The present paper develops a two-sector, specific factor general equilibrium framework for analyzing endogenous skill formation in a dynamic set-up and examining the consequence of a public subsidy policy on education on the skilled-unskilled wage inequality in a small open economy. It shows that given the technologies of production the policy produces a favorable impact on the wage inequality only in one of the two periods while producing an adverse consequence in the other. If the wage income inequality improves (deteriorates) in period 1 it worsens (ameliorates) in period 2 under the same sufficient conditions. The results are found to be more or less valid even in the presence of unemployment of unskilled labour. Finally, some composite policy recommendations have been suggested so that the relative wages always move in favor of the poorer section of the working population. © 2017 Elsevier Inc.