The Impact of Trade Liberalization on Income Inequality: Does the Direction of Trade Matter?

Abstract

Recent trends in inequality have raised concerns among researchers and policymakers globally. The role of globalization, one of the leading forces driving this trend, continues to be intensely debated in academic and policy circles. Invoking standard trade theory, this paper analyses whether and the extent to which trade liberalization has contributed to the recent trends in inequality. The approach and findings of the paper are novel: previous studies of trade liberalization’s impact on inequality do not explicitly control the direction of trade. The empirical results show that trade liberalization is associated with decreasing income inequality overall, but contingent on the direction of trade, it has opposing effects: North–North and South–South trade are inequality-reducing while North–South trade is inequality-increasing. Simply put, liberalizing trade between countries of similar developmental levels does not raise inequality. This paper affirms, using recent data, that trade with developing countries raises inequality in developed countries. Additionally, it finds that North–South trade (particularly imports from high-income to low-income countries) may also raise inequality in developing countries, contrary to Heckscher–Ohlin–Stolper–Samuelson model predictions. Skill-biased technical change, a consequence of trade liberalization between North and South, is the main mechanism driving inequality increases in developing countries.