Optimal Tariffs with FDI: The Evidence

Abstract

Recent theoretical work suggests that the presence of foreign direct investment (FDI) lowers a country’s noncooperative Nash tariff. To test this hypothesis, we first adapt the theoretical model formulated by Blanchard (2010) to derive an intuitive, empirically testable equation. This equation is an augmentation of the standard formula equal to the inverse of export supply elasticity. Using constructed estimates of export supply elasticities and measures of FDI, we test this hypothesis with respect to tariffs set by China prior to 2001. We focus on China before its accession into the World Trade Organization (WTO) for two primary reasons: first, China is a recipient of FDI during this time; and second, prior to becoming a WTO member China can be seen as a player in a noncooperative game. We find evidence to suggest that before entering the WTO, China chooses lower tariffs, ceteris paribus, for industries that receive more FDI. This is an important result since having a better understanding of how countries act unilaterally will provide insight into the multilateral cooperative outcome; that is trade negotiations.Foreign direct investment; Optimal tariffs