Mobile capital, optimal tariff, and tariff war

Abstract

INTRODUCTION"Trade war" has become a hot topic in the media recently. Challenging conventional wisdom, we revisit the characteristics of optimal tariffs and tariff wars by introducing capital as a production factor. We find that, when capital is freely mobile, smaller countries apply higher tariff rates and can be better off under tariff wars than under zero tariffs-small countries may win tariff wars. 1 Even if capital import taxes are available, small countries may win tariff wars, although larger countries can apply higher tariff rates.Since Bickerdike (1906), the optimal tariff theory with strategic interdependence has been developed and extended in various ways. Starting with the seminal paper by Johnson (1953Johnson ( -1954, a number of researchers have examined the relationship among country size, optimal tariffs, and the welfare consequences of tariff wars (e.g.