Fiscal Competition, Labor Mobility, and Unemployment

This paper provides an analytical framework to study fiscal competition between two countries when the strategic instrument is the payroll tax raised to finance unemployment benefits. Each country's production sector uses immobile skilled and mobile unskilled workers. Unemployment arises as a consequence of a minimum wage in the unskilled sector. It is shown that when the countries are symmetric, (i) fiscal competition leads to an underprovision of unemployment benefits and (ii) tax rates are strategic substitutes for sufficiently high values of the relative risk aversion parameter. Some numerical illustrations are presented for the case of asymmetric countries.