Do countries compensate firms for international wage differentials?

• In competition for FDI, countries tend to compensate firms for wage differentials.
• We use the breakdown of communism in eastern Europe as a natural experiment.
• Labor cost differentials are shown to have a strong impact on statutory tax rates.

We address the role of labor cost differentials for national tax policies. Modeling a tax competition race between two countries competing for a population of mobile firms, we show that in equilibrium, the high-wage country charges a lower tax than the low-wage country. Moreover, under tax competition the high-wage country attracts more firms than in a setting without taxation. Exploiting exogenous variation in labor cost differentials induced by the breakdown of communism in eastern Europe, we find that tax policies are in line with the model prediction. Our most conservative estimates suggest that a one dollar increase in the compensation cost differential (in prices as of 2000) triggers a cut of the statutory corporate income tax rate by about one percentage point.