On the Distributional Effects of Trade Policy: A Macroeconomic Perspective

This paper develops a theoretical model to explore the relationship between openness to trade and long-term income inequality. Empirical evidence on the issue is mixed, though greater inequality is often cited as a possible cost of trade liberalization. To quantify the effect of liberalization on inequality I calibrate a two-sector (agriculture and non-agriculture) open-economy macroeconomic model to the Mexican economy. Agents in the model are subject to idiosyncratic, uninsurable labor income risk, and precautionary saving generates endogenous distributions of wealth and income. When preferences are characterized by subsistence floor for food consumption, trade liberalization implies large welfare gains for low wealth agents. At the same time, liberalization increases long-run wealth and income inequality. After liberalization land-owners are worse off since the price of land falls along with the relative price of the agricultural commodity. When tariff revenue must be replaced by an alternative instrument, higher labor taxes are preferred to higher taxes on consumption or capital