How fiscal policies reduce labor force participation in open economies: evidence on the tax competition and compensation hypotheses

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University of Delaware
The competition hypothesis states that high capital mobility associated with market integration places downward pressures on capital tax and social expenditure while the compensation hypothesis asserts that market integration results in an expansion of social expenditures and higher taxes. I found evidence of their coexistence and interaction. The behavior of the tax policy reveals evidence supporting the tax competition hypothesis and social spending patterns exhibit evidence for the compensation hypothesis. I take a further step analyzing their impacts on the labor market. In line with theory, two fiscal responses are found to have negative impacts on the labor force participation rate. The impact from the compensative social expenditure is found to be stronger than that of the tax policy because it not only reduces the labor participation directly but also raises additional burden on the labor tax because market integration limits the government's choice of tax.