For more than a century, Cabot Stains stood as a pillar of the Massachusetts business community -- a small, family-owned enterprise that produced high-quality finishes for wood products. But by the later 1970s, president Samuel Cabot III, fed up with both the state's high tax rates and the company's aging industrial plant in Chelsea, decided it was time to make a move.

"Sure we had a sentimental feeling for Massachusetts," explains 44-year-old Cabot, scion of one of the Bay State's oldest families. "But you don't deny economic benefit for your company simply out of sentiment. We were faced with a hopeless situation. Our plant was poorly laid out. There was no way to expand. To use a bad pun, we were painted into a corner." So Cabot decided to head for nearby, low-tax New Hampshire.

State officials soon learned of Cabot's plans -- and they reacted as if he were stealing the crown jewels. "The governor said, 'Do anything to keep Cabot in Massachusetts," recalls John Judge, deputy director of the Governor's Office of Economic Development, adding with a smile, "even if we had to have the state police lined up at the border."

It wasn't clear, however, that the state's good intentions would do the trick. Although Judge was able to locate a feasible plant site, the financing hinged on a federal urban development action grant (UDAG). Cabot's application, filed in June, spent the summer mired in the bureaucratic recesses of Washington, D.C. For three frustrating months, Cabot waited for the UDAG money to come through. "We had the bulldozers raring to go at the edge of the lot," he says, "but nothing was happening."

As it turned out, however, something had happened. In October, John Judge called Washington and was told matter-of-factly that the grant had been rejected. For some reason, Cabot had never been informed.

Faced with the likelihood that the company would move to New Hampshire after all, Judge turned to his colleagues in the Massachusetts Office of Communities & Development. Within two days, the state came up with a $600,000 low-interest, 20-year loan and a $155,000 grant for sewer improvements.

This fall, Cabot Stains, which projects 1985 sales of roughly $20 million, is moving into a new plant that doubles the company's production capacity and reduces production costs by as much as $1 million a year." I came out of this harboring a lot of suspicions about ever dealing with the Feds," Cabot says. "Nothing really happened until the state got involved. I'll tell you, if I had to decide about eliminating UDAG, I'd go ahead and do it -- and leave the money with the state."

The experience of Cabot Stains is part of a drama being played out all across the country. More and more, state governments are taking the initiative in promoting economic development at a time when the federal government seems to be treating from the arena.

Under the Reagan Administration, scores of programs designed to boost economic growth have been severely trimmed. Since 1980, for instance, federal aid to states for employment and job training has been slashed about 50%; community and regional development funds have been cut by one third; and Small Business Administration outlays, except for disaster loans, are down from $950 million to a proposed meager $150 million for 1986. At the same time, there has been a decline in the percentage of the federal budget allocated for improvements in the economic infrastructure (that is, for commerce and housing credit, and, until recently, education). And, to make matters worse, Washington has also imposed strict statutory limits on state use of industrial revenue bonds, one of the most important means by which states have promoted economic development in the past.

In the face of such cutbacks, state governments have had to come up with economic initiatives of their own. "I don't think much about what they're doing at the federal level.I know I can't count on them for assistance," observes Washington's Democratic Governor Booth Gardner. "As a governor, you have three choices: You can cut programs, which have already been cut; you can raise taxes; or you can come up with ways to promote economic growth."

From a political standpoint, of course, that is really not much of a choice at all. Rather than raise taxes or cut programs, governors from Boston to Sacramento have been forced to search for new policies that will encourage economic development and create jobs, and their search has led them to target small, growing companies for special consideration. Tax laws and regulations are being changed to improve the climate for entrepreneurs, while other forms of short- and long-term assistance -- ranging from better education and training programs to direct intervention in the capital markets -- are being development.

Some observers see in all this the emergence of a new set of de facto industrial policies, which are designed to serve the needs of the entrepreneurial economy. Says Bill Schweke, the veteran director of the Washington, D.C.-based Corporation for Enterprise Development, "The states are the ones that are finding the bumper-sticker slogans that the national parties haven't found yet."

This isn't to suggest that any consensus exists on the kinds of state programs most likely to produce a healthy economic climate. On the contrary, there are sharp differences of opinion between those who favor strong state action no encourage entrepreneurial activity in specific, targeted areas and those who believe the state's role should be limited to fostering the general economic conditions in which entrepreneurship can flourish.

But perhaps more significant than the issues being debated is the fact that the debate is happening at all. That fact bears witness to the powerful pressures on state governments to respond to the new growth imperative -- pressures that have forced politicians of both parties to abandon old positions, alter their public images, and generally adapt to life in a changing world. Along the way, erstwhile liberal Democrats have turned pro-business and expressed growing disenchantment with the party's penchant for viewing Washington as the center of the economic universe. "What is called for is a great deal of humility on the part of the federal government," says Don Campbell, an aide to Michigan's liberal Democratic Senator Doland Riegle. "Maybe we should look back now and listen."

Not that Democrats are the only ones who have been changing their political stripes. Republican governors are also reorienting themselves, moving beyond the antitax, antigovernment ideology that has dominated their party since the mid-1960s. It is even happening in California, birthplace of both Reaganism and the tax revolt. There, Governor George Deukmejian is overseeing a multibillion-dollar effort to reform the state's educational system -- an effort designed to meet the needs of the state's rapidly expanding high-technology economy. In some ways, the program seems more in tune with the philosophy of former governor Pat Brown, an old-line liberal Democrat, than with that of Deukmejian's tightfisted predecessors, Democrat Jerry Brown and Republican Ronald Reagan.

"This is positive conservatism," says Steven Merksamer, Deukmeijian's chief of staff. "We're not doing these things just because they are good, but because they are key to creating a viable economic future. Our goal is not to tear down government, but to make it more efficient and accountable."

Conservative or liberal, the trend is reminiscent of nothing so much as the turn-of-the-century Progressive movement, which rallied popular support for laws and regulations aimed at protecting small enterprises from unfair competition with the giant corporations of that era. Like the Progressives, these pro-entrepreneurial governors hail from both parties. And like the Progressives, they offer hope for those seeking alternatives to major-party ideas -- in this case, the simplistic supply-side beliefs of the Reaganites and the heavy-handed centralism of traditional Democrats.

No Democrat better exemplifies the trend than Governor Michael Dukakis of Massachusetts. When he first took office in 1975, the state's unemployment rate stood at 11.2%. Its older industries, such as textiles and shoes, were in decline, while its high-tech sector was suffering from post-Vietnam cutbacks in military spending. Meanwhile, state taxes were among the highest in the nationl, earning Massachusetts the nickname of Taxachusetts.

In his first term, Dukakis did little to alter that impression. He was generally perceived as a big-spending, tax-raising liberal Democrat, and he often found himself at odds with the business community, which overwhelmingly supported his opponent, conservative Democrat Edward King, when Dukakis came up for reelection in 1979. Dukakis lost that race, but he returned four years later, defeating King by a substantial margin.

After the election, Dukakis immediately went to work creating a new image for himself. Among other things, he picked up the banner of entrepreneurship -- meeting with Massachusetts Institute of Technology's David Birch to discuss small business's role in the job-generation process; or singing the praises of entrepreneurs in his 1985 State of the State address (and citing Mitch Kapor of Lotus Development Corp., a special guest, as a prime example). These days, Dukakis often speaks of himself as a kindred spirit of small business. "I'm a Greek, and small business has always been our thing -- start by washing dishes, then buy the restaurant, and end up owning the block where the restaurant is located," he said in a recent interview. "These small companies are the key to the economy."

The business community has noticed the change. "My perception is that, in contrast to his last administration, he's doing quite a bit to show he recognizes that a business constituency that has to be taxed, first must be healthy," says Bob Lee, president of Hotwatt Inc., of Danvers, Mass., and a director of the Small Business Foundation of America. "During his first term, it wasn't that he was against the needs of business. He just didn't think about them."

In fact, the change doesn't seem to represent a philosophical about-face so much as a recognition by Dukakis that it is now good politics to be pro-entrepreneur. Even in his first term, after all, he tended to emphasize state aid for local small businesses, breaking with the traditional state-development approach of trying to persuade large out-of-state companies to expand into Massachusetts. He just didn't seek, or get, much credit for it.

While freely admitting that the state's remarkable recovery -- unemployment now stands at 4.4%, the lowest in the nation -- has been mainly the doing of individual entrepreneurs, Dukakis believes that the programs launched in his first term have helped create "the right conditions" to spur growth. A case in point is the Massachusetts Industrial Finance Agency (MIFA), which, since its founding in 1978, has guaranteed industrial development bond financing totaling more than $3 billion for about 1,850 business expansions in the state. Another is the Massachusetts Technology Development Corp. (MTDC), a state-run venture fund founded in 1978.

High-tech industries, which last year added 25,000 new jobs to the Massachusetts economy, have received much of Dukakis's attention. The state has provided job training for high-tech workers, boosted educational spending, and targeted "centers of excellence" to promote such industries as photovoltaics, polymers, and microelectronics. In addition, the state government, through MTDC, has invested $7 million directly in 34 technology companies.

But Dukakis hasn't neglected the state's older industrial areas. The southeastern Massachusetts city of Taunton, for example, suffered a prolonged decline in the 1970s, as the metalworking industry succumbed to tough international competition. By 1982, unemployment in Taunton (population: 45,000) had soared to more than 13%.

Since then, Mayor Richard Johnson has managed to get Taunton's unemployment rate down to 5%. When rumors circulated that Taunton Silversmiths Ltd. was for sale, the mayor helped engineer a leveraged buyout of the company, using low-interest MIFA loans, thereby assuring that it would remain in Taunton. Johnson has also lured new small businesses to the city; earlier this year, he worked with Governor Dukakis to persuade Surrey Industries Inc., a plastic-bag manufacturer, to move into the facility abandoned by Parker Bros.

To be sure, Dukakis doesn't deserve all, or even most, of the credit for Taunton's turnaround. "The fact that he's taken on [business development] as a theme of his administration is good," says Howard Foley, president of the Massachusetts High Technology Council. "But Taunton would have happened with or without Dukakis. They've got a lot going for themselves there."

Nevertheless, Dukakis believes there is a lesson in the Taunton experience. "What we're showing is that you can do what you want -- and do it better -- on the state level," he says. "Instead of a mayor or a businessman in a dying city going to Washington to lobby for a $500,000 loan, let him come to the state instead. Better to get results than create another large bureaucracy."

That philosophy is remarkably similar to the one espoused by Pennsylvania Governor Dick Thornburgh, a Republican. Inspired, he admits, by the Massachusetts experience, Governor Thornburgh has designed a new kind of economic-development policy to combat his state's double-digit unemployment.

Like most old industrial states, Pennsylvania has traditionally sought salvation from afar, going after such large companies as Volkswagen to build new plants in the Keystone State. While not opposed to such efforts, Thornburgh has been cautious about using state funds to lure outside investors. He refused, for example, to offer General Motors Corp. a $25-million incentive package that had been passed by the legislature is hopes of bringing the much-ballyhood Saturn Project to Pennsylvania. "GM made $4.5 billion [net income] last year," he explains. "The notion that some cash prize -- a bribe -- [would make a difference] was ridiculous. . . . Besides, I'd rather have 50 small [companies] with 100 employees each anyway."

It has come as something of a surprise that Thornburgh has taken such strong, and controversial, stands on economic development issues. A lawyer by training, he was elected in 1978 as a moderate "good government" Republican, known mainly for his successful prosecution of corrupt state officials. And yet, as governor, he has made his principal contributions in the economic arena.

Under Thornburgh, the Pennsylvania Industrial Development Authority -- which had previously provided most of its low-interest loans to large industrial concerns -- has begun steering about half of its loans toward companies with fewer than 50 employees. The governor has also worked closely with the State Milrite Council, a partnership of labor leaders, businesspeople, and university officials that was set up in 1979 to help develop a new economic-policy consensus. In 1982, the Milrite Council played an active role in the creation of a new state agency, the Ben Franklin Partnership, which has established four technology centers where companies can bring proposals for new projects. If the partnership's board approves a proposal, the Ben Franklin Partnership then helps arrange financing from private sources, which must total at least 30% of the project costs.

In addition, Thornburgh sponsored a $190-million bond issue for a Pennsylvania Economic Revitalization Fund to provide, among other things, seed capital for small businesses and money for infrastructure development. The fund also established a center to help entrepreneurs deal with state agencies, and 13 small-business development centers to provide management assistance. More recently, Pennsylvania has set up a venture pool -- the state receives only 2% of the nation's private venture funds -- using 1% of the state's pension funds.

Thornburgh's pro-small business policies represent "a major rethinking of traditional GOP attitudes," notes state commerce secretary James Pickard. Other Republican activists agree. "I'm a free-market man myself, but I see merit in setting in motion the natural evolutionary trends," says Milrite Council chairman Dick Reinhardt, owner and president of Plant Improvements Inc., a small warehouse-equipment distribution company. "I see the state efforts as a catalyst, an important one, that can create a level playing field."

Some small-business people remain skeptical, however. They argue that the close ties among the Milrite Council, the Ben Franklin Partnership, and the state university system tends to give Pennsylvania's policies an overly academic orientation. Decisions on research projects, they say, often reflect the leisurely concerns of researchers rather than the time-sensitive needs of small companies. "Small business doesn't break for spring vacation," says Harold G. Hall, president of Pittsburgh-based Hall Industries Inc., a $5.5-million-a-year steel-fabrication company.

But perhaps the most controversial approach to small-business assistance belongs to another Rustbelt governor, Michigan Democrat James Blanchard. A former congressman who was one of the prime boosters of the Chrysler bailout, Blanchard was elected governor in 1982 with strong backing from organized labor. At the time, Michigan was reeling under a $1.7-billion deficit, depression-level unemployment, and the lowest credit rating of any state in the Union. Blanchard responsed like a latter-day FDR. He put together a brain trust and drove an unpopular onetime tax increase through the legislature. He also started pumping funds into public-works projects. It all seemed like the New Deal reincarnate, but no one was singing "Happy Days Are Here Again."

Then Blanchard started to surprise people. He signed legislation cutting some 90% of the business taxes paid by small companies with low earnings. He pushed for major reductions in the cost of worker's compensation; created a small-business ombudsman to help companies deal with state bureaucracy; began a review of regulatory paperwork required by state agencies; streamlined procedures involved in issuing securities and setting up franchises; and located 12 small-business assistance centers in key locations around Michigan.

For small business -- long the old man out in a state dominated by big business and big labor -- the change couldn't have been more welcome. "It took a Democrat to do these things," observes Alan Suits, president of Recomtex Corp., an East Lansing-based biotechnology company. "It was like Nixon going to China. If a Republican had tried [such reforms], the Democrats would have fought it."

Yet other aspects of Governor Blanchard's economic program have raised concerns in the small-business community. In sharp contrast to both Pennsylvania and Massachusetts, which actively seek economic diversity, Michigan under Blanchard has chosen to steer the use of state resources, including a $450-million venture capital fund, toward entrenched industries, notably automotive suppliers."You create conditions and you target things," explains Blanchard, whose targeting decisions have won the support of both auto executives and the United Auto Workers.

But many entrepreneurs see targeting as a colossal strategic blunder, setting the stage for a potential economic disaster. Equally disturbing, some critics charge that the state has been using funded agencies, such as the Industrial Technology Institutes -- which receives as much as one quarter of its revenue from such established manufacturers as General Motors -- to cajole small auto suppliers into adopting GM's manufacturing automation protocol (MAP), a program of standardization for all communications devices to be used on the floor of the factory of the future.

"Making MAP before the so-called factory of the future is even in place is like having IBM compatibility before you ever had an Apple," says Robert Vincent, president and founder of GeoSpectra Corp., an Ann Arbor-based high-tech company serving the natural-resource industry. "I'm worried about the big-business culture being extended via this publicly funded path to the small-business community."

"It's warped," says former GeoSpectra president Howard Keating. "The future of this state has got to be in diversification, or we're going to get caught in the same old trap. The mentality continues to be, 'GM, Ford, Chrysler; GM, Ford, Chrysler."

Few states, however, seem to be going as far as Michigan in targeting a particular industry for special treatment. Indeed, some activist governors, mostly in the Sunbelt, reject the notion of state-directed industrial planning altogether. The states, they argue, should think more about the long term -- building the economic infrastructure, creating the right environment for growth.

"We're trying to enhance the atmosphere for entrepreneurs to come to California and do what they do best," says James B. Vaughn, director of the state's Office of Business Development. "To us, that means minimizing the role of government in business life. This is a very individualistic place, and no one can show me that government can allocate capital better than individuals can. Hell, if the government had been in charge of venture capital, you might never have seen Silicon Valley."

Texas's Democratic Governor Mark White echoes Vaughn's sentiments. "The main thing for Texas government is to open the door for entrepreneurship, and then get out of the way," he says. "You don't focus on any one industry. You essentially open the door to the maximum ability of each individual to go out to plan and take chances. You support him and give him the chances, but you do not subsidize him."

Of course, it is hardly surprising to hear such views expressed in the Sunbelt. After all, California (unlike Michigan or Pennsylvania) doesn't really need to rely on state-sponsored venture capital: Its entrepreneurs already have access to roughly a third of the nation's private venture capital. Instead, California and many other Sunbelt states are concentrating their efforts on making basic improvements in the services considered most crucial to long-term economic growth -- especially education.

According to the Bureau of Labor Statistics, by 1995 nearly 46% of all new jobs will require higher levels of education, compared with only 38% today. So severe are the perceived long-range consequences of a deteriorating education system that even such a conservative state as Texas recently boosted its sales tax -- the first such increase in 13 years -- in order to fund a three-year, $2.8-billion education-reform program. Significantly, much of the support for this spending has come from the traditionally antitax business community, led by conservative entrepreneur H. Ross Perot.

Nowhere is this new enthusiasm for education more evident than in California's business community. With the strong backing of state superintendent of public instruction Bill Honig, executives and entrepreneurs have pressured the Deukmejian administration into launching a massive education program, which has increased funding for education by more than 20% over three years.

"The entrepreneurial community is beginning to realize that this economy is increasingly built on knowledge," notes Orange Community electronics entrepreneur Randy Knapp, a longtime Republican activist and an ally of Honig. "I'm a conservative, but I realize we can't survive without a strong public education system. An investment in education is the best you can make. The returns are fantastic."

Such views represent a significant change of heart among conservatives. But neither they nor their liberal counterparts are likely to start pushing for a return to the time when business looked to Washington for economic initiatives.

"Let's face it, the regions of this country are too different from each other for the federal government to generate programs to meet everybody's needs," notes California's Vaughn. "The creativity is down on the local level with the states.

"Let California do things its way, and Pennsylvania can try something different. Why not diversity? The key thing is that the commitment be made close to where the action really is."