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Do countries compensate firms for international wage differentials?

  • Ferdinand Mittermaier

    ()

    (University of Munich)

  • Johannes Rincke

    ()

    (University of Erlangen-Nuremberg)

We address the role of labor cost differentials for national tax policies. Using a simple theoretical framework with two countries competing for a mobile firm, we show that in a bidding race for FDI, it is optimal for governments to compensate firms for international labor cost differentials. Using panel data for western Europe, we then put the model prediction to an empirical test. Exploiting exogenous variation in labor cost differentials induced by the breakdown of communism in eastern Europe, we find strong support for the model prediction that countries with relatively high labor costs tend to set lower tax rates in order to attract mobile capital. Our key result is that an increase in the unit labor cost differential by one standard deviation decreases the statutory tax rate by 7.3 to 7.5 percentage points.

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File URL: http://ieb.ub.edu/aplicacio/fitxers/2010/12/Doc2010-54.pdf
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Paper provided by Institut d'Economia de Barcelona (IEB) in its series Working Papers with number 2010/54.

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Length: 36 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:ieb:wpaper:2010/12/doc2010-54
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