Tariffs and Capital Flows

This paper analytically explores how FDI are affected by Tariffs as President Trump has imposed retaliatory tariffs on countries which have trade surplus with US and declared this as a strategy to attract tariff jumping FDI into US.. Our motivational empirical results show that with greater trade-openness, historically, greater trade deficit led to larger FDI into US. So correcting deficits artificially by a tariff would actually adversely impact FDI flows into US. We then show that:(i) based on the long-run Heckscher-Ohlin [HOS] model where capital is mobile and FDI is an avenue whereby capital outflows could occur based on the rate of return, for US type economy, return to capital will fall as Wage will rise via Stolper-Samuelson effects while for exporting trade-surplus economies like China, the result would be opposite as labor-intensive goods are taxed by US tariff. As return to capital rises, capital will outflow from USA; (ii) However, alternatively, in a very short-run scenario where inter-country capital flows are not so fast (immobile) and not-easy for moving out but within-country perfectly mobile, the outcomes could be very different. With sector-specific capital in the exporting trade-surplus economy, return to capital might fall in both places and the result can go either way. Historically free trade created the trade deficit but return to capital in USA was higher and attracted FDI. Thus, tariff escalation might go either way, without having much to do with controlling trade surplus or deficit.