Open economies review 16: 341–362, 2005 c © 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands. Can Import Tariffs Deter Outward FDI?

In this paper we analyze a country’s optimal trade policy when its labor market is unionized and firms are footloose. We show that an important objective for governments to use import protec-tion is to prevent their domestic multinationals to go to a non-unionized location abroad and to serve their country from a distance. A domestic government will set a positive tariff to dissuade its multinational from engaging in outward FDI when the additional profits it repatriates, do not com-pensate for the loss of domestic union rent. To put it differently, we show that when the domestic labor market is unionized, trade liberalisation between countries with similar wage levels is likely to result in domestic welfare losses as a result of outward FDI. Only when wage differences between countries are large enough, can outward FDI improve domestic welfare and optimal tariffs will be zero. In this paper we document theoretically that countries with unionized labor markets and footloose multinationals clearly have an interest in using trade policy to deter their firms from engaging in outward FDI to serve their market from a distance