Abstract

We derive a new formula for the optimal uniform tariff in a small-country, heterogeneous-firm model with a traded and a nontraded sector, and with roundabout production in both. Tariffs are applied on the imported differentiated inputs in the traded sector, which are bundled with domestic inputs to produce a nontraded finished good. First-best policy requires that markups on domestic intermediate inputs are offset by subsidies. We compare the optimal second-best tariff – when such subsidies are not used – to the first-best tariff from a one-sector, no roundabout model. Under a wide range of parameter values the second-best import tariff is lower. In a 186- country, 15-sector quantitative version of our model, the optimal uniform tariff has a median value of 10% (7.5% for countries with above-median shares of manufacturing production), and it is negative for five countries.