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. 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.