Trade, Foreign Investment, and Industrial Policy for Developing Countries 4041

investors, which means abandoning policy neutrality. Our goal in this chapter is to
explore the popular but controversial idea that developing countries benefit from aban-
doning policy neutrality vis-a-vis trade, FDI and resource allocation across industries.
Policy neutrality does not necessarily mean free trade, or a neutral stance regarding
taxation of multinational corporations, or even a common tax structure for all indus-
tries. Both optimal tax theory and practical fiscal considerations imply that countries
(especially poor ones) will often want to rely on tariffs as a source of revenue or set dif-
ferent tax rates across industries. Are developing countries justified in imposing tariffs,
subsidies, and tax breaks that imply distortions beyond the ones associated with optimal
taxes or revenue constraints? We refer to this set of government interventions as
“industrial policy.”
The presence of externalities is the main theoretical justification for deviating from
policy neutrality. Learning externalities from exports could justify export subsidies;
knowledge spillovers from foreign companies could justify tax breaks for FDI; produc-
tion externalities in “advanced” sectors could justify infant-industry protection or other
measures to expand those industries. We begin this review in Section 2 with a series of
simple models to highlight the role of Marshallian and interindustry externalities,
industry-level rents, sector-specific coordination failures and information spillovers as
a rationale for industrial policy (“IP”).
The main message that emerges from this review is that the theoretical justification for
infant-industry protection requires at a minimum either that the country have a latent
comparative advantage in the protected industry or that the international price for this
industry is higher than warranted by the true opportunity cost of this good in the rest
of the world. Moreover, for protection to deliver large gains, the protected industry must
exhibit large Marshallian externalities. In contrast to the temporary trade barriers
associated with infant-industry protection, permanent protection of a sector may raise
welfare if it generates positive externalities to other sectors. In all these models, however,
other policies may be more efficient than protection. Even when protection could
improve welfare, a production subsidy would be more efficient since it avoids the tempo-
rary consumption losses associated with protection. In addition, protection may not work
if the market failure is due to sector-specific coordination problems, since tariff-induced
growth does not necessarily help to solve coordination failures. Finally, just as R&D sub-
sidies can address the externalities arising from innovation spillovers, policies to promote
entry into new industries can address information spillovers associated with the discovery
of new profitable activities.
While government intervention could address a number of market failures in theory,
one key question is whether IP has been successful in practice. The theoretical discussion
is followed by a review of the empirical literature on industrial policy in Section 3.
One challenge that we face in evaluating the empirical literature is the large gap between