Bhagwati and Ramaswami (1963) showed that if there is a distortion, the Paretian first-best policy is to intervene with a tax (subsidy) at the point at which the distortion occurs. Hence a domestic tax-cum-subsidy with respect to production would be first-best optimal when there was a domestic distortion (defined as the divergence between domestic prices and the marginal rate of transformation in domestic production) just as a tariff policy would be first-best optimal under monopoly power in trade (which involves a foreign distortion). An important corollary, for the case of a distortionary wage differential, is that while a tax-cum-subsidy policy with respect to factor use would be first-best optimal. the second-best optimal policy would be a domestic production tax-cum-subsidy rather than a tariff policy.
While these central results are valid, Kemp and Negishi (1969) have correctly argued that two subsidiary propositions of Bhagwati and Ramaswami (1963) are false. These are (1) that no tariff (export subsidy) may exist which is superior to free trade in the presence of a domestic dis-tortion, and (2) that no production tax-cum-subsidy may yield greater welfare than nonintervention when the nation has monopoly power.
We can demonstrate, however, that the Kemp-Negishi results are, in fact, special cases of the first of the following two theorems in the theory of second-best, which we shall prove.
Labor Economics | Law | Political Economy
Jagdish N. Bhagwati, V.K. Ramaswami & T.N. Srinivasan,
Domestic Distortions, Tariffs, and the Theory of Optimum Subsidy: Some Further Results,
J. Pol. Econ.
Available at: https://scholarship.law.columbia.edu/faculty_scholarship/4052