Trade, Inequality and Distribution-neutral Fiscal Policy

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 independent 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 everyone 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.