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Trade Liberalization, Capital Mobility, and Social Welfare

Priya Ranjan


Abstract

This paper constructs a theoretical model to study the implications of trade liberalization and increased capital mobility for social welfare. Social welfare is the sum of welfares of individual agents with unequal distribution of capital. The government uses a redistributive tax-transfer scheme to maximize social welfare. In addition, tax revenue is also used to undertake productivity enhancing investment. In this setting, it is shown that trade liberalization in a capital abundant country increases social welfare even though it increases inequality. The reason is that the government's ability to tax and use the proceeds to redistribute and undertake public investment is not compromised. However, globalization in the form of increased capital mobility has different effects. In particular, it could lower social welfare by reducing the ability of the government to tax. Taxation becomes costlier because of the possibility of capital flight. This not only constrains the government from making redistributive transfers but also reduces its ability to undertake productivity enhancing investment. An implication of the latter is that it creates a vicious circle whereby lower investments reduce the returns to domestic capital leading to increased capital flight reducing further the ability of the government to tax and undertake productivity enhancing investment. If the impetus for capital flight comes from a lower taxation abroad, the results are similar. A policy implication is coordination of taxes to prevent backlash against globalization. Alternatively, a cautious approach towards capital account liberalization may be warranted. Bottomline: when it comes to social welfare, not all facets of globalization are equal.

Using cross-country data the paper finds that capital account liberalization is associated with lower taxation. It also finds a decline in the share of public investment in total investment following capital account liberalization.