Free Trade, Immigration & Income Inequality

I have pointed out before that the increase in inequality is probably exaggerated, and that the primary cause of the real increase is probably inflationary policies and to a much lesser extent the top marginal tax reductions.

This however doesn't necessarily mean that there couldn't be other partial explanations as well. Two explanations that are often suggested is free trade and immigration. I will now analyze them both in the same post since most of the analysis is similar and as they both involve interaction with foreigners and as they both (assuming that government intervention hasn't subverted incentives) will increase aggregate income of both the native born and foreigners, while hurting some groups.

But just how are they supposed to increase inequality? Well, there are three possible ways:

1) By increasing wage inequality.
2) By increasing profits relative to labor income. As the rich tend to own a much higher percentage of shares, this will increase inequality.
3) By moving poor people from poor countries to rich countries.

The third is obviously only applicable to immigration. It doesn't mean that the poor people become poorer (indeed, they almost always increase their income by moving to rich countries), but since they are now included in the inequality statistics of rich countries, it does increase inequality as long as their income is significantly below average in their new country). Note also that this is the only way in which the arrival of unemployed immigrants will increase inequality. The below analysis of the effects of factor 1 and 2 from immigration is only applicable to employed immigrants.

Starting with the effects of free trade on inequality, it should be noted that the effects on factor 1, wage inequality, depends on exactly which goods and services are traded.

The key thing to remember is first of all that the higher the extent certain (net) imported goods are purchased by the poor, free trade will reduce inequality-and vice versa for the extent to which the rich purchase it. And secondly, that the higher the extent certain (net) imported goods are produced by low wage workers, free trade will increase inequality-and vice versa to the extent to which the rich produce it.

As far as I know, no evidence exists that any income class are under- or over-represented when it comes to either production or consumption of net imported or net exported goods in general. There are sectors with net imported tradable goods where workers have low wages, and where consumers might have high incomes, such as production of expensive clothes where free trade likely increased income inequality, but that is probably not that common. In other sectors, where workers are better paid and/or consumers poorer, free trade will have a more ambigious effect on wage inequality, or even reduce it.

As for the effect on profits relative to labor income, there exists no good reason to believe that free trade alters it. Some opponents of free trade argues that because free trade allows capitalists to move production offshore, this will improve the capitalist's bargaining power and so increase profits at the expense of labor income.

But while it is true that free trade increases the ability of domestic capitalists to threaten workers with moving production to other countries this doesn't mean that it will increase the profit share for two reasons. That is because first of all, free trade will also increase the ability of foreign capitalists to start production here, improving the bargaining power of workers. And secondly, because the inflow of foreign goods will create a downward pressure on the margins of domestic capitalists when trying to sell their products to domestic workers.

All in all, the theoretical analysis shows that free trade in general doesn't increase inequality. While free trade in a few goods (such as production of expensive clothes) have that effect, free trade in most other goods have either an ambiguous effect or the opposite effect.

With regard to immigration, the effect on wage inequality depends on what country you're talking about and which immigrants they accept. Countries that only accept highly skilled immigrants probably reduce wage inequality, as their arrival will lower the relative wages of high earners and thus raise the relative wages of people with low wages, unless (this is probably rare) the buyers of those services are similarly relative high income.

However, in countries where employed immigrants disproportionately work in sectors with low pay, immigration will increase wage inequality, unless (again probably rare) the buyers of these services are similarly low income.

In the case of immigration, there are stronger reasons to believe that employer's bargaining power compared to workers is increased. That is because just as in the case of free trade, domestic employers will increase their ability to substitute from domestic to foreign workers.

But unlike in free trade, there is no mechanism apart from lower wages which will make it more profitable for foreign capitalists to enter. Competition from foreign producers in the sense of producers in foreign countries is by definition inapplicable here. A smaller effect to the extent that immigrants who can't find normal jobs try to create new companies could however create this effect on competition to some extent.

All in all, immigration still likely improve the bargaining positions of employers.

With regard to skilled immigrants, the effect on inequality is therefore ambiguous, with lower wage inequality counteracting an improved bargaining position of employers.

With regard to low skilled immigrants, the effect is clearly to increase inequality as it not only increase wage inequality but also improves the bargaining ability of employers and moves poor people from poor to rich countries.

So, in conclusion, low skilled immigration as well as free trade in certain goods will increase inequality. Highly skilled immigration and free trade in most goods have a more ambiguous effect on inequality, while free trade in some goods will decrease inequality.