Taxation, information asymmetries, and a firm's financing choices

This paper is intended as a survey of the effects of taxation and asymmetric information on the financing choice of the firm. The literature on taxation posits a straightforward relationship between the pretax cost of funds and the required return on an investment project to cover the cost of finance which is a function only of tax rates. The real decisions of the firm are assumed in these analyses to be affected only by the after-tax cost of funds. The paper examines how differential taxation of retained earnings, new share issues, and debt finance affects the financing choice of the firm in the absence of asymmetric information. It examines the problems of asymmetric information that arise with external finance and the mechanisms that have been created in rural sectors of developing countries to counter the problem of asymmetric information. The final section of the paper examines policy options open to government to reduce the costs of the inefficiencies created by asymmetric information. Unfortunately, policy prescriptions appear to be very dependent on the form of the information asymmetry. General government solutions to the problem of asymmetric information may not be possible without a precise understanding of the nature of the information problem.