Tax Policy and Endogenous Factor Supply in a Small Open Economy

Abstract

Since a paper by Kemp and Jones [6], there have been few attempts at modeling the effects of variable factor supply in a simple trade model, with almost all papers confined to a two-good, two-factor, small-open-economy model. Papers were typically concerned with the effect of variable factor supply on the shape of the economy's production possibility set, and with the result derived in Kemp and Jones [6] that when one factor is endogenously supplied in a simple twogood, two-factor general equilibrium trade model, output supply functions may no longer be upward-sloping, as in Frenkel and Razin [5], and Martin [7; 8], for example. A more general treatment is given in Dixit and Norman [3] and Woodland [14], where in an m-good, n-factor general equilibrium trade model, it is assumed that a subset of the factors of production are endogenously supplied, but very few comparative statics experiments are explored. A recent paper by Mayer [9] synthesizes much of this earlier work in a two-good, two-factor general equilibrium model, and provides an initial attempt at modeling the employment effects of tariff changes. Since the existence of variable factor supply in even a very simple general equilibrium trade model has been shown to complicate the simplest comparative statics results, the literature has paid very little attention to the exploration of the effects of various tax policy changes on factor supply. As a result, an important channel of the effects of trade tax changes on equilibrium has been largely ignored, that being the effect of trade tax changes on factor market equilibrium, and the concomitant effects on equilibrium in the small open economy. The question of the effects of variable factor supply is also important given the obvious attention that policy-makers and various interest groups pay to the employment effects and industry output effects of trade and factor tax policy changes. Another important implication of the lack of attention paid to endogenous factor supply in international trade models is the inability of trade models to analyze the effects of taxes on factor supply. In the standard Heckscher-Ohlin trade model of a small open economy with an endowment of factors of production, factor taxes can have no real effects. The objective of this paper is to use the general equilibrium trade model with endogenous factor supply developed in Dixit and Norman [3] and Woodland [14] to illustrate the implications