Loans Versus Grants in the Context of Urban Development Funding

Abstract

First, we show the equivalence of loans and grants as a means of subsidizing urban development projects in a perfect capital market setting. However, with capital markets being imperfect, redeemable loans may serve as a credible commitment device in order to overcome problems of asymmetric information between public authorities and private investors and may also mitigate overinvestment problems for EU member states in their relationship to the European Commission. However, the more public authorities rely on redeemable loans, the higher the volatility of the monetary outcomes for public authorities. As a consequence, a more intense utilization of redeemable loans may eventually lead to increasingly volatile tax necessities as a reaction to fluctuating payoffs for public authorities from financing urban development projects. Such higher tax volatility might be welfare destroying in itself and could counteract the positive role of redeemable loans in settings of asymmetric information.