Recently I commented on the fact that one thing missed in the debate over the Auckland supercity was the effect it would have on competition between cities. Over at Offsetting Behaviour Eric made the same point and expanded on the idea by noting that voice is nice, but the threat of exit is a more powerful check on local governments' activities. For the case of local government this was explained in the 1956 paper A Pure Theory of Local Expenditures by Charles M. Tiebout. In short, competition among jurisdictions for residents forces them to run their operations more efficiently; mobility across jurisdictions also allows matching between consumer preferences and government service bundles. So, if the rates in one of the local councils are getting steep relative to the services provided by the council, moving to the other side of town can help.
Now the same basic reasoning can be applied at a higher level of aggregation, that of the country. Competition for taxes, in a multiple state system, forces rulers to provide relatively more secure property rights. As a result, the states system encourages faster capital accumulation and growth. This is the idea that Cem Carayalcin uses to help explain the faster rate of economic growth in Europe compared to the rest of the world since around 1500.
Carayalcin's paper is Divided We Stand, United We Fall: The Hume-North-Jones Mechanism for the Rise of Europe, International Economic Review, Vol. 49, No. 3, August 2008, pp. 973-997, and the title stays much. The fact that Europe was divided and thus there was competition between states for tax actually helped it.
Carayalcin points out that the "great divergence" between Europe and the rest of the world occurred relatively recently - post around 1500. He then asks, What enabled Europe, with all its laggards, to dominate the previously successful Eastern economies? His article emphasizes one important mechanism, highlighting the contrast between the European states system and Eastern empires. Political competition for a mobile tax base in a states system forces rulers to expropriate less, to provide relatively more secure property rights and to provide relatively more public services to their footloose subjects. Rulers who do not face such competition would be more likely to choose higher expropriation rates relative to what they provide in return. By effectively limiting the "exit" options of the ruled, an empire rewards its ruler with a captive tax base that can be subjected to higher levels of expropriation. As a result, the states system encourages faster capital accumulation and growth.
Thus in the Carayalcin argument, as in the Tiebout model, the threat of exit, which is possible because of competition between states or cities, is a powerful check on a governments' activities, whether this be at the local or country level. Competition helps discipline a government's activities and thus helps induce the conditions necessary for growth.