26 product be equal to the international interest rate.” We consider policies that levy a differential income tax on the income from foreign capital, which implies that it is the after-tax marginal product that is equated to the international interest rate: (24) (it) AF, =r The marginal product of type 1 capital (foreign investment) will be higher the lower is the ratio of foreign to domestic capital. A higher tax on foreign investment will require a higher marginal product from foreign capital, and thus will imply a lower ratio of foreign to domestic capital in the long-run.

With endogenous investment, the growth rate of the economy will be given by:

# (25) g = (AF, (t)-6-p)o F,'< 0

Citizens in the economy will accumulate type 2 capital at a rate that depends on the marginal product of that capital. More foreign investment (because of lower taxes, for example) implies a higher marginal product of domestic capital, so it will imply a higher growth rate. (The ratio of foreign to domestic capital will be fixed in the long run by (24) and thus the two types of capital will grow at the same rate.) The theory thus makes a strong prediction: taxation of foreign capital will decrease foreign investment and lower growth.®

## f. Sectoral policies

The model of distortions can be applied naturally to the consideration of sectoral policies. Equation (7) can be used to think of policies that affect the relative prices of different types of investment goods, such as physical versus human capital, or equipment versus structures. Disaggregated data from Summers and Heston (1988) can be used to examine the relative prices of different types of physical investment goods as measures of price distortions. In testing the predictions of the model, one could exploit also the disaggregated data on quantities of investment by type available from this data set.

Equation (7) is also a useful short-cut to think of the sectoral composition of inputs .o aggregate production.” For example, type 1 capital could be interpreted as being made up of manufacturing goods and type 2 capital as being made up of agricultural goods (although we Of course, this determination of foreign direct investment is oversimplified for the purposes of clarity. Lizondo (1990) contains a survey of the theory.

“This argument could be taken to an extreme, implying that subsidizing foreign capital would actually raise growth. There are two Withcaveatsthat should be made to this conclusion. First, subsidies of foreign capital must be financed-such as by a tax on domestic capital. rate Cobb-Douglason domestic capital. production,Second, foran examplincreas **e** ,ingrowththe growth wouldrate declineachieved with anby increasea subsidyinon theforeignsubsidy investmrate fin **a** ncedctuall b **y** an increaseworsens w **e** lfare,i **n** thesincettax it induces investment whose return does not cover the opportunity cost to the economy of the capital, which is given by the international interest rate, rc’. There is a long tradition in the literature recognizing this kind of "immiserizing growth", e.g. Bhagwati and Brecher (1980), and Brecher and Diaz-Alejandro (1977). The same conclusion holds true for any other distortion (such as tariffs) that acts as a subsidy to foreign investment.

‘TAlthough we speak of all inputs as "capital", this framework can also be used to analyze distortions of prices of intermediate inputs. Such distortions have analogous effects on growth to those of distortions of capital goods prices.