Trade Can Worsen Income Inequality

Economists show that international trade can worsen income inequality

MIT economists studying individual income data in Ecuador found that international trade generates income gains that are about 7% higher for those at the 90th income percentile, compared to those at the median income. , and up to 11% higher for the top income percentile. Credit: MIT News

Using Ecuador as a case study, economists show that international trade widens the income gap in different countries.

International trade intensifies domestic income inequality, at least under certain circumstances, according to a new empirical study that two[{” attribute=””>MIT economists helped co-author.

The research, focusing on Ecuador as a case study, digs into individual-level income data while examining in close detail the connections between Ecuador’s economy and international trade. The study finds that trade generates income gains that are about 7 percent greater for those at the 90th income percentile, compared to those of median income, and up to 11 percent greater for the top percentile of income in Ecuador.

“Earnings inequality is higher in Ecuador than it would be in the absence of trade.”

“Trade in Ecuador tends to be something that is good for the richest, relative to the middle class,” says Dave Donaldson, a professor in the MIT Department of Economics and co-author of a published paper detailing the findings. “It’s pretty neutral in terms of the middle class relative to the poorest. The [largest benefits] are found both among those who have created businesses and among those who are well off and work as employees. So it’s both a labor effect and a capital effect at the top.

The study also identifies the dynamics that generate this result. Ecuadorian exports, mostly commodities and raw materials, tend to help the middle class or less well-off, while the country’s import business generally helps the already well-off – and overall, import has a greater effect.

“There is a horse race between the export channel and the import channel,” explains Arnaud Costinot, also a professor in the economics department at MIT and co-author of the article. “At the end of the day, what is quantitatively most important in the data, in the case of Ecuador, is the import channel.”

The article, “Imports, exports and income inequality: measures of exposure and estimates of incidence”, appears online in the Economics Quarterly Review. The authors are Rodrigo Adao, associate professor at the University[{” attribute=””>University of Chicago Booth School of Business; Paul Carillo, a professor of economics and international affairs at George Washington University; Costinot, who is also associate head of MIT’s Department of Economics; Donaldson; and Dina Pomeranz, an assistant professor of economics at the University of Zurich.

Commodities out, machinery in

The effect of international trade on a nation’s income distribution is hard to pinpoint. Economists cannot, after all, devise a country-size experiment and study the same nation, both with and without trade involvement, to see if differences emerge.

As an alternate strategy, the scholars developed an unusually detailed reconstruction of trade-related economic activity in Ecuador. For the period from 2009 to 2015, they examined revenue from 1.5 million firms with a tax ID, and income for 2.9 million founders and employees of those firms. The scholars collected revenue data, payments to labor, and divided up individual income data according to three levels of education (ending before high school, high school graduates, and college graduates) across all 24 provinces in Ecuador.

Digging further, the research team compiled customs records, VAT (Value-Added Tax) data on purchases, and domestic firm-to-firm trade data, to develop a broad and detailed picture of the value of imports and exports, as well as business transactions that occurred domestically but were related to international trade.

Overall, oil accounted for 54 percent of Ecuador’s exports in the period from 2009 to 2011, followed by fruits (11 percent), seafood products (10 percent), and flowers (4 percent). But Ecuador’s imports are mostly manufactured products, including machinery (21 percent of imports), chemicals (14 percent), and vehicles (13 percent).

This composition of imports and exports — commodities out, manufactured goods in — turns out to be crucial to the relationship between trade and greater income inequality in Ecuador. Firms that employ well-educated, better-paid individuals also tend to be the ones benefitting from trade more because it allows their firms to buy manufactured goods more cheaply and flourish, in turn bolstering demand for more extensively educated workers.

“It’s all about whether trade increases demand for your services,” Costinot says.

“The thing that is happening in Ecuador is that the richest individuals tend to be employed by firms that directly import a lot, or tend to be employed by firms that are buying a lot of goods from other Ecuadorian firms that import a lot. Getting access to these imported inputs lowers their costs and increases demand for the services of their workers.”

For this reason, ultimately, “earnings inequality is higher in Ecuador than it would be in the absence of trade,” as the paper states.

Reconsidering trade ideas

As Costinot and Donaldson observe, this core finding runs counter what some portions of established trade theory would expect. For instance, some earlier theories would anticipate that opening up Ecuador to trade would bolster the country’s relatively larger portion of lower-skilled workers.

“It’s not what a standard theory would have predicted,” Costinot says. “A standard theory would be one where [because] Ecuador has [a] relatively rare, compared to a country like the United States, of skilled workers, not unskilled workers, as Ecuador turns to trade, low-skilled workers are expected to benefit relatively the most. We found the opposite.

Moreover, Donaldson notes, some trade theories incorporate the idea of ​​“perfect substitution,” whereby similar goods will be traded between countries – with resulting level wages. But not in Ecuador, at least.

“It’s the idea that you could have one country making one good and other countries making the same good, and a ‘perfect substitution’ between the countries would create a lot of pressure to equalize wages in the two countries,” says Donaldson. “Because they both manufacture the same good in the same way, they cannot pay their workers differently.” However, he adds, while “the first thinkers [economists] I didn’t think that was literally true, it’s always a matter of how strong that force is. Our results suggest that the strength is quite weak.

Costinot and Donaldson recognize that their study must take into account various complexities. For example, they note, about half of Ecuador’s economy is informal and cannot be measured using official records. Additionally, global “shocks” can affect business models in any given country at any given time – something they test and incorporate in the current study.

And while business patterns may also change more gradually, data from 2009-2015 is stable enough to suggest that researchers have identified a clear and continuing trend in Ecuador.

“People don’t change jobs very often and the income distribution doesn’t change much,” Donaldson says. “We made sure to check that – in the sample, the stability is very high.”

A global model?

The study also naturally raises the question of whether similar results could be found in other countries. In the article, the authors list many other countries to which their methods could be applied.

“Ecuador is certainly very different from the United States, but it is not very different from many middle-income countries that mainly export commodities in exchange for manufactured goods,” Costinot says. Donaldson, for his part, is already working on a similar project in Chile.

“This model of participation [in global trade] is important, and exporting can be very different from country to country,” says Donaldson. “But that would be very easy to find out, if you just found the data.”

Reference: “Imports, Exports, and Earnings Inequality: Measures of Exposure and Estimates of Incidence” by Rodrigo Adão, Paul Carrillo, Arnaud Costinot, Dave Donaldson and Dina Pomeranz, March 2, 2022, The Quarterly Journal of Economics.
DOI: 10.1093/qje/qjac012

Research support was provided, in part, by the US National Science Foundation, the Center for Economic Policy Research, the UK Department for International Development and the European Research Council.

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