Interstate Competition Is Why States Cannot Afford to Be Lazy

Every complaint department in America has the same secret weapon, and it is not a clipboard. It is the customer's ability to walk out the door. The restaurant with the surly waiter has to fix itself or close. The bank with the rude teller loses accounts. The only organization that gets to ignore that rule is the one that holds a monopoly, and the government of the United States is the biggest monopoly in the country. You cannot move to a different one without a passport, a visa and a very patient consulate.

But here is the thing nobody in the faculty lounge likes to say. Fifty states means fifty sets of rules, and you can change your address from one to another by renting a truck. That is a stunning feature of the American system, and it explains more about good government than most textbooks do. Let me make the case: the competition among the states is the best check on government we have, it works better than any national agency could, and the strongest objection to it, the "race to the bottom," is real but answerable.

The idea has a name and a date

In 1956 an economist named Charles Tiebout published a short paper in the Journal of Political Economy called "A Pure Theory of Local Expenditures." His problem was an old one. Economists said that a government could not know what people wanted from public goods like schools, parks and police, because unlike a store, the government does not watch you shop. Tiebout said that was wrong, at least for local governments, because people do shop. They shop by moving.

His picture was this. Suppose there are many communities, each offering a different mix of taxes and services. A family looks over the menu and picks the community that suits it. One that wants top schools and does not mind high property taxes picks one place. One that wants low taxes and few services picks another. The result, Tiebout said, is that people sort themselves according to their preferences, and communities are pushed to give them what they want at a fair price. People "vote with their feet," a phrase that has been quoted ever since.

Tiebout laid out conditions: people have to be able to move, they have to know the differences, there have to be a lot of places to choose from, and moving cannot cost too much. None of these is perfectly true in real life, and he knew it. But the core insight is solid. The more mobile the voters, the more the government has to earn them.

Let's put that in an argument the way a debater would.

1. Governments, like businesses, tend to get lazy when they cannot lose customers.
2. In the American federal system, residents and firms can leave a state at modest cost, and they do.
3. Therefore state governments face a pressure that no national agency faces, because no one can leave the national government short of leaving the country.
4. That pressure rewards states that run schools, roads and courts well at a price people will pay, and punishes the ones that do not.

I'd call that a persuasive case. Now for the receipts.

Delaware, the franchise state

If you want to see competition between states at its most extreme, look at one of the smallest states in the Union with a business model built on corporate law. Delaware is where a huge number of America's large public companies are incorporated, a fact that has little to do with where they actually do business and everything to do with Delaware's offer.

The offer is a body of corporate law that is predictable, flexible, and enforced by a specialized court. Delaware's Court of Chancery has no juries; its judges are experts in business disputes and decide them quickly. The General Corporation Law, revised in 1899 and updated regularly since, is written with an eye on what managers and investors need. In return, companies pay Delaware an annual franchise tax and fees, which make up a meaningful share of the state's revenue. A state with a small population gets funds that would otherwise cost its residents far more.

How did Delaware get there? It had help from a neighbour that overreached. In 1913, New Jersey, under Governor Woodrow Wilson, passed a set of antitrust measures known as the Seven Sisters Acts, which made New Jersey a less friendly place to incorporate. Businesses took notice, and Delaware, which had already been courting them, picked up the customers New Jersey pushed away. That's a perfect little story of competition in action: one state raised the price of its product, and a rival lowered it.

Whether Delaware's law is good for investors is a fair debate, and scholars have fought over it for decades. In 1974 William Cary of Columbia argued in the Yale Law Journal that the competition produced a race to the bottom, with Delaware favoring managers over shareholders. Ralph Winter replied in 1977 that the opposite was true: companies that wanted to raise money had to offer terms investors would accept, so competition produced a race to the top. Keep that argument in your pocket, because the whole question of this essay is packed in it.

South Dakota and the credit card

Here is a stranger story. In 1978, in a case called Marquette National Bank of Minneapolis v. First of Omaha Service Corp., the Supreme Court held that a national bank could charge its customers the interest rate allowed in the bank's home state, even if the customer lived in a state with lower caps. That changed the geography of credit overnight. A bank could choose its home state and export its rates.

South Dakota's governor at the time, Bill Janklow, saw the opening. In 1981 the state repealed its interest-rate caps and invited the big banks. Citibank moved its credit card operations to Sioux Falls. Jobs followed. A small, mostly rural state became a hub for the card business because it decided to offer a legal climate a national bank would pay to join.

South Dakota did it again with trust law. In 1983 the state repealed the old rule against perpetuities for trusts, which allowed trusts to last for generations, and added favourable rules on privacy and taxes. Other states copied it. Competing states began rewriting their own trust statutes in response, which is exactly how competition spreads ideas.

Wyoming and the low-tax model

Next, Wyoming, which never taxes the individual income of its residents and has no corporate income tax. The state runs on revenue from mineral extraction, sales tax and property tax, and it has used low taxes as an invitation. It also gave the country a legal invention. In 1977 Wyoming passed the first limited liability company statute in the United States, which gave business owners the liability protection of a corporation with the flexible tax treatment of a partnership. Every state eventually adopted its own version. Think about that: a state with a tiny population wrote a law that now covers an enormous share of American small businesses.

A caution: Wyoming's model is not a template for every state. It depends on natural resources and a small population, and a bigger, denser state cannot copy the formula without adjusting it. Still, that's the point of the system. Each state tries something. The ones that work get copied. The ones that fail serve as a warning. Brandeis Called the States Laboratories and Conservatives Took Him at His Word tells that story from Justice Brandeis's side.

What it means for a family: a worked example

Here is a hypothetical, labelled as such. A family of four earns $90,000 a year. State X has a flat 5 percent income tax. State Y has none. The tax in State X is $90,000 times 0.05, which is $4,500 a year. Moving costs the family $9,000 for the truck, deposits and a month of overlap on rent. That's $9,000 divided by $4,500, or exactly two years to break even.

Of course, a family does not move for taxes alone. State Y may have higher property taxes, worse schools or a longer commute. But now multiply the family by thousands. A state does not need everyone to leave. It needs enough people to notice that the grass is a little greener, and the legislature starts to pay attention. That is the discipline in action, and it is why Income Tax or No Income Tax, and What Each Choice Costs a State deserves a close read before anyone writes off the low-tax model.

The strongest objection: the race to the bottom

Now to the best argument on the other side, stated as its champions would state it.

The race-to-the-bottom argument says that when states compete, they will cut whatever costs money, including protections that everyone benefits from. If one state allows a factory to dump waste, others will follow or lose the factory. If one state lets employers pay children for long hours, others will have to match. In this telling, competition among governments is not like competition among restaurants. Restaurants compete to be better; governments compete to be cheaper, and the cheapest is not always the best.

That is not a silly argument. History has examples. In the early twentieth century, many states hesitated to restrict child labor because they feared driving employers away. When Congress tried to ban the interstate shipment of goods made by child labor in 1916, the Supreme Court struck the law down in Hammer v. Dagenhart in 1918, and the problem remained until the Court reversed course in United States v. Darby in 1941. And of course, the nation's worst chapter of state-level policy, Jim Crow, was not corrected by competition; it was corrected by the Fourteenth Amendment, the Civil Rights Act and federal courts.

Here is the answer, in three parts.

One, competition is a tool for ordinary policy choices, not for fundamental rights. The Constitution sets a floor below which no state may go. The Fourteenth Amendment guarantees due process and equal protection in every state, and the Bill of Rights, applied to the states, protects speech, religion and the rest. Interstate competition operates above that floor. Nobody argues that Mississippi may compete by offering to suspend the First Amendment. The argument is that within the space the Constitution leaves open, states should be free to differ.

Two, the evidence for a general race to the bottom is weaker than the theory. Delaware shows the dispute: investors are not fools, and they pay for good governance. States that skimp on roads, courts and schools find it harder to attract the very employers they want. A state with a rotten court system or filthy water does not win the race; it loses the workers. Consider also that many states compete on quality, offering strong universities, good highways and trained workforces.

Three, the biggest problem with the "bottom" story is who gets to define "bottom." A national agency that sets one rule for fifty states is a single point of failure. If it is wrong, it is wrong everywhere. When fifty states try different approaches, a bad idea hurts one state and teaches forty-nine.

There is one more fair worry that I'd grant: competition can turn into bidding for favours. When a state offers a single company a package of tax breaks, subsidies and promises to locate a plant, that isn't free competition among rules. It's a deal for a favoured firm, and it often costs taxpayers more than it returns. The conservative answer is to compete on general rules, such as low and predictable taxes, fair courts and sensible licensing, and not on special deals. A state that gets that right does not need to hand out prizes.

The right to leave

One more piece of the picture. The whole system depends on the right to move, and the Supreme Court has protected it. In Saenz v. Roe in 1999, the Court struck down a California law that limited new residents' welfare benefits to what they would have received in their previous state, holding that the right to travel includes the right of a newcomer to be treated like other citizens of the state. A state may not punish people for crossing its border. That protection is why the "vote with your feet" idea is not a metaphor but a legal right.

It is also a reason for humility. If you run a state, you cannot take your voters for granted. And if you live in one, you have a power that a citizen of a unitary country does not have. Use it, and use the next one, the vote, too.

What this means for the rest of the library

Competition is the machinery behind a lot of what is covered on this site. Three Towns, Three Rule Books and the Case for Letting States Differ shows how three communities handle the same problem differently. Subsidiarity Is the Old Idea Behind Keeping Power as Close to Home as Possible gives the philosophy. And Why Your State Cannot Print Money the Way Washington Does explains the hard budget limit that makes the competition real, because a state that overspends cannot simply create dollars. For the licensing side, see You Need the Government's Permission to Braid Hair? Licensing Gone Wild, where states that cut red tape compete for workers.

The bottom line

• States compete for residents and firms because moving across a state line is cheap and legal. That competition is a discipline no national agency can match.
• Delaware's corporate law, South Dakota's credit and trust laws, and Wyoming's low-tax model and 1977 LLC statute are real examples of states winning by offering something better.
• The race-to-the-bottom objection has force on questions of basic rights, which the Constitution handles with a national floor, but it is weaker on ordinary policy, where investors, workers and employers punish bad governance.
• Prefer general rules to special deals. A state that offers everybody low, predictable taxes and fair courts beats a state that bribes one company.
• Ask your own legislature a plain question: what are we doing to keep the family next door from moving to the next state over? If the answer is "nothing," you have found your project.