Labor market frictions, capital, taxes and employment

This paper studies the role of the tax on mobile capital in labor markets with matching frictions and the effects of such frictions on inefficiency of capital taxation. Firms acquire capital and create vacancies, and workers apply for firms. Due to matching frictions, vacancies may not be filled, and workers may not be employed. Firms’ investment in capital, wages and market tightness are determined in a way that a firm’s profit and a worker’s utility are jointly maximized. In addition, the return to capital net of the tax is equalized across jurisdictions, as capital moves between jurisdictions. An increase in the capital tax of a jurisdiction alters firms’ capital investment, wages and market tightness of the jurisdiction. In particular, it decreases employment and wages of the jurisdiction, providing an explanation for why policymakers of a jurisdiction provide incentives such as tax cuts for mobile capital. More capital increases the wages only when workers are employed and hence have higher incomes, decreasing the benefit of more capital for risk-averse workers and reducing the incentives of a jurisdiction to lower the tax and attract capital. The equilibrium capital tax thus may be too low or too high relative to the efficient level, and capital is taxed even with the head tax.