Who is afraid of capital mobility? On taxation of labor income and the level of public services in an open economy

This paper deals with the effects of international capital mobility on the taxation of labor income and on the size of the public sector. It employs a model of the labor market where national trade unions set the wage level i n their country and national governments set the tax rate of a proportional labor-income tax. The tax revenues are used to finance a public good and u nemployment benefits. In this model, competition between the national trade unions caused by international capital mobility leads to full employment, and the governments supply the public good on the first best level. As no u nemployment benefits have to be financed, the tax on labor income may decli ne with the introduction of capital mobility. These tax cuts may even overc ompensate the unions for the wage decline.