Restricting Capital Outflow - The Political Economy Perspective

31/08/2003 |  Frish Roni
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The Foreign Exchange Market
Restricting Capital Outflow - The Political Economy Perspective
Roni Frish

Abstract

According to the CAPM model the individual can maximize his utility by diversifying his capital across countries, so why does a government restrict the capital outflow of its residents? This paper argues that foreign resident capital owners have less political power than domestic capital owners; hence capital liberalization weakens the political power that protects capital and increases capital tax. Indeed, most of the empirical evidence suggests that capital liberalization is positively correlated with government expenditure, social security spending and corporate tax.

According to this paper residents have two objectives: one is to diversify their own capital across countries to eliminate risk; the other is to increase the home country's capital stock (and wages). The model emphasizes the tradeoff between those two targets: if residents invest their own property abroad they will not be committed to protecting the capital owners' interests in the next period. Hence foreign investors will not invest in this economy and the residents will not achieve the second target of increasing capital stock. The residents can commit themselves ex-ante to protecting capital only by restricting capital outflow.

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