Working Paper: CEPR ID: DP1837
Authors: Assaf Razin; Efraim Sadka; Chiwa Yuen
Abstract: Foreign direct investment (FDI) is observed to be a predominant form of capital flows to low- and middle-income countries with insufficiently developed capital markets. This paper analyses the problem of channelling domestic savings into productive investment, in the presence of asymmetric information between the managing owners of firms and other portfolio stakeholders. We emphasize the crucial role played by FDI in sustaining equity-financed capital investment for economies plagued by such information problems. The paper identifies how, in the presence of information asymmetry, different capital market structures may lead to foreign over- or under-investment and to domestic under- or over-saving, and thus to inefficient equilibria. We show how corrective tax-subsidy policies, consisting of taxes on corporate income and the capital incomes of both residents and non-residents, can restore efficiency.
Keywords: foreign direct investment; portfolio debt and equity flows; asymmetric information; international taxation
JEL Codes: F21; F35; H25; H30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign direct investment (FDI) (F23) | improved capital allocation (G31) |
| absence of foreign direct investment (FDI) (F23) | low investment (G31) |
| low productivity firms (D22) | market failure (D52) |
| foreign direct investment (FDI) (F23) | restoration of equity market function (G18) |
| foreign direct investment (FDI) (F23) | channelling domestic savings into productive investment (O16) |
| corrective tax-subsidy policies (H23) | alignment of rates of return (G19) |
| absence of foreign direct investment (FDI) (F23) | collapse into lemon market (D43) |