Is Free Trade Optimal for a Small Open Economy with Tourism? Chi-Chur Chao *, Bharat R. Hazari +, Jean- Pierre Laffargue #, and Eden S. H. Yu + * Chinese University of Hong Kong, + City University of Hong Kong, # PSE-CNRS and CEPREMAP, Paris, France

 Small open economy, tariff lowers welfare Large open economy, optimal tariff > 0 First best: DRS = DRT = FRT Question: Would these results hold with tourism? Background

 Tourism is an important growth industry Tourism Receipts in Hong Kong International Tourism Receipts 2006 US billion $% of GDP RankCountryUS billion $RankCountryUS billion $ 1United States85.46UK33.5 2Spain51.17Germany32.8 3France46.38Australia17.8 4Italy38.19Turkey16.9 5China33.910Austria Japan8.5 Source: World Tourism Organization (UNWTO).

 (temporary) movement of consumers from one country to another to consume non- traded goods and services  this transforms non-traded goods into tradables  creating an additional tourism induced terms of trade effect  Two types of terms of trade Key Features

 Three sector, small open economy  Foreign tourists demand only the domestically produced non-traded goods  Two types of policies: Tariffs ( t ) Investment taxes ( τ ) Assumptions

 Effects of tariff: Tariff raises the importable good price  Substitution effect for non-traded  Price of the non-traded goods increases  Favorable terms of trade effect  Optimal tariff > 0 even for a small open economy  Additional Effect of Tariffs: Tariffs  Capital inflows may  immiserizing growth  Investment tax

 On tourism and trade Hazari and Sgro, Tourism Trade and National Welfare, Elsevier,  On capital flow Brecher and Diaz Alejandro, JIE,  On non-traded goods Komiya, IER, Makoto and Nugent, AER, Literature

Model with Tourism  Three Sectors  Production Functions GoodsPrices X, agriculture,Exportablenumeraire Y, manufacturing, importableImportablep ZNon-tradedq K = foreign capital inflow until L = unskilled labor S = skilled labor V = land r = domestic rate of return τ = investment tax

 Factor Rewards w = wage of unskilled labor s = wage of skilled labor r = rate of return on capital v = rate of return on land  Perfect Competitive Equilibrium (unit price = unit cost) (1) (2) (3)

 By envelop property  Equations (1) to (7) have 7 unkowns: w, s, r, v, X, Y, Z, for given p, q, K. = unit demand for unskilled labor in X (4) (5) (6) (7)

 Block recursive system: Eq. (1)  w Eq. (2), (5) and (6)  s, r and Y as functions of p and K Eq. (3) and (7)  v and Z as functions of q Eq. (4)  X as a function p, q and K.

 Revenue Function Envelope Property:

 Demand Side Domestic Demand (Expenditure Function) (Compensated demand) ( Y and Z are substitutes) Tourist Demand T = tourist expenditure - +

 Equilibrium Conditions Eq. (8) To (11) have 4 unknowns: u, M, K and q 2 policy variables: t and τ (8) (9) (10) (11) Domestic demand for Z Tourist demand for Z Supply of Z

Optimal Tariff and Investment Tax  Welfare Analysis From (8) : From (9) : From (10) : From (11) : (12) (15) (14) (13)

(given )  Welfare Effect of Tariffs only (for a fixed τ ) Solving (12) – (15) : where No tourism and When (16) Free trade is optimal

Setting du/dt = 0, if  Free trade is not optimal (See Figure 1a) (17)

t τ 0 Figure 1a

 Welfare Effect of Investment Taxes (for a fixed t ) when (See Figure 1b) (19) (20)

t τ 0 Figure 1b

 Jointly Optimal Tariffs and Investment Taxes Solving (17) and (20) : With tourism (See Figure 1c) (22) (23)

t τ 0 E Figure 1c

 Jointly Optimal Tariffs and Investment Taxes Solving (17) and (20) : With tourism (See Figure 1c) ↑shifts the schedule to the right  higher optimal t and τ. (See Figure 1d) (22) (23)

t τ 0 E Figure 1d E’E’

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