Due to its small size and isolated mountainous location, Andorra has preserved its political independence over the years. But these factors also contributed to its economic and developmental impoverishment before World War II. The economy historically has been based on pastoral farming, the processing of tobacco and timber, and the smuggling of goods (mainly tobacco) into the neighboring regions of France and Spain. Over the last 4 or 5 decades of the 20th century, however, the principality has achieved considerable prosperity. This has been mostly due to its status as a tax-free port, the rapid development of tourism in Europe, the dramatic economic progress of its large neighbors France and Spain, and the European integration processes. Many investors and immigrants, both legal and illegal, are now attracted to its thriving economy and its lack of income taxes .
Tourism has been developing at a high rate since the mid-1950s and now dominates the principality's economic life. The extensive winter ski facilities, the cool summer climate, and the availability of inexpensive goods in the stores attract numerous tourists to Andorra's humming summer and winter resorts. With about 270 hotels and 400 restaurants, as well as many shops, the tourist industry provides a livelihood to a growing portion of the domestic and immigrant labor force .
Trade in consumer products is also very active, mostly in imported manufactured items, which, because of their duty -free prices, are considerably cheaper than in other European countries. Partly due to this, smuggling in the country, once a major livelihood, is still widespread. Duty-free status and the price differences between Andorra and its neighbor countries, however, are seen as a serious problem by the European Union (EU) and have had a very significant stake in the debate concerning the principality's relationship with the union. Andorra is a member of the EU customs union and is treated as an EU member for trade in manufactured goods (for which there are no tariffs ), yet its duty-free shopping status gives it an edge over EU member states. However, the country's comparative advantage in duty-free shopping has been negatively affected as the economies of neighboring France and Spain have been liberalized and opened up over the 1990s, resulting in lower tariffs and a wider choice of consumer items.
Negotiations on maintaining Andorra's duty-free status and developing its trade links with the EU began in 1987, soon after neighboring Spain was admitted to the union. A difficult agreement, in effect since July 1991, has set some duty-free quotas and placed limits on certain goods such as tobacco, alcoholic beverages, and dairy products. But as of 2001, Andorra was still allowed to maintain its price differences from other EU countries, and visitors could still enjoy limited duty-free allowances. By creating a modern legal framework, however, the 1993 constitution has allowed Andorra to begin the needed shift from an economic model substantially based on duty-free shopping to one relying largely on international banking and finance.
Andorra's gross domestic product (GDP) for 1998 was worth US$1.2 billion, with tourism providing by far the principal component (roughly 80 percent). GDP per capita was a healthy US$18,000 in 1996.