Impact of Trade on Inequality: New Evidence of What, When, and Where

Abstract

The relationship between trade and inequality is complex, and the existing literature concludes that the impacts of trade on inequality are ambiguous. This article addresses this ambiguity and presents robust evidence that the effects of trade on inequality depend on economic development, when it occurred in recent decades, and their various measures. It proposes a novel identification strategy to solve for endogeneity problem in the literature by using trade as predicted by a gravity equation as an instrument for actual trade. It estimates the effect of both trade policies and trade volumes on inequality measured both before and after taxes and transfers. This article takes advantage of large and long panel data by conducting cross-examinations by economic development and economic history. The results show that international trade exacerbates inequality in the pre-taxes, but the effects disappear after taxes and transfers are adjusted; thus, it supports the compensation hypothesis. It increases inequality in rich economies while reducing it in poor economies, which confirms the standard Stolper and Samuelson theorem. Post-1991 trade experience was inequality increasing but pre-1991 trade was inequality decreasing; however, trade opening by reducing regulations, taxes, and tariffs was always inequality increasing. (JEL codes: D63, P33, and F63)