Trade Liberalization and the Great Labor Reallocation

What is the role of migration frictions in shaping the effects of trade policy? I address this question by analyzing the impact of tariff reductions on the spatial allocation of labor in China and how this impact depends on migration frictions that stem from China’s household registration system (hukou). I first provide reduced-form evidence that trade liberalization has induced significant spatial labor reallocation in China, with a stronger effect in regions with less hukou frictions. I show that the standard quantitative spatial models, by design, would imply that the gains from trade are largely irrelevant to factor market reforms. A more realistic calibration suggests that trade liberalization increases China’s welfare by 0.72%, a sizable share of which comes from mitigating the cost of domestic frictions: if China first abolishes the hukou system, the gains from tariff reductions decrease by 18%, and its negative distributional consequences are greatly amplified. In contrast, a standard spatial model suggests that hukou abolition increases the gains from tariff reductions by 2% and alleviates its negative distributional consequences.