Investment, Adverse Selection and Optimal Redistributive Taxation
24 Pages Posted: 5 Mar 2016 Last revised: 20 Feb 2018
Date Written: February 17, 2016
This paper studies redistributive taxation in a credit market with adverse selection and signaling. Entrepreneurs of high-quality projects may over- or under-invest relative to the social optimum to signal their type. An anonymous, budget-balanced, redistributive tax system unambiguously benefits entrepreneurs of low-quality projects because they are cross-subsidized by entrepreneurs of high-quality projects. Pledging government subsidies as collateral relaxes incentive constraints. In some cases, the cost of cross-subsidization is offset by the relaxation of incentive constraints, and hence, the tax system might create Pareto improvements by either increasing or decreasing aggregate investment.
Keywords: Adverse selection, investment, taxes, welfare
JEL Classification: D04, D60, D82, D86, H25, H82
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