The Effect of Trade Openness on Income Inequality with the Role of Institutional Quality

Abstract

This study investigates the effect of trade openness on income inequality using the panel system generalised method of moments (GMM). The sample countries consist of 65 developed and developing countries and the time period covers from 1984 to 2012. This study also provides new evidence that sheds light on the role of institutional quality in influencing the effectof trade openness on income inequality. The empirical results reveal that trade openness tends to increase income inequality. In addition, the marginal effect also revealed that institutional quality has a corrective effect on the trade openness – income inequality nexus.

Trade Openness and Income Inequality: A Case of Southern African Development Community Countries†

“…Thus, the theoretical argument contradicts the empirical evidence (Goh and Law, 2019) that trade openness increases the diffusion of technology and the dissemination of new knowledge and ideas, which raises the returns to skilled labor and reduces demand for unskilled labor as economic sectors shy away from international market competition. As the World Trade Organization (WTO) continues to deter boundaries and discrimination amongst its trading partners, many economists, researchers, and analysts have been keen to examine the income inequality effects of trade openness.…”

“…The Heckscher- Ohlin (1935) and Stolper and Samuelson (1941) theories hypothesize that the trade results in an increase in the abundant factor's real wages and a decrease in the scarce factor's real wages. As a result, trade is always a compromise between profit and loss for some (Goh and Law, 2019). This implies that trade openness will reduce income inequality in developing countries and increase income inequality in developed countries, suggesting a significant trade-off between trade openness and income distribution.…”

“…Other studies (Dorn et al 2017;Hazama, 2017;Goh and Law, 2019) considered both developed and developing countries and used similar estimation techniques to analyze trade openness and income inequality. Yet, their results are different as some studies are in line with the Stolper-Samuelson theory and some are not.…”

“…At the same time, the fixed effects in Hazama (2017) indicate that trade openness referring to exports reduces income inequality in lower-income countries, yet the result is negligible for high-income countries between 1971 and 2012. However, Goh and Law (2019) considered both developed and developing countries from 1984 to 2012 and the GMM results indicate that trade openness exacerbates income inequality in 65 developed and developing economies. On the other hand, Goh and Law (2019) suggest that institutional quality is crucial for a favorable effect of trade openness on income inequality.…”

“…However, Goh and Law (2019) considered both developed and developing countries from 1984 to 2012 and the GMM results indicate that trade openness exacerbates income inequality in 65 developed and developing economies. On the other hand, Goh and Law (2019) suggest that institutional quality is crucial for a favorable effect of trade openness on income inequality. The inferences in Hazama (2017) corroborate with Dorn et al (2021), who claim that trade openness reduces income inequality in developing but worsens income inequality in developed economies between 1970 and 2014.…”