Inequality, Redistribution and Optimal Trade Policy: A Public Finance Approach

Abstract

In this paper, we explore the relationship between optimal trade and redistributive policies when the gains from trade are unequally distributed. We use a competitive trade model with input-output linkages where trade affects relative wages and the reallocation of workers across various sectors is frictional. We study how income taxes and trade policies should be designed in order to balance the efficiency gains from trade with the costs associated with the resulting increased inequality. We show that for a large class of global production structures, the global trade of goods and services must be undistorted even when personal taxes are incomplete. In other words, barriers to trade such as tariffs are never optimal. In contrast, producer taxes in the form of value-added taxes (VAT) that are differentially levied on different sectors play a crucial role in redistributing the gains from trade. We provide formulas that highlight the main determinants of optimal VAT and non-linear income taxes. Finally, in a quantitative version of our model, we study the optimal response to the rise of China in international trade. Our quantitative analysis establishes that differential VAT taxes play the main role of redistributing the gains from trade, while income taxes do not.