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Trade Liberalization and Foreign Direct Investment

Lisandro Abrego

CSGR Working Paper No. 26/99

April 1999


This paper quantifies the welfare impact of unilateral trade liberalization and computes the optimal tariff structure for Costa Rica in the presence of trade-policy-induced international capital flows and foreign capital taxation. For this, an applied general equilibrium model integrating trade, capital flows and international capital income taxation is used. The model has been calibrated to a 1990-91 data set for the economies of Costa Rica and a group of OECD countries. In the model, foreign capital income is taxed by host countries and the tax-credit system operates in foreign investors home countries. Results for Costa Rica show that complete trade liberalization ends up being welfare-reducing, as it leads to an outflow of capital and loss of tax revenue which more than offset the efficiency gains from an enhanced resource allocation. The optimal tariff structure for the Costa Rican economy turns out to be a mixture of import tariffs and subsidies, though of a relatively small level.


Keywords: Trade Liberalization, Foreign Direct Investment, International Capital Income Taxation, Foreign Tax Credits, Costa Rica.


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