Transfers, Trade Taxes, and Endogenous Capital Flows: With Evidence from Sub-Saharan Africa

Sub-Saharan Africa (SSA) is highly dependent on imported capital goods that are used in the import competing industrialized sector. The exporting sector focuses on primary products where land and labor are predominantly used. We build a two-good general equilibrium model, where the import competing sector uses imported capital input. Transfers induce changes in commodity terms of trade, which in turn affects capital inflows and the price of imported capital. The welfare effect of transfers is considered in the context of induced changes in these variables. In the context of an exogenous export tax, we find that endogenous capital flows aggravate the transfer problem that exists under trade taxation. When trade liberalization is tied to transfers, we find that the tying of aid may worsen or alleviate the transfer problem, depending on how the existing export tax compares with the optimum. We complement our theoretical analysis with an empirical analysis of the transfer problem in the context of endogenous capital inflows. This is done by estimating a regression model with fixed effects for a panel of 14 countries in SSA. Our findings substantiate the concerns raised by the theoretical analysis.