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Optimal Redistribution in an Open Economy

  • Oleg Itskhoki

    (Harvard University)

Conventional wisdom suggests that the optimal policy response to rising income inequality is greater redistribution via higher marginal tax rates and more progressive tax schedules. In this paper we study an economy in which trade is associated with a costly entry into the foreign market, so that only the most productive agents can profitably participate in foreign trade. In this model, trade integration simultaneously leads to rising income inequality and a more sensitive efficiency margin of taxation, both driven by the extensive margin of trade. As a result, the optimal policy response may be to reduce the marginal taxes, thereby further increasing inequality. In order to reap most of the welfare gains from trade, countries may need to accept increasing income inequality.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 967.

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Date of creation: 2009
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Handle: RePEc:red:sed009:967
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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