Foreign labor costs and domestic employment: What are the spillovers?

This paper studies the international spillover effects of country-specific labor cost changes in the presence of labor market frictions. A two-country model with search frictions predicts that a cut in foreign labor costs leads to an increase in domestic employment, driven by a positive terms of trade effect on job creation. I find empirical evidence in support of this positive spillover effect, the terms of trade channel, and the dependence on the degree of labor market rigidity. This is done by a panel regression that estimates the effect of exogenous variation in foreign unit labor costs, instrumented by changes in foreign statutory social security contribution rates, on domestic employment and output.

► I analyze spillovers from foreign labor costs in a 2-country model with search frictions.
► A fall in foreign labor costs increases domestic employment and output.
► Magnitude of spillover depends positively on the degree of frictions.
► The implications for spillover are tested using a panel of OECD countries.
► Estimates, including 2SLS with statutory tax rates, confirm that spillovers are positive.