The importance of entrepreneurship for economic growth and development is widely recognized. State and local policymakers and economic development officials are gradually turning their attention away from policies such as direct subsidies that encourage business relocation towards policies aimed at promoting entrepreneurship. Since states with high rates of entrepreneurship also have high levels of venture capital some state policymakers advocate using public resources to expand the pool of available venture capital in a state. Although a popular development strategy, a new study shows this approach is flawed.

At the heart of this public policy issue are two competing views of how to facilitate entrepreneurship. For some policymakers encouraging entrepreneurship involves improving the entrepreneurial climate through the lowering of tax and regulatory burdens. This view is consistent with a large body of academic literature showing that a good way to encourage entrepreneurship is to provide individuals with the freedom to pursue their dreams. Other policymakers focus on the financial constraints facing would-be entrepreneurs and how public policy can mitigate the financial hurdles to entrepreneurship. State financing of venture capital firms is consistent with this view.

Given the limited amount of resources that governments have for economic development, it is important to know which of these two approaches is most likely to foster entrepreneurship. A new study by economists Steven Kreft and Russell Sobel published in the Cato Journal provides some evidence on that question by examining the direction of causality between venture capital and entrepreneurship. It’s important for policymakers to know whether an increase in entrepreneurial activity attracts additional venture capital or whether increased availability of venture capital attracts more entrepreneurs.

Using the number of sole proprietorships and patent activity in a state as measures of entrepreneurship, Kreft and Sobel find that increased entrepreneurship causes more venture capital to automatically flow into the state. More importantly, they find that influxes of new venture capital do not then cause entrepreneurship to increase. Crowding out of private venture capital is one possible reason why state funded venture capital fails to increase entrepreneurship. This suggests that the trend of state-sponsored venture capital funds have the cart before the horse. Since entrepreneurial activity appears to be what attracts venture capital into a state, the best way to encourage entrepreneurship within a state is to focus on creating a policy environment where individuals are free to be innovative.

Unfortunately Wisconsin is currently planning to invest $50 million from its $66.5 billion state employee trust fund state into venture capital firms that invest primarily in local companies. Similar efforts have been undertaken in other states, including Colorado, Michigan, Ohio, Oklahoma, and Minnesota. However Kreft and Sobel’s new research shows that state financing of venture capital in these states is unlikely to stimulate entrepreneurship.

So what should state policymakers do? Kreft and Sobel’s research finds that the degree of economic freedom within a state is positively related to the entrepreneurial activity in that state. In other words, policymakers should follow the example of states like North Carolina and Nevada and focus on lowering taxes, securing property rights, minimizing regulatory barriers and other public policies consistent with individual freedom. By doing so, it will increase the rate of new business start-ups, and the venture capital necessary to help fund these new ventures will flow into the state automatically. Capital is more mobile than labor, so the focus of state economic development policy should be on how to make it easier for individuals to pursue their dreams.