Tax competition among U.S. states: racing to the bottom or riding on a seesaw?

This paper provides an empirical analysis of the determination of capital tax policy by U.S. states based on new panel data, a new econometric technique, and a new theoretical model. The analysis is undertaken with a panel data set covering all 48 contiguous states for the period 1969 to 2004 and is guided by the theory of strategic tax competition. The latter suggests that capital tax policy is a function of out-of-state tax policy, in-state and out-of-state economic conditions, and, perhaps most importantly, preferences for government services. Using the Common Correlated Effects Pooled estimator to account for cross-section dependence, and time lags to account for delayed responses, we estimate this reaction function for three state capital tax instruments: the investment tax credit rate, the corporate income tax rate, and the state's capital weight in its multi-state income apportionment formula. We find the slope of the reaction function--i.e., the equilibrium response of in-state to out-of-state tax policy--is negative, contrary to many prior empirical results. We document that a positive slope is obtained when either aggregate time effects or time lags are omitted. We show that the positive slope found in misspecified models is the result of synchronous responses among states to common shocks rather than competitive responses to out-of-state tax policy. While striking given prior findings in the literature, these results are not surprising. The negative sign is fully consistent with qualitative and quantitative implications of the theoretical model developed in this paper. Rather than \"racing to the bottom,\" our findings suggest that states are \"riding on a seesaw.\" ; Formerly titled: Tax Competition and Capital Mobility: Evidence from the U.S. States