Playing by the new subsidy rules: Capital subsidies as substitutes for sectoral subsidies

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Abstract

In a small, open economy characterized by an increasing-returns sector and foreign-owned capital, a sector-specific instrument generally is needed to achieve the optimum. A capital subsidy alone can be used for decentralization, however, when the optimal production plan is specialization in the externality-generating activity. The effect of a capital subsidy on home income and its distribution depends on the pattern of production and the share of domestic capital that is foreign owned. In a diversified economy, a subsidy benefits capital owners, harms labor and raises national income only if foreign capital ownership is sufficiently small. In a specialized economy, a subsidy may raise national income even if all domestic capital is foreign owned and, if it does, both labor and capital owners gain. Thus, a capital subsidy may be an attractive replacement for sector-specific subsidies proscribed by international agreements.

Original languageEnglish (US)
Pages (from-to)463-482
Number of pages20
JournalJournal of International Economics
Volume43
Issue number3-4
DOIs
StatePublished - Nov 1 1997

Keywords

  • Capital mobility
  • Factor subsidies
  • Increasing returns

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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