One Proviso: Interstate Tax Competition

Though as a general rule sales taxes are preferable to income taxes, one factor which can invalidate the rule is interstate tax competition. As the Tiebout hypothesis long ago suggested, people vote with their feet (by moving to new locations), for or against the prevailing levels of government taxes and spending.[2] As a result, in the competition for businesses and residents, state leaders must take into account how their tax rates compare with those of their neighboring states.

For example, if a state has an income tax rate which is lower than those of its neighbors, and a sales tax rate which is equal to (or higher than) those of its neighbors, raising the sales tax may not be the best choice. Doing so might inhibit the growth of the retail sales industry by encouraging consumers to shop in a neighboring state.

In the case of where a state's income tax rate is lower than that of its neighbors, raising the income tax might be less harmful to economic growth than raising the already disproportionately high sales tax. This is especially a concern for small states, since their neighboring states are usually within a manageable driving distance for tax-conscious shoppers. It is less of an issue for large states such as California, Texas, and Florida, where it is considerably more difficult for most residents to drive to a neighboring state to do their shopping.