this paper we test for strategic interaction among U.S. states in the determination of tax rates on capital income. We find that states have a positively sloped reaction function to the tax policies of rival states when tax rates are chosen simultaneously. We also identify that a state’s size has a positive effect on local tax rates. A large literature in public economics is devoted to the study of competition among governments. The problem is interesting because competition among public agents—governments—differs importantly from many aspects of what we know about competition among private agents—consumers or firms—both in terms of equilibrium allocations and welfare outcomes. Underlying this problem are the effects of competition on governments ’ behavior and its normative implications, in particular how it affects the size of governments and the allocation of public funds for the provision of public goods. Examples of competition in tax policies among governments include the following: competition for mobile capital, or tax competition; competition for mobile shoppers, or commodity tax competition; and competition for mobile firms. These examples are characterized by the mobility of the tax base in response to tax differentials among jurisdictions. In the presence of this phenomenon, a state government’s choice of tax instruments is crucial for the determination of stable sources of revenues. Competition among governmental bodies can also take many forms. For example, it can be horizontal: among states within a federation, among independent countries, or among regions within an economic union. It can also be vertical: between local and state governments or between state and federal governments. As motivation for the empirical analysis, we focus on the literature on tax competition, reviewed recently by Wilson (1999). In this framework, governments determine tax rates on capital. The Rubén Hernández-Murillo is an economist at the Federal Reserve