Employee Protection and the Tax Sensitivity of Wages: International Evidence

Abstract This study examines whether employment protection legislation (EPL) affects the tax sensitivity of wages in an international setting. Using data on staggered corporate income tax changes across 18 OECD countries and a difference-in-differences approach, we find that tax hikes have a negative effect but tax cuts have no significant effect on changes in average employee wages. Stringent EPL can reduce the tax burden shifted to employees when the tax rate rises, especially in firms domiciled in countries with weaker investor protection. However, the effects of stringent EPL are insignificant when the tax rate falls. Further analyses show that EPL has more significant effects on the tax sensitivity of wages for more profitable and smaller firms. Our empirical results support the theoretical prediction that when tax-induced rents are distributed among shareholders and employees, the latter benefit from an improved bargaining position through stringent employee protection.