How does a redistribution of trade gains affect welfare when income inequality matters? To answer this question, we extend the  model to unionized labor markets and heterogeneous workers. As redistribution schemes, we consider unemployment benefits that are financed either by a wage tax, a payroll tax or a profit tax. Assuming that welfare declines in income inequality, we find that welfare increases up to a maximum in the case of wage tax funding, while welfare declines weakly (sharply) if a profit tax (payroll tax) is implemented. These effects are caused by the wage tax neutrality (due to union wage setting) and by a profit tax-induced decline in long-term unemployment. As a result, the government's optimal redistribution scheme is to finance unemployment benefits by a wage tax.
trade liberalization redistribution income inequality heterogeneity trade unions