15 September 2020

Trade, Education, and Income Inequality

New trade relations can aggravate income inequality in a country. Less educated workers are not mobile enough to move to the more lucrative commercial sector in the short term. A high standard of education and long-term trade relations reduce this income inequality.

Key Issue

Non-gravity trade is the exchange of goods and services that is not determined by standard variables of a gravity equation – most importantly, following Tinbergen (1962), the distance between countries and their economic mass. In the spirit of this definition, we construct measures of bilateral non-gravity trade between the United States and 154 countries. An interesting stylized fact is that non-gravity trade displays much more volatility than gravity trade: the within-country variance of non‑gravity trade is about one order of magnitude larger than the within-country variance of gravity trade.

Approach and Methodology

Our contribution to the trade literature is threefold. First, we introduce the concept of non-gravity trade. Analogous to the literature on total factor productivity, non‑gravity trade is computed as a residual. Our second contribution is to show that the distinction between gravity trade and non-gravity trade matters. We focus on the impact this distinction has on a particular outcome: income inequality. Third, we link the literature on international trade and income distribution with the literature on education and labor mobility. We show that education has a significant effect on the relationship between non-gravity trade and income inequality.

Key Findings and Conclusions

Our model relates income inequality to trade, education, and the interaction between the two. The model’s estimates show that in countries where only a small share of the population is educated, an increase in non-gravity trade is associated with a significant increase in income inequality. As education of the population increases, the positive correlation between non-gravity trade and income inequality becomes smaller. There is no significant relationship between non-gravity trade and income inequality in countries that are on the forefront of education.

There is an important difference between gravity and non-gravity trade with regard to the impact of these variables on income inequality. The effect of trade due to gravity forces – i.e., gravity trade − is statistically insignificant and quantitatively small. Regardless of education, gravity trade has no significant effect on income inequality.