and Thierfelder (2002), who review the CGE literature on the effects of preferential liberalization and report that welfare gains in neoclassical models tend to be very modest. The results of Brown et al. (2004), even when only merchandise trade reform is considered, are considerably larger than the other estimates—again consistent with the observation of Robinson and Thierfelder (2002) that “new trade” features such as imperfect competition or liberalization of services tend to generate much larger improvements in welfare.

The main drawback of these studies is that even the most recent ones, with the exception of USITC (2004), rely on tariff data several years before the beginning of DR-CAFTA, and all but Bussolo and Niimi (2006) focus on Central America as a whole. This ignores important differences across countries, adds countries that are not DR-CAFTA members, and prevents differentiation between tariff reform within Central America and between Central American countries and the US. Furthermore, all of the above studies tend to focus on comparative static gains and do not address issues such as tariff reduction phase-in periods or capital accumulation over time. Finally, with the exception of Bussolo and Niimi (2006), who use a flexible direct tax rate to maintain a fixed fiscal deficit, it is not clear how the existing studies address the fiscal implications of lost tariff revenue. This paper addresses these drawbacks by focusing on Honduras, one of the smallest and poorest countries in Central America. The pattern of tariff cuts in this paper is designed to approximate the provisions of DR-CAFTA more closely than the studies that simply eliminate all import taxes on trade with the US, and the recursive dynamic nature of the model employed here allows for gradual phase-in of these tariff reductions. Furthermore, this paper provides a more realistic assessment of DR-CAFTA outcomes by explicitly juxtaposing tariff liberalization vis-`avis the United States with a more comprehensive DR-CAFTA reform (including all DR-CAFTA members) and unilateral liberalization with respect to all trading partners. Finally, the analysis in this paper goes beyond traditional gains from trade by incorporating elements of “deep integration,” which include increased inflows of FDI into Honduras and potential productivity spillovers from foreign-owned firms to the rest of the economy.

# **4 Honduras before DR-CAFTA**

## **4.1 Social Accounting Matrix**

The results of this paper are based on a 2004 social accounting matrix (SAM) for Honduras, which was created specifically for this exercise. The starting point for the detailed SAM is a macro-economic SAM, constructed from the national accounts, public expenditure, and balance of payment statistics.<sup>6</sup> The results of compiling these data are shown in Table 1. The row and column names denote, respectively, activities, commodities, factors, households, government, rest of the world, taxes, import tariffs, and saving-investment.

In order to disaggregate the macro-SAM in Table 1 into a detailed social accounting matrix, we draw on a number of data sources including a 1997 SAM for Honduras developed in Cuesta (2004), a 2004 Honduran household survey,<sup>7</sup> COMTRADE and TRAINS databases published by the UN, and a Central America regional SAM from GTAP.<sup>8</sup> The 1997 Honduras SAM includes 24 activities and 24 commodities, of which 7 are in agriculture, 2 in natural resources, 6 in manufacturing, and 9

> 6These are obtained from IMF _International Financial Statistics_ (IFS), _Government Financial Statistics_ (GFS), and _Balance of Payments Yearbook_ .

> 72004 Encuesta de Hogares de Prop ́ositos M ́ultiples, or EPHPM, published by the Instituto Nacional de Estad ́ıstica ( `http://www.ine-hn.org/` ).

> 8Documentation of the GTAP database is available on-line at `http://www.gtap.org` or in Dimaranan (2006).

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