Tax competition occurs when states and localities use their tax codes to attract business, individuals, or other economic activity from other states and localities. Governments may create exemptions, deductions, credits, or other sorts of tax “breaks.” They may also create special classes of taxpayers or property. The broadest tax competition takes place as governments set tax rates, or even choose what kinds of taxes they will have. Examples would include a city that creates a property tax break in order to encourage a factory to locate in its limits, and a state that keeps its sales tax rate low (or zero) in order to attract shoppers from adjoining states.
Since these tax incentives are meant to give the state or locality that enacts them a competitive advance over other states or localities, then it is very possible that those other governments will offer greater inducements. This could create what is often called the “race to the bottom,” a destructive cycle in which the governments lower their taxes in order to attract economic activity, but are unable to gain a lasting advantage as other governments also lower their taxes. The danger is that all governments will then end up with insufficient revenues to fund basic services, without gaining anything.
On the other hand, tax competition may also be viewed in a more positive light. It should act as an inducement for governments to maintain taxes at as low a level as possible, allowing economic activity to function more efficiently, thereby generating more economic activity overall and making up for some or all of the revenue that was lost by the original tax break. It will also tend to allow the production of products at a lower cost, to the benefit of consumers. Tax competition can also be seen as a natural limit on the growth of government, forcing governments to live within their means, and to not raise taxes to levels that damage private economic activity.
There is some support for both of these views. There have been many instances of tax breaks being provided to businesses that may generate many fewer jobs and other economic benefits than originally expected, or that relocate when a better offer appears. There are also many instances where tax competition is not possible, because people or businesses cannot easily relocate, and tax rates have tended to rise to a point that is seen by many as excessive. Indeed, most state and local governments are able to maintain tax levels sufficient to fund services, and not all economic activity has yet moved to the locales with the lowest taxes.
There is also a third view that most decisions as to the placing of business are made for reasons having nothing to do with tax levels, and likewise people’s choice of location and even shopping habits are not predominately tax related. Nevertheless, tax competition is a constant subject of concern to many state and local governments.
SEE ALSO: Fiscal Federalism
David Brunori, State Tax Policy: A Political Perspective (Washington, DC: Urban Institute Press, 2001); and Daphne A. Kenyon, Interjurisdictional Tax and Policy Competition: Good or Bad for the Federal System? (Washington, DC: Advisory Commission on Intergovernmental Revenue, 1991).