The role of interest rate taxes in credit markets with divisible projects and asymmetric information

This paper assumes that entrepreneurs have divisible projects with random payoffs. However, managerial skill is unobservable to outsiders. Projects are assumed to be financed through debt. A pooling equilibrium is shown to exist in which good and bad entrepreneurs sell debt at the same price. If both types of entrepreneur have a positive probability of bankruptcy, project scale will be too large. This provides a prima facie case for raising interest rates and hence the cost of capital through taxation. If in equilibrium only the poor entrepreneurs go bankrupt, there is an outlying possibility that interest rates are too low and a subsidy is called for.