eigners who spend only on tradable goods, government indirectly targets the tradable sector, which generates large learning-by-investing externalities and boosts aggregate saving and investment. In a way, the government “outsources” the targeting problem to foreigners.

The difficulty of targeting policy measures at specific sectors has long been emphasized by the economic literature. First, selective subsidies pose potentially severe agency problem, as they offer ample opportunities for rent extraction.<sup>6</sup> Secondly, sector-specific targeting imposes vast knowledge requirements on government, which are unlikely to be met in practice. Pack and Saggi (2006) survey the literature on this topic and present a detailed list of such requirements.<sup>7</sup> Furthermore, WTO rules have severely curtailed the ability of developing countries to deploy sector-specific taxes – and subsidies, as any such actions if they lead directly or indirectly to expanding exports – would fall by design under restrictions on “trade-distorting interventions.”<sup>8</sup> Our formal model describes a small economy with two intermediate goods sectors, a tradable and a non-tradable sector. The two intermediate goods can be combined to yield a composite final good that can be used for consumption and investment. Both intermediate sectors employ two factors, labor and capital, where our measure of capital includes all factors that can be accumulated, i.e. physical as well as intangible forms, such human capital in the form of schooling or training, organizational capital, institutional capital etc. This is a common interpretation of capital in the endogenous growth literature, since the accumulation of all these factors has the potential of spillover effects. As is common in many developing economies, we assume that capital accounts are closed for private agents, and only government can trade financial assets with the outside world.

We make two crucial assumptions in our analysis: First, we assume that the economy exhibits learning-by-investing externalities, i.e. that the level of technology in the economy is proportional to the amount of capital accumulated. This implies that the economy is of the _AK_ -type as in Romer (1989), i.e. that growth is endogenous to the economic system and can be affected by policy. For evidence on such spillover effects in developing countries see e.g. Xu and Sheng (2010). Syverson (2010) provides a more general survey.

Secondly, we assume that tradable goods are more intensive in our measure of capital than non-tradable goods, which implies that the production of tradable goods

> 6Even in economies with highly developed institutions, these concerns are of major importance, as illustrated e.g. by the large number of fraudulent schemes seeking to profit from the European Union’s Common Agricultural Policy (see e.g. New York Times, Oct. 27, 2009, “Fraud Plagues Sugar Subsidy System in Europe” or New York Times, Dec. 28, 2009, “Olive Growers’ Claims Prompt Investigation”).

> 7Klimenko (2004) describes conditions under which even a perfectly benevolent government that attempts to target specific industries may end up inefficiently steering a country away from its long-run comparative advantage, if information is imperfect.

> 8This point is noted also by Charlton and Stiglitz (2006) and Rodrik (2009). UNCTAD (2006) describes in detail the restrictions on national policies imposed by multilateral trade agreements.

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