Although patterns of tree species distributions along environmental gradients have been amply documented in tropical forests, mechanisms causing these patterns are seldom known. Efforts to evaluate proposed mechanisms have been hampered by a lack of comparative data on species' reactions to relevant axes of environmental variation. Here we show that differential drought sensitivity shapes plant distributions in tropical forests at both regional and local scales. Our analyses are based on experimental field assessments of drought sensitivity of 48 species of trees and shrubs, and on their local and regional distributions within a network of 122 inventory sites spanning a rainfall gradient across the Isthmus of Panama. Our results suggest that niche differentiation with respect to soil water availability is a direct determinant of both local- and regional-scale distributions of tropical trees. Changes in soil moisture availability caused by global climate change and forest fragmentation are therefore likely to alter tropical species distributions, community composition and diversity.