Quantitative Implications of the Home Bias : Foreign Underinvestment, Domestic Oversaving, and Corrective Taxation

There is strong evidence about a home-court advantage in international portfolioquot; investment. One explanation for the bias is an information asymmetry between domestic andquot; foreign investors about the economic performance of domestic firms. This asymmetry causesquot; two types of distortions: an aggregate production inefficiency and a production-consumptionquot; inefficiency, leading to foreign underinvestment and domestic oversaving respectively. Suchquot; market failures are found to be quite severe, slightly more so with equity flows than with debtquot; flows. These inefficiencies can nonetheless be corrected by a mix of tax-subsidy instruments consisting of taxes on corporate income and on the capital incomes of both residents andquot; nonresidents. When only a partial set of instruments is available, however each tax instrument can change radically and may even be reversed although the welfare gainsquot; can be fairly substantial and sometimes close to the first best optimum. This partial set ofquot; instruments appears to be more effective in handling the market failure in the case of equityquot; flows than in the case of debt flows