On the long run economic performance of small economies

In this paper, we analyze the long run economic performance of a small economy open to foreign investments. Policy instruments used to attract investments are taxes and attractive public infrastructures, whereas the policy choices of the rest of the world are taken as given. Applying the Pontryagin’s maximum principle, we first show that there exists one long run optimal size of the small economy which is saddle-point stable. The transitional path is two-dimensional, if the small economy is patient enough. Then, we show that the share of tax income allocated to the infrastructure expenditures plays an important role in attaining such a steady state. However, a deviation from this policy path can lead to an eventual economic collapse.