Do VAT cuts help stabilize employment? Evidence from China’s VAT rate reform

Abstract

This paper develops a simple model to study the influence of China’s value-added tax (VAT) rate reform on employment. The model delivers important information about how monopoly and unskilled labor enhances the substitution of non-labor factors for labor. Taking China’s VAT rate reform as a quasi-natural experiment, this paper examines the model’s predictions with a difference-in-differences (DID) approach. The results suggest that China’s VAT rate reform has a negative employment effect and that the decrease in the relative price of non-labor inputs to labor serves as an important channel through which non-labor factors squeeze labor out. Reducing the degree of market monopoly and improving the skill level of labor can effectively mitigate the adverse impact of the reform on employment.