Tariffs and Production Subsidies as Devices to Relax the Incentive Problem of a Progressive Income Tax System.

This paper shows that tariffs and production subsidies can Pareto-improve welfare in a small open economy when a government is concerned with income redistribution under asymmetric information. In international trade theory, free trade is optimal if the government can use lump-sum taxes and transfers. However, in reality the government cannot use the lump-sum taxes and trabsfers due to asymmetric information between the government and individuals. In this case the government needs to use a progressive incomem tax system for income redistribution. This paper shows that in such a situation even if the goverment use Pareto-optimal progressive income tax system used free trade, tariffs can Pareto-improve welfare.