Adverse selection,asymmetric information,and foreign investment policies

This paper explores the welfare consequences of foreign investment taxation in a small open economy, based on the notion that the true productivity of imported capital may be unknown to policy-makers. It is shown that while asymmetric information between capital importers and the host government precludes the use of a productivity specific policy measure, an across-the-board policy suffers from the problem of adverse selection among capital imports of differential productivities. Conditions under which a reversal of the optimal foreign investment policy in the face of asymmetric information are examined.