Is free trade optimal for a small open economy with tourism?

We explore the welfare effects of tariffs and investment taxes for a small open economy in the presence of tourism. Inbound tourism converts local non-traded goods into tradeable, generating a tourism terms-of-trade effect. Because of this favourable expenditure-shifting effect when goods are substitutes, increases in import tariffs and investment taxes can actually improve welfare of domestic residents. We establish that for a small open economy with tourism, free trade is not the first-best policy. The optimal rates of tariffs and investment taxes are then derived and simulated for the economy with tourism. © 2009 Springer Berlin Heidelberg.