Smoothing the Adjustment to Trade Liberalisation. WWWforEurope Working Paper No. 61

We use a dynamic general equilibrium trade model with comparative advantage, heterogeneous firms, heterogeneous workers and endogenous firm entry to analyse economic policy to compensate the losers of trade liberalisation and to reduce the ensuing wage inequality. We consider several instruments of economic policy: a wage tax to redistribute income between skilled and unskilled workers; sector-specific consumption taxes and profit taxes to affect inter-sectoral wage inequality; sector-specific firm entry subsidies, worker sector-migration subsidies and training subsidies to speed up the adjustment process. We find that the re-distributional and efficiency effects of these instruments differ very much. Probably the most potent tool to reduce the wage inequality after trade liberalisation is training subsidies. Although the policy also generates inefficiencies because too many workers are trained, the costs of these inefficiencies are relatively low.