Welfare State, Market Imperfections, and International Trade

Within a two-sector-two-country model of trade with aggregate scale economies and unionisation, a move to a more generous welfare state in one country increases welfare in that country and can have positive spill-over effects on the other. Furthermore, synchronised expansions of social security are more welfare enhancing than unilateral ones. Our results counter the fears that a race to the bottom in social standards may result from the ‘shrinkingtax-base’ entailed by international capital mobility. While affecting trade patterns and income distribution, capital mobility interacts with welfare state policies in increasing welfare, even when capital flows out of the country that started the shock.