Working Paper: NBER ID: w24784
Authors: Spencer G. Lyon; Michael E. Waugh
Abstract: Should a nation's tax system become more progressive as it opens to trade? Does opening to trade change the benefits of a progressive tax system? We answer these question within a standard incomplete markets model with frictional labor markets and Ricardian trade. Consistent with empirical evidence, adverse shocks to comparative advantage lead to labor income losses for import-competition-exposed workers; with incomplete markets, these workers are imperfectly insured and experience welfare losses. A progressive tax system is valuable, as it substitutes for imperfect insurance and redistributes the gains from trade. However, it also reduces the incentives for labor to reallocate away from comparatively disadvantaged locations. We find that optimal progressivity should increase with openness to trade with a ten percentage point increase in openness necessitating a five percentage point increase in marginal tax rates for those at the top of the income distribution.
Keywords: progressive taxation; trade; social insurance; welfare losses; income distribution
JEL Codes: E1; F11; H21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse shocks to comparative advantage (F69) | labor income losses for import-competition-exposed workers (F66) |
| increased openness to trade (F19) | optimal progressivity of the tax system increases (H21) |
| increased openness (O36) | uninsurable income risk increases (G52) |
| increased uninsurable income risk (G52) | need for social insurance increases (H55) |
| increased openness (O36) | welfare gains from optimal tax policy increases (H21) |
| progressive tax system (H29) | welfare gains larger than flat tax system (D69) |
| increased openness (O36) | benefits of social insurance increase (H55) |
| increased openness (O36) | costs of redistribution change (H23) |
| optimal tax progressivity increases with increased trade exposure (H21) | progressive tax system becomes systematically more beneficial (H29) |
| no cases of tariff being welfare-improving (D69) | recommendation of zero tariff and more progressive tax system as optimal policy (H21) |