The Impact of Optimal Tariffs and Taxes on Agglomeration

The zero-profit condition implies that in equilibrium revenues equal costs.
This condition fixes each firms output to x = σw, while each firm employs
(σ - 1)w unskilled employees and one skilled employee.

Nominal regional income Y consists of three components, wage income of
the unskilled and skilled workers as well as government income G:

Y = 1 + Lw + G.                     (4)

Government income can be separated further in tariff revenues G_I from im-
ported varieties and tax revenues GA from agricultural consumption. Tariff
revenues can be derived by determining the import demand from the utility
(1), using the producer price of p = 1 as well as trade costs τ . Since govern-
ment receives the share T_I of the value of imported varieties, tariff revenues
are given by

Gi = Ti (1 -L)_r^θ=- P ^σ-1γY                 (5)

1 - T_I

with Θ defined in (3). Agricultural tax revenues are easier to determine
since government receives the share T_A of regional expenditure for agricul-
tural goods, namely GA = TA (1 - γ)Y. Combining tax and tariff revenues
government income is given by:

G = [t∣(1 - Z   ^θ P'    + Ta(1 - γ)1 Y            (6)

1 - T_i

Since government income G depends on nominal income Y and vice versa
according to (4), both equations can be solved simultaneously for Y and G
to yield:

1                 1-T

Y = T (¹ + Lw), G = —T— (¹ + Lw),

(7)

with T = 1 - Ti (I - L)-^θ- P ^σ-1γ - Ta(1 - Y ).

1 - Ti

The parameter (1/T) denotes the factor by which nominal income is increased
by tariffs and taxes.

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