To explain the large differences in labor productivity across U.S. states we estimate two models--one based on local geographical externalities and the other on the diversity of local intermediate services--where spatial density results in aggregate increasing returns. Both models lead to a relation between county employment density and productivity at the state level. Using data on gross state output we find that a doubling of employment density increases average labor productivity by around 6 percent. More than half of the variance of output per worker across states can be explained by differences in the density of economic activity.