VAT Reform and Labor Cost Stickiness: Evidence from China

Rising labor costs have weakened product competitiveness and posed challenges to economic growth. We investigate the effects of a tax cut in alleviating labor cost stickiness by exploring China’s shift from a production-based to a consumption-based value-added tax (VAT) between 2004 and 2009. Using a multi-period DID model and data from Chinese A-share-listed firms for 2003 through 2011, we find that the VAT reform significantly reduced firms’ labor cost stickiness and increased their ability to manage employment adjustment costs by providing wage flexibility. The stickiness of labor costs declined most for firms characterized by labor-intensive operations, situated in more market-oriented areas, and with higher growth opportunities. Our findings show that VAT reform has had a real effect on firms by alleviating labor cost stickiness.