Labour Taxation and Foreign Direct Investment

This paper analyzes the implications of effective taxation of labor for profits and, hence, the location decision of a multinational enterprise. We set up a stylized partial equilibrium model and, presuming that worker effort is a function of net wages, assume that a higher employee-borne tax burden reduces effort. In turn, this raises a firm’s production costs and reduces efficiency. Accordingly, we show that a higher employee-borne income tax negatively influences a multinational’s profit by reducing manager effort. Furthermore, we compile data on personal income tax profiles for 49 economies and the year 2002. We decompose tax profiles into the component borne by employers and that borne by employees. We then determine effective tax rates for employees across four centiles of the distribution of gross wages: 33, 100, 167, and 500 percent of the average, following the OECD’s Taxing Wages Approach. Apart from describing features of the personal income tax data, we use them to shed light on their role for bilateral foreign direct investment (FDI) stocks among the economies considered. Not surprisingly, personal income tax rates turn out relatively less important than profit tax rates for bilateral FDI stocks. The employee-borne part of labor taxes determines bilateral FDI significantly different from zero: both a higher employee-borne tax rate on average wages and, in particular, an increase in the progression from the average wage to five times the average wage is less conducive to headquarters location and, hence, reduces a country’s bilateral outward FDI stocks.