When Do Open Borders Make Economic Sense?

Kellogg finance professor Sergio Rebelo found this inconsistency in attitudes perplexing. After all, today, developed countries like the U.S. “have technologies that allow people to be much more productive than in the developing world,” he explains. Therefore, free immigration could ostensibly provide immigrants a higher standard of living while offering developed nations higher returns on capital and land, which would compensate for any decline in wages. “So why wouldn’t you want to bring in immigrants from the developing world, in what seems to be a win–win situation for the country as a whole?” asks Rebelo.

One possible answer involves the government services and benefits available to citizens, or what social scientists call the “welfare state.” In 1977, Nobel laureate Milton Friedman noted that although America had an open immigration policy until the 1880s, such a policy could never be reinstated in the modern era. What had changed, Friedman surmised, was that public services had ballooned since the days of free immigration. “If you have a welfare state in which every native is promised … a minimum level of subsistence regardless of whether he works or not,” Friedman argued, then free immigration would not be possible. The United States would be flooded by low-skilled immigrants from all over the world, straining the government’s resources and forcing it to levy additional taxes to compensate.

Thus, Friedman argued, a country could either choose to have a generous welfare state or to open its borders to immigration, but not both.

But is this trade-off as unavoidable as Friedman suspected? In a recent study, Rebelo, with coauthors João Guerreiro, a PhD student at Northwestern, and Pedro Teles of Portugal’s Católica-Lisbon School of Business & Economics, set out to rigorously examine the relationship between immigration and taxation.

The researchers’ findings suggest that Friedman’s intuition about immigration was spot-on—and that distinguishing between high- and low-skilled immigration can have important consequences.

Studying the optimal immigration policy from the narrow perspective of the citizens of a given country, they find that free immigration is optimal only when the government can levy different taxes on citizens and immigrants. Otherwise, policymakers interested only in the welfare of their citizens will, indeed, constrain certain kinds of immigration.

“I think Friedman put his finger on this issue,” Rebelo says.

Modeling the Costs and Benefits of Immigration

To study the optimal immigration policy, Rebelo and colleagues developed a model economy with both high- and low-skilled citizens who permanently live and work in the country.

In the model, the well-being of citizens depends on how much they work and consume, as well as on the level of “public goods”—government-provided services such as “national defense, public lighting, fire protection services, and roads,” Rebelo explains.

The government seeks to maximize the average citizen’s well-being. Because some citizens are lower-skilled, and therefore earn lower wages, maximizing average well-being requires the use of taxes and transfers (such as welfare programs or tax credits) to redistribute income from high- to low-skilled workers.

In addition to citizens, there’s “a large pool of potential immigrants standing ready to enter the country,” Rebelo says. Immigrants who enter the country get full access to the public goods provided by the government. This assumption is based on reality: while there are exceptions (undocumented immigrants cannot access programs like food stamps or Social Security, for instance), Rebelo notes that most immigrants do benefit from public goods such as roads, schools, and hospitals.

Another key assumption built into their model is that the government is interested only in the well-being of its current citizens and has no regard for the well-being of potential immigrants.

“It’s a cold-hearted, uncaring assumption that does not reflect how we feel,” Rebelo admits. “But we think that this assumption is likely to describe how decisions about immigration policy are made in the real world. Politicians represent the interests of people who already live in the country and vote in elections, not the interests of foreigners who could potentially immigrate.”

How Does Immigration Affect a Country’s Economy?

The researchers first consider a scenario where the government can perfectly distinguish between low- and high-skilled workers, and between immigrants and citizens. In addition, the government can charge different “lump-sum” taxes to different groups.

In this simple scenario, the researchers find, an open-border immigration policy maximizes the well-being of the average citizen. The government would simply charge immigrants a lump-sum tax to offset the added cost of the public goods they consume. In essence, the government keeps its redistribution and immigration policies separate: it sets up the welfare state to redistribute income among its citizens, while charging all immigrants an “admission fee” to pay for the additional public goods they use.

However, this simple policy is difficult to implement in practice. Not only would a government need to collect accurate information about worker skills, but it would also need to levy lump-sum taxes that do not depend on income or consumption. “These taxes are unpopular from a political standpoint,” Rebelo says. “Margaret Thatcher famously lost her last election in part because she proposed introducing a lump-sum tax.”

What’s more, real-world governments cannot perfectly distinguish high- and low-skilled workers. So any attempt to levy taxes based on skill levels would likely encourage high-skilled workers to pretend that their skill is low to reduce the tax they owe. “You are giving high-skill people the incentive to say, ‘Well, I may look like an engineer but I’m really just in charge of cleaning the equipment,” says Rebelo.

A more realistic scenario is one in which the government cannot perfectly distinguish between the skill levels of citizens and levies the same income tax schedule on all citizens. Under this scenario, the ideal immigration policy depends on whether or not the government can use different income tax codes for citizens and immigrants.

If they can levy different taxes, the researchers find, the optimal policy is still to have open borders.

The logic: immigrants would again pay an “admission fee” to compensate for the cost of the public goods they use. But increasing the supply of workers in an economy reduces wages—specifically, when low-skilled immigrants enter the country, they drive down wages for low-skilled citizens, leading to greater inequality. To account for this effect, the “admission fee” is lower for high-skilled immigrants than for low-skilled immigrants. This policy therefore encourages more high-skilled immigration, which will lower the wage gap between high- and low-skilled workers, and reduce income inequality.

On the other hand, if the tax code is the same for citizens and immigrants, the government can no longer deter low-skilled immigrants through a tax. Instead, the optimal immigration policy is now to ban low-skilled immigration while opening the borders to high-skilled workers. In this scenario, the influx of high-skilled workers boosts production while reducing income inequality between citizens.

Making Sense of Real Immigration Policy

The researchers’ models rely on several simplifying assumptions. Still, Rebelo says, these simple models provide a window into the logic that drives real-world immigration policies.

For example, the final scenario hews closely to how Scandinavian countries operate. “Those countries are well-known for having generous income-redistribution systems,” Rebelo says. “They welcome high-skill immigration. But at the same time, they generally ban the immigration of low-skill workers who would obviously benefit from the generous welfare state.”

Of course, optimizing citizens’ economic well-being is just one way of thinking about immigration policy. But Rebelo and colleagues argue that real governments do tend to prioritize their constituents’ economic prosperity over that of others.

“We think that our assumptions are a better description of reality than assuming that, for example, politicians in Sweden are maximizing the welfare of citizens elsewhere in the world,” Rebelo says. “We think that’s unlikely to be the case.”