In Discussion Paper No. 1381, Research Fellow Assaf Razin, Efraim Sadka and Chi-Wa Yuen highlight key sources of market failures in the context of international capital flows and provide guidelines for an efficient tax structure in the presence of capital market imperfections. They distinguish between three types of international capital flows: foreign portfolio debt investment (FPDI), foreign portfolio equity investment (FPEI), and foreign direct investment (FDI).

The model employed incorporates risk and information asymmetries between foreign and domestic investors. In the case of FPDI, the emphasis is on market failures associated with domestic lenders being better informed about the credit-worthiness of domestic borrowers than their foreign counterparts. For FPEI, special attention is paid to asymmetries between domestic and foreign investors. Domestic agents have an informational advantage regarding the prospective profitability of domestic firms. FDI is viewed as involving accumulation of both physical and managerial skills, which circumvents problems of asymmetric information. The results show efficiency gains arising from a non-uniform treatment of the various vehicles of international capital flows. In order for the three types of capital inflow to coexist efficiently, their tax treatment cannot be identical.