Optimal Tariffs and Income Taxes under Imperfect and Uncertain Foreign Investment

Abstract

International investment as well as international trade is now a wide phenomenon, and optimal policies to be selected in the presence of both international trade and investment have been a great concern. Jones [7] and Kemp [9] have done pioneering works in this area of study. Previous studies, however, have mostly postulated that international capital movements are perfect. While perfect capital mobility is expected in the long-run, Bhagwati and Brecher [2] and Brecher and Bhagwati [3] emphasized short-run sluggishness of foreign investment; that is, even in the presence of international differentials in rates of return to capital the amount of foreign capital existing in the host country is fixed in the short-run. A realistic case, however, will be between complete fixity and perfect mobility of foreign capital. This is especially true in the medium-run. In such a case the amount of foreign capital existing in a country at a particular future point in time may be reasonably conceived as uncertain to that country. Uncertainty may arise for various reasons. The case includes uncertainty about the level of the rate of return to capital in the world market, and also uncertainty about production technology employed by foreign investors. These cause amounts of foreign capital to be received by the host country uncertain to it even under perfect international capital mobility. Uncertainties in such a case are relevant when the host country government has a long-run perspective, and is concerned with the long-run consequences of its policies. This paper addresses the open question of levels of optimal policies to be chosen when foreign capital movements are uncertain as well as imperfect, and examines whether they modify or make intact the optimal policies established traditionally. Policies considered here are import tariff and income tax by the host country, since these are prevalent and have attracted much attention in the literature of international trade and investment.