We develop a two-country model of tax competition in which governments attempt to attract more capital by adjusting the corporate income tax rate. We allow labor market imperfection and investigate how it relates to the intensity of tax competition. It is shown that in response to a symmetric increase in the labor market costs, capital becomes less sensitive to corporate income tax rates. When the labor market costs increase, firms’ profits drop more greatly in the foreign market than in the domestic market due to the existence of trade costs. Thus, firms become less concerned about the level of tax rates in the locational decision.