<!-- Start of picture text --> Policy Research<br>Public Economics<br><!-- End of picture text --> WPS 936 This paper - a product of the Public Economics Division, Country Economics Department - is one of a series of papers commissioned for the research project, "An Evaluation of Tax Incentives for Industrial and Technological Development," (RPO 675-10), funded by the Bank's Research Support Budget. Copies of this paperare available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Carlina Jones, room NIO-063, extension 37699 (July 1992,46 pages).

Lyon surveys the effects of taxation and asymmetric information on the financing of investment. In the absence of these two factors, traditional economic models predict that funds for investment flow to projects with the highest expected return. The form of the investment (for example, whether by equity, bank loan, or another form of debt finance) is irrelevant.

In the presence of either taxation or information asymmetries, however, neither of these predictions necessarily holds. Financing may not go toward those projects with the highest expected return and the form in which the financing is conveyed can affect the profitability of the project to both the provider of funds and the recipient.

What are the policy implications of the effects of these factors on the financing of investment?

- Depending on technological characteristics, informational asymmetries can result in either overinvestment or underinvestment in an economy. Clearly, depending on which outcome occurs, policy recommendations to correct the inefficiency differ. While persistent overinvestment is unlikely to characterize most developing economies, there are certainly many occasions when funds are applied to projects with low expected returns.

e Increases in the level of wealth and collateral in an economy can greatly reduce the costs of asymmetric information. Increases in collateral reduce the risks faced by lenders. Entrepreneurs with poor projects are less likely to undertake them when they must risk more of their own wealth. Government policies that increase the ability of individuals to collateralize wealth - for example, by promoting property rights and the establishment of a legal system that allows the low-cost transfer of collateral - can increase the ability of potentially successful projects to receive financing. Policies that facilitate the ability of individuals to accumulate savings play a related role. In addition to increasing the collateral of an entrepreneur, the ability to earn high rates of return increases the opportunity cost of undertaking projects with low expected returns.

* Creating decentralized securities markets is likely to be less advantageous where information asymmetries are great. Individual providers of funds have an incentive to free-ride on the information and monitoring of entrepreneurs provided by others. Only firms with established reputations may be able to obtain funds in these markets.

* Similarly, while competition among lenders is generally promoted, such competition can also reduce the incentive for individual lenders to lend to entrepreneurs where infornation and monitoring costs are large. Competitors would attempt to "steal" these borrowers away after they were certified as creditworthy. Further, limited competition allows a lender to use the sanction of denying credit as an instrumen **t** o influence borrowers to act responsibly in order to obtain future financing.

_-_ As the result of information asymmeties, certain types of projects are more likely to obtain financing at a lower cost using equity finance rath,"r than debt. If the tax costs of equity are higher thani those of debt, however, these projects may be relatively underfinanced. Tax policy might wish to consider whether the tax treatment of equity and debt should be equalized or whether tax costs of these projects can be reduced in other ways.

* Government may feel an obligation to intervene directly in credit allocation, but should do so only where it has a greater ability to identify creditworthy recipients than other lenders do. In the absence of any comparative advantage, government attention to the basic infrastructure that reduces the costs of obtaining information and enforcing contracts is likely to better assist the efficient allocation of credit.

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