Inequality, Redistribution and Optimal Trade Policy

Recent evidence, as illustrated by Autor et al. (2013) as well as Caliendo et al. (2015), suggests that international trade and global reallocation of production has contributed to domestic reallocation of labor and income inequality. In this paper, we explore the relationship between optimal trade and redistributive policies. In particular, in an environment where international trade affects the relative wages and the allocation of labor across various sectors, we study how taxes and tariffs should be designed in order to balance the efficiency gains from trade with the costs associated with the resulting increased inequality. To do so, we use a two-country Ricardian model of trade which can be thought of as a generalized version of the model developed by Caliendo et al. (2015). More specifically, each country is consisted of many competitive sectors. Workers choose their occupation modeled as a multinomial logit model and the intensity of their work effort in the chosen sector. Accordingly, the multinomial logit captures the idea that different workers have different costs and benefits of working in each sector and yet retains significant tractability in the framework. We assume that countries differ in their comparative advantages across different sectors as well the composition of their work force in terms of their cost of their sectoral choice. We are interested in government policies that are in the form of linear tariffs on imports and exports as well general income taxes. We solve the optimal taxation problem of the world in which all governments coordinate. This can be viewed, for example, as a binding international trade agreement that maximizes welfare of all individuals in all countries and aims at a comprehensive overhaul of tariffs and income taxes. We first show that if governments have access to sector-specific transfers, tax and transfers that depend on workers' sectors, then optimal tariff should be zero. This result is independent of the choice of utility function and social welfare function. Opening to trade, changes the distribution of wages across sectors and increases income inequality. If sector-specific transfers exist, they can be used to completely offset this effect on income without affecting the trade in goods. Hence, government can achieve its desired goal without tariffs. We next turn our attention to a more realistic setup in which governments do not have access to sector-specific transfers. We assume that fiscal policy instruments are incomplete to the extent that they only depend on income (and not other characteristics such as occupation, etc.). This features leads to existence of a deadweight loss from taxation which in turn depends on the distribution of wages in the economy. Since tariffs affect the distribution of wages, they can be efficiently used to lower the deadweight loss of taxation. As a result, optimal trade policy leads to non-zero tariffs even when countries can coordinate their policies. We use our framework characterizes the key determinants of optimal tariffs: comparative advantage, sectoral productivities, as well as the elasticity of sectoral choice in each country.