Trade, Foreign Investment, and Industrial Policy for Developing Countries 4063

Ramaswami, 1963) suggests that a government’s objectives can be met more efficiently
using instruments other than tariffs, and that when these instruments target the distor-
tion at the source, a tariff of zero maximizes welfare for a small economy. Unless there
are specific distortions or externalities associated with trade, the most efficient policy
instrument to conduct industrial policy is not likely to be tariffs. In a recent review
on the fiscal implications of trade reform, Pelzman and Shoham (2006) point out that
“in the theoretical public finance literature it is well established that an optimal policy
for a small open economy is to reduce tariffs to zero and raise consumption taxes (see
Diamond-Mirrlees, 1971; Dixit, 1985), thus maintaining production efficiency” (p. 9).
In practice, however, there are several reasons why countries have continued to use
tariffs to promote domestic industry. The most direct policy instruments are frequently
not available in countries with limited abilities to collect income, consumption, or pro-
duction taxes. Anderson (1996) shows that in a budget constrained economy, where it
is difficult to compensate tariff cuts with increases in consumption or other taxes, tariff
reductions lead to a curtailment of government spending and a resulting under-provi-
sion of public goods, which lowers welfare. Irwin (2007) compares the deadweight
losses per dollar of revenue raised by tariffs with other forms of taxation in the United
States. He argues that although the deadweight losses (per dollar) for tariffs were high in
the nineteenth century, “import duties were probably much easier to collect and
enforce . . . than other modes of taxation” (p. 19). Irwin (2002) draws similar conclu-
sions for Argentina and Canada at that time. For the same reasons, it could be argued
that in some developing countries trade protection could be an effective policy tool to
implement IP. An important implication is that if fiscal considerations are the reason to
use trade protection rather than production subsidies, then clearly tariffs would be the
efficient policy and not quantitative restrictions.
In the rest of this section we review the empirical research on the effectiveness of
infant-industry protection. We begin by discussing case studies where protection was
clearly motivated by infant-industry considerations and then move on to other
approaches that exploit the cross-industry and cross-country variation in trade barriers
to see whether protection had the consequences predicted by infant-industry models.

3.1 Single-industry studies

There are very few detailed evaluations of infant-industry protection. Some important
papers that explicitly take into account learning effects include Baldwin and Krugman
(1986, 1989), Hansen, Jensen, and Madsen (2003), Head (1994), Irwin (2000), and
Luzio and Greenstein (1995). Baldwin and Krugman (1986) study protection to the
semiconductor industry in Japan. They use a simulation model to show that the
Japanese semiconductor industry in Japan could not have emerged as a global player
without the protected domestic market. Protection was needed to achieve the kinds
of economies of scale and learning effects that would allow the industry to move down