Revisiting the Cost of Protectionism: The Role of Tax Distortions in the Labor Market

Abstract

Most studies of the welfare impacts of trade policy have ignored interactions between restrictive trade policies and pre-existing distortions from the income tax. This paper adds an income tax and consumer labor/leisure decision to a specific factors trade model in order to examine the effects of such interactions. The paper demonstrates that when these interactions are taken into account, the potential gains or losses from tariffs, import quotas, or voluntary export restrictions are significantly magnified. However, as long as the trade barrier doesn?t lead to a net increase in rents for domestic households, the optimal level of the trade barrier is unchanged from the first-best case.

Trade policies which do increase domestic rents, either in the form of quota rents or rents to fixed factors in production, suffer an additional efficiency cost, and the optimal policy in this case is less strict than in the first-best case. Conversely, trade policies which lead to a net decrese in domestic rents have a lower cost, and so the optimal policy is more strict.

These results are distinctly different from results of recent studies of second-best effects in other fields, most notably in environmental regulation, where only the costs and not the benefits of regulation are magnified by interactions with the tax system.

JEL Classification: F10, H21