How Do Firms Respond to Place-Based Tax Incentives?

In this paper, we evaluate the effects of payroll tax changes on firm behavior, by exploiting a unique policy setting in Norway, where a system of geographically differentiated payroll taxes was suddenly abolished due to an EU regulation. We find that firms are only partially able to shift the increased costs from higher payroll tax rates onto workers’ wages. Instead, firms respond to the tax increase primarily by reducing employment. The drop in employment following the tax reform is particularly pronounced in labor intensive firms—which experience a larger windfall loss due to the tax reform than non-labor intensive firms—and in multi-establishment firms—which respond to the payroll tax increase in part by reducing the number of establishments per firm. Overall, our findings point to liquidity effects whereby a sudden and largely unexpected payroll tax increase aggravates firms’ liquidity constraints, forcing them to cut employment to bring down costs.