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Competition is good—but only when it encourages a “race to the top.” That’s true in business and among the states as well. Competition can encourage policy innovation.

For example, Pennsylvania carefully (but reasonably) regulates hydraulic fracturing, and it is reaping the benefits as companies create jobs by safely extracting oil and natural gas. Next door, New York won’t allow fracking, and its economy remains in the doldrums.

Yet such competition can also drive cronyism: When one state won’t pitch in direct financial incentives (i.e., bribes) for a pet project, perhaps another state will.

For example, longtime political operative Terry McAuliffe says he wants to produce an electric car the size of a golf cart. A few years ago, his company, GreenTech Automotive, opened a plant in Mississippi.

Why there, instead of his home state of Virginia? “You want this, you’ve got to offer incentives,” McAuliffe told Bloomberg in 2010. “I want to see legislation. That’s part of our negotiations.”

Virginia declined. “Bottom line, we have no reason at this point to believe there’s validity to the job creation numbers (or inferred project),” Elizabeth Povar, director of business development at the state’s Economic Development Partnership, wrote in an e-mail obtained by the Richmond Times-Dispatch.

Mississippi, on the other hand, agreed to pony up some $5 million in loans and grants. In return, McAuliffe’s company said it would generate 1,500 local jobs and produce 150,000 cars a year. Those expectations won’t be met this year; GreenTech vice president Marianne McInerney told The Washington Post this month that the company aims to produce 7,000 vehicles this year and employ roughly 450 people in Mississippi.

Tiny electric cars may—or may not—be the vehicles of the future. That’s not the point. The bottom line is that governments shouldn’t be using taxpayer dollars to push certain products or technologies.

Instead, states can and should compete to develop business-friendly climates while protecting their citizens. States should reform their tax codes, reduce red tape, and improve their tort systems.

For example, instead of handing out direct financial incentives, Mississippi could attract jobs by improving its legal and economic climate. Companies prefer to set up shop in states where they are confident they won’t be subjected to frivolous lawsuits. Yet the American Legislative Exchange Council’s survey Rich States, Poor States ranks the state’s liability system 48th out of 50. Improving its tort litigation system (as Texas has done) would encourage more businesses to set up shop in the Magnolia State.

When the federal government or the state governments act as venture capitalists, taxpayers lose. It’s a form of federalism—but the wrong kind.