Trade Liberalization and Endogenous Growth in a Small Open Economy: A Quantitative Assessment

This paper develops a numerical endogenous growth model approximating an infinite horizon which allows us to investigate the relationship between trade liberalization and economic growth. Although economic theory generally implies that trade liberalization will enhance economic growth, and these phenomena are positively correlated in empirical tests, the connection is not well substantiated in numerical general equilibrium models based on neoclassical assumptions. In our model, an intermediate input affects aggregate output through a Dixit-Stiglitz function. Additional varieties provide the engine of growth in this framework, and the existence of this mechanism magnifies the welfare cost of tax distortions. In this model with lump sum revenue replacement, reducing a tariff from 20% to 10% produces a welfare increase (in terms of Hicksian equivalent variation over the infinite horizon) of 10.7 percent of the present value of consumption in our central model. We investigated the sensitivity of our results to all of the key parameters in the model and found that the welfare estimates for the same tariff cuts ranged up to 37 percent with capital flows, and down to 4.7 percent with inefficient replacement taxes. Larger tariff cuts, which have characterized the experience of many developing countries in the past 30 years, resulted in estimates of the welfare gains that were at least proportionate to the size of the cut. We applied the model to five developing countries and estimated the impact of the tariff changes which they plan to undertake as part of their Uruguay Round commitments. Our estimated gains are large in relation to the literature estimates of the impact of the Uruguay Round. While our results clearly support the paradigm that trade liberalization leads to significant income increases, but they also illustrate the crucial importance of complementary reforms to fully realize the potential gains from the trade reform. Notably, with the ability to access international capital markets, the gains are more than doubled. Moreover, use of inefficient replacement taxes will significantly reduce the gains. These combined results show that complementary macroeconomic, regulatory, and financial market reforms to allow capital flows and efficient alternate tax collection are crucial to realize the large gains.