Dynamic Effects of Subsidizing the Tourism Sector

Abstract

This paper studies the short-run and long-run effects of a production subsidy to the tourism sector of a small open economy, which can also be thought of as a region within a country. The authors introduce a two-sector dynamic general equilibrium model in which the tourism sector is considered to be labour-intensive and produces traded services. The other sector is capital-intensive and produces a non-traded good, which is also used for capital accumulation. Labour and capital can move freely between sectors. Economic decisions are made by forward-looking representative agents which optimize their intertemporal welfare by choosing consumption of both the non-traded good and tourism services, the sectoral allocation of labour and the rate of wealth accumulation. The authors discuss the short-run, dynamic and long-run effects of a production subsidy to the tourism sector. In the short run, the introduction of a subsidy to tourism production leads to a boom in that sector. As time passes, the economy-wide capital stock is decumulated and production of tourism falls. In the long run, compared to the situation before the subsidy was implemented, tourism production remains on a higher level, whereas output of the non-traded good drops.