ADVERSE SELECTION, INVESTMENT, AND PROFIT TAXATION

This article introduces government revenue requirements and attendant taxation into a financial market model with informed borrowers (entrepreneurs) and uninformed lenders. It finds that: (1) in general, an allocationally neutral proportional profit tax yields an equilibrium which is constrained inefficient, despite the constrained efficiency of the no-tax equilibrium; (2) many constrained efficient allocations can only be supported by a profit tax regime which depends on the entrepreneur's investment choice and thus, which is tantamount to direct intervention in the financial market; and (3) some 'first best' allocations can be supported by an investment-invariant tax regime which includes a proportional profit tax and a positive fixed transfer.