Redistribution, production inefficiency and decentralized efficiency

This paper analyzes the role of production distortion in income redistribution in an international trade model. In particular, it examines the role of the Stolper and Samuelson effect on efficient income redistribution. It first shows that production inefficiency can be part of a Pareto-efficient tax system for a small country when there is an asymmetric information problem between the government and individuals. Second, the paper shows that such production inefficiency is not only Pareto-improving for a small country, but is also essential in achieving worldwide tax-constrained Pareto-efficient allocation. These two results suggest important implications for commercial policies. The original version of this paper was circulated in 1996 as No. 391 of the Discussion Paper Series of Research Seminars in International Economics at the University of Michigan (http://www.fordschool.umich.edu/rsie/workingpapers/wp.html), with the title “Tariffs and production subsidies as devices to relax the incentive problem of a progressive income tax system”. Since the distribution of the working paper version, this paper has been cited and used in several papers, such as Guesnerie (2001) and Spector (2001). I hope that this updated version of the paper is useful for researchers.