How do states respond to federal fiscal shocks? In this paper we present a new mechanism of vertical fiscal externalities that induces heterogeneous effects across states. The case of natural resources allows exploiting the variation in states’ fiscal capacity to examine these heterogeneous effects. Consistent with previous studies, we find that increases in federal tax rates are contractionary for the average economy. However, they are mitigated, or even reversed in those states with high fiscal capacity. We offer a theory of inter-regional competition that rationalizes this finding: areas with high fiscal capacity make a relatively smaller increase in tax rates in response to a federal tax hike, which triggers a capital movement from low to high fiscal capacity states and, as a consequence, contributes to create an expansionary (contractionary) effect in the latter (former). We provide evidence for this mechanism by examining narrative-based federal tax shocks, and various state-level characteristics.