Playing by the new subsidy rules: capital subsidies as substitutes for sectoral subsidies

In a small, open economy characterized by an increasing-returns sector and foreignowned capital, a sector-specific instrument generally is needed to achieve the optimum. A capital subsidy alone can be used for decentralization, however, when the optimal production plan is specialization in the externality-generating activity. The effect of a capital subsidy on home income and its distribution depends on the pattern of production and the share of domestic capital that is foreign owned. In a diversified economy, a subsidy benefits capital owners, harms labor and raises national income only if foreign capital ownership is sufficiently small. In a specialized economy, a subsidy may raise national income even if all domestic capital is foreign owned and, if it does, both labor and capital owners gain. Thus, a capital subsidy may be an attractive replacement for sector-specific subsidies proscribed by international agreements.