International Trade Responses to Labour Market Regulations

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This paper studies how differences in labor market regulations (“social standards”) shape countries' comparative advantage in services, using administrative data on cross-border supply of services within Europe from 2004 to 2020. I exploit exogenous variations in labor taxes and minimum wages faced by exporting firms engaged in a large trade program: the European posting policy. To avoid a “race to the bottom” in social standards, this EU policy required exporting firms to pay domestic minimum wages and labor taxes, and those prevailing rules vary across countries, sectors, and over time. Both reduced-form country case-studies and theory-consistent gravity estimation show evidence of large trade responses to higher labor standards, with an elasticity that is above one. On average, a 1% increase in exporting firms' labor cost through labor standards harmonization reduces bilateral trade flows in services by 1.2%. I show that the prevailing social standards rules in the EU posting policy increased support for international integration in rich countries, rationalizing the political economy of imposing domestic labor market regulations to foreign firms.