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Capital gains taxation and asset price volatility
Do capital gains tax cuts destabilize or stabilize asset prices? In an asset pricing model with heterogeneous agents and realization-based taxation, a tax cut has two opposing effects. It dampens volatility by reducing realization-based trading frictions, but also amplifies it by strengthening the pass through from expectations to prices, fuelling self-fulfilling fluctuations. Estimated on US stock-market data, the model implies that the sequence of tax cuts since the 1970s triggered a net increase in volatility of about +35%, driven primarily by stronger belief-to-price pass-through. Policy experiments suggest a tax on unrealized gains robustly reduces volatility, whereas a financial transaction tax has mixed effects.
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