Taxation of labour income and the skilled-unskilled wage inequality

•Tax on labour in agricultural sector increases skilled-unskilled wage inequality.•Tax on labour in industrial sector increases wage inequality if all goods are traded.•Tax on labour in intermediate good sector has the opposite effect.•When intermediate good is non-traded, a tax on labour decreases wage inequality.

Using a simple general equilibrium model of a small open economy that produces (i) an industrial good, (ii) an agricultural good, and (iii) a sector specific intermediate good, under competitive conditions, this paper examines the impact of a tax on labour on skilled-unskilled wage inequality. It is shown that, when all goods are traded, a tax on labour in the industrial sector increases skilled-unskilled wage inequality. On the other hand, a tax on labour in the intermediate good sector has the opposite effect. However, when the intermediate good is non-traded, the impact of a tax on labour in either of the two sectors is negative. Furthermore, irrespective of whether or not the intermediate good is traded, a tax on labour in the agricultural sector increases skilled-skilled wage inequality.