Many countries use tax competition tools to stimulate enterprises to improve innovation efficiency. Consequently, in China, does tax competition have an incentive effect on the improvement of enterprise innovation efficiency, and what is the existing mechanism? Considering the characteristics of industrial enterprises engaged in various innovative activities to achieve sustainable competitive advantage and taking the panel data of industrial enterprises in 31 provinces and regions of China from 2011–2018 as the research object, this paper empirically studies the influence of tax competition and its mechanism on the innovation efficiency of industrial enterprises. It is shown that excessive tax competition in China hinders the improvement of the innovation efficiency of industrial enterprises, in which capital flow plays a partially mediating role. Further research shows that after the implementation of an innovation-driven development strategy, the degree of tax competition in China was reduced, which alleviated the adverse impact of excessive tax competition on the innovation efficiency of industrial enterprises, and capital flow also reduced this negative effect. The results reflect the good effect of implementing an innovation-driven development strategy in China, and it also shows that excessive government intervention is not conducive to the effective allocation of market resources. Tax Competition is a double-edged sword; therefore, it is necessary to promote the innovation efficiency of industrial enterprises by combining promising government and an effective market. The conclusions are important for the appropriate shaping of fiscal policy.