’s workers, for example, might initially become more productive if they were given more tractors. But, if they had more than one tractor each or too many to operate usefully on the farm’s land, any further increase in the number of tractors would bring diminishing returns. By contrast, the adoption of new technology, such as enhancement of seed planting efficiency, will raise productivity. This combination of skill with inputs such as land, labor, and capital is an example of entrepreneurship.
In addition to entrepreneurship, research shows that U.S. states with better educational attainment and greater investment in research and development see faster growth in TFP. Minnesota can improve in both these areas.
Minnesota’s educational system compares favorably with other states on a range of educational outcomes, though its mediocre performance on AP test scores should be noted. Overall, if a focus on academic excellence and these standards can be maintained, education will continue to boost Minnesota’s economic future. But this is not a call to ramp up education spending. Research shows that in Minnesota, between 1970 and 2011, SAT scores adjusted for participation and demographics had no noticeable increase while, over the same period, inflation adjusted per pupil spending increased by 80 percent. Further increases are likely to hit diminishing returns.
Minnesota’s outlook for research and development (R&D) is not encouraging. In each of the last four years for which we have data, the share of state GDP spent on R&D has lagged the national average. In 2009, Minnesota led the U.S. in R&D spending as a share of GDP, 3.05 percent to 2.03 percent. By 2015, this situation was reversed and our state lagged the nation, 2.46 percent to 2.73 percent.
As Adam Smith wrote, there is a “great deal of ruin in a nation,” and the same goes for a great state like Minnesota. The standard of living in the state is the result of sheer hard work rather than impressive levels of productivity. This short-changes Minnesotans. If Minnesota’s workers were as productive as the national average, our state’s GDP per capita would be $5,800 or 9.2 percent higher. Our high tax policies exacerbate our economic deficiencies by driving productive workers out of the state and deterring others from coming here. For the sake of our state’s economic future, we need to change direction.
John Phelan is Center of the American Experiment’s economist. He is a graduate of Birkbeck College, University of London, where he earned a BSc in Economics, and of the London School of Economics, where he earned an MSc. He worked in finance for ten years before becoming a professional economist. He worked at Capital Economics in London, where he wrote reports ranging from the impact of Brexit on the British economy to the effect of government regulation on cell phone coverage.