Does Trade Increase Inequality when Skills are Endogenous?

The paper explores the role of government policies in a situation where the wage gap between high‐skilled and low‐skilled workers is widening owing to increasing foreign competition in low‐skilled intensive goods. A two‐period, three‐sector general‐equilibrium model of a small open economy is developed in which individuals choose whether to invest in skills or not. The government influences individual decision‐making through its tax system. The paper shows that increasing import competition or lowering taxes on skilled workers widens inequality when the skill distribution is exogenous (the direct effect), but often the opposite occurs through the indirect effect, that is through the additional incentive to become skilled. Numerical results indicate that there exists a nonmonotonic relationship between the terms of trade and inequality. The indirect effect tends to dominate the direct effect when import competition is intense, and vice versa.