Optimal tariffs with FDI : the evidence

Recent theoretical work suggests that the presence of foreign direct investment
(FDI) lowers a country’s noncooperative Nash tariff. To test this hypothesis, we first
adapt the theoretical model formulated by Blanchard (2010) to derive an intuitive, empirically testable equation. This equation is an augmentation of the standard formula
equal to the inverse of export supply elasticity. Using constructed estimates of export supply elasticities and measures of FDI, we test this hypothesis with respect to tariffs set by China prior to 2001. We focus on China before its accession into the World
Trade Organization (WTO) for two primary reasons: first, China is a recipient of FDI
during this time; and second, prior to becoming a WTO member China can be seen as
a player in a noncooperative game. We find evidence to suggest that before entering
the WTO, China chooses lower tariffs, ceteris paribus, for industries that receive more
FDI. This is an important result since having a better understanding of how countries
act unilaterally will provide insight into the multilateral cooperative outcome; that is
trade negotiations.