Abstract
How does a redistribution of trade gains affect welfare when income inequality matters? To answer this question, we extend the [1] model to unionized labor markets and heterogeneous workers. As redistribution schemes, we consider unemployment benefits that are financed either by a wage tax, a payroll tax or a profit tax. Assuming that welfare declines in income inequality, we find that welfare increases up to a maximum in the case of wage tax funding, while welfare declines weakly (sharply) if a profit tax (payroll tax) is implemented. These effects are caused by the wage tax neutrality (due to union wage setting) and by a profit tax-induced decline in long-term unemployment. As a result, the government’s optimal redistribution scheme is to finance unemployment benefits by a wage tax.
Highlights
How does the redistribution of trade gains affect welfare when income inequality matters? To answer this question, we set up a general equilibrium model with heterogeneous firms and monopolistic competition in the goods market as done by [1]
We extend this approach by worker heterogeneity and unionized labor markets in order to analyze how these empirically-relevant features affect the performances of the redistribution policy
This is in strong contrast to the corresponding literature, where income inequality is neglected and the government can only choose a redistribution scheme to minimize the welfare loss for an ex ante-defined level of compensation
Summary
Empirical evidence suggests that trade gains are not distributed over the economy and that some groups are even worse off. To ensure political support for international integration, it is argued that the government should redistribute income towards those individuals who are harmed by trade liberalization (see [5,6] for this line of reasoning). Only UB affect welfare by a decline in income per capita (because unions set higher wages, which causes the unemployment rate to rise) and (as intended) by a decline in income inequality. Since the former is modest for relatively low values of UB, we find a positive effect on welfare. The average productivity of firms declines, implying that employment and income per capita decrease This effect is strong enough to cause welfare to decline, but because of the reduced long-term unemployment, this decline is relatively weak. The decline in welfare is stronger compared to the profit tax case
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