Trade, Inequality and Distribution-neutral Fiscal Policy

Publication Date01 May 2019
AuthorSugata Marjit,Suryaprakash Mishra,Lei Yang,Sandip Sarkar
01_FTR831797.indd Article
Trade, Inequality and
Foreign Trade Review
54(2) 61–74, 2019
©2019 Indian Institute of
Foreign Trade
Fiscal Policy
Reprints and permissions:
DOI: 10.1177/0015732519831797
Sugata Marjit1,2,3
Suryaprakash Mishra4
Sandip Sarkar5
Lei Yang6
Gains from trade and inequality do not feature prominently in trade theory. The
standard criterion of Pareto efficiency indicates nothing about inequality when
applied to the redistribution of gains from trade. Yet, trade-induced inequality
has become a talking point and extremely contentious issue worldwide. In a
Heckscher–Ohlin–Samuelson (HOS) model of trade, we consider tax-transfer
policies that do not decrease the absolute income of any group, as suggested by
the standard Pareto rule and keep the pre-trade degree of inequality between
skilled and unskilled workers unchanged. Such a fiscal policy exists and is inde-
pendent of whether the tax is progressive or proportional. We show that the
aggregate gain in real income due to trade can be distributed to make every-
one better off without increasing inequality. A generalization of the basic result
shows that any Pareto efficient allocation can be transformed into a distribution-
neutral allocation through appropriate fiscal policy.
JEL Codes: F11, J31, D63, H20, H23
Trade model, inequality, Pareto efficiency, distribution-neutral fiscal policy
1 CTRPFP, Centre for Studies in Social Sciences Calcutta (CSSSC), Kolkata, West Bengal, India.
2 GEP, University of Nottingham, Nottingham, UK.
3 CESIfo, München, Germany.
4 National Law University, Delhi, New Delhi, India.
5 Xavier University, Bhubaneswar, Odisha, India.
6 Hong Kong Polytechnic University, Kowloon, Hong Kong.
Corresponding author:
Sugata Marjit, Centre for Studies in Social Sciences Calcutta (CSSSC), R–1, Baishnabghata Patuli
Township, Kolkata, West Bengal 700094, India.

Foreign Trade Review 54(2)
The recent decision by the UK to leave the European Union (EU) marks a rare
event in the history of economic thought. This is the first formal vote of no-confi-
dence against the policy of free trade in goods, services and factors. A majority of
Londoners voted to remain in the EU while many industrial workers and low-
skill, less educated citizens voted to leave. Many have interpreted this as a deci-
sion against rising inequality within the UK caused by deteriorations in the labour
market and social provisions resulting from immigration from the poorer European
countries. This article assesses how Brexit has enriched our understanding of the
standard trade and welfare theories and to what extent inequality has become a
pivotal theoretical issue in such matters.
Certain facts need to be stated at the outset. That free trade always leads to
gains for everyone is an incorrect proposition. Economic theory argues that free
trade leads to an increase in the aggregate real income for countries engaging in
trade only under ideal conditions. If the government does not intervene, then some
will lose. Those who fare worse under trade include the current producers of
goods and services that will be imported and sold at lower prices and workers
whose jobs are being outsourced. Workers who face competition in the labour
market because of immigration, legal and illegal, from Eastern Europe or from
ISIS-controlled Syria will suffer. Additionally, the British health system has a
heavier burden because of blanket social coverage and because the UK must
donate a fraction of its GDP to the EU treasury. The natural question is whether
the aggregate gains from trade from integration between the EU and the UK are
enough to compensate every group for their loss and still generate a surplus for
the nation. The literature on international trade describes this as a process where
the ‘gainers bribe the losers’. The state must design a compensation mechanism
that guarantees that everyone remains at least at their pre-trade welfare level.
Such a mechanism implies that the state will tax the gainers and transfer enough
to compensate the losers. If no one is worse off and some are betteroff, society
will be better off. This is a welfare criterion suggested by Pareto known as the
Pareto criterion.
Although Pareto’s initial interest was in matters of inequality, his criterion,
which is followed with devotion in the academic profession, does not mention
inequality of any sort. However, inequality has become the culprit behind the anti-
globalization movement. The fact that some have gained substantially since
Britain entered the EU while others are stuck with what they used to have means
that not everyone feels that they are as well off as before because relative concerns
are important at the individual level. Supporters of the Pareto criterion might
argue that no one is worse off, but those in the lower branch of the distribution
ladder would be concerned as they ask themselves why others are doing so much
better than they are. This raises a fundamental question regarding the perception
of social inequality at the individual level.
Civilized human beings may not like rising inequality in society independently
of whether they are personally affected by such a process. To ensure that the

Marjit et al. 63
degree of inequality is kept unchanged, we need a stronger rule for individual hap-
piness. Everyone must be provided with enough so that no individual will be
concerned about inequality, that is, the relative position of everyone must remain
unchanged and society should gain in aggregate. Many allocations that change the
distribution will disturb one or the other. We ask the following question: does
trade promise enough gains to maintain the degree of inequality of the initial dis-
tribution and to provide more to everyone? This article uses the well-known
Heckscher–Ohlin–Samuelson (HOS) model of international trade at an elemen-
tary level to argue that this is always feasible.
Because trade increases the aggregate real income of the trading nation, we can
redistribute income in such a way that everyone gets at least the same level of
income as before and some get higher incomes. The issue of Pareto-improving
transfers of aggregate gains from trade has been discussed by Dixit and Norman
(1986) and Kemp and Wan (1986). However, this does not necessarily guarantee
that relative income also remains the same; the degree of inequality might be
disturbed. Technically speaking, the Lorenz curve or the Gini index may change.
Someone who feels that the job is done once the Pareto principle is satisfied might
be mistaken because some people will not like if their relative incomes fall. In this
article, we provide a concrete example of such an allocation by appealing to a
textbook model of international trade.
Free trade under ideal conditions generates overall gains from trade, increasing
the real national income. This is a standard proposition in international trade.
However, there are distributional consequences: some gain and some lose. The
general proposition is that the gainers can bribe the losers. Political authorities
should be able to generate compensation mechanisms to help the losers. As aggre-
gate real income increases relative to autarky, potentially everyone can be made
better off. Thus, free trade benefits all in the sense that even those who do not gain
by trade can be compensated by the state if necessary. This is as much as trade
theory can tell us.
International trade theory does not suggest anything to address rising inequal-
ity after trade. If trade increases wage inequality between the skilled and the
unskilled workers,...

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