Events at CERGE-EI

Pau Belda, MSc.

Barcelona School of Economics, Spain

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Abstract: Why have there been more asset price boom-bust cycles since the 1980s despite the drop in macroeconomic risk? This paper argues that the fall of the Capital Gains Tax (CGT) has been a crucial factor. In a model of learning about prices, I show that a lower CGT make prices more responsive to changes in investors’ beliefs, thereby elevating the likelihood of self-fulfilling booms and busts. The model can account for several hard-to-explain facts about the US stock market when using the observed path of tax cuts. In particular, it replicates 40% of the increase in excess volatility despite the decline in consumption growth volatility and 75% of the equity premium. Even with the drop in the safe real interest rate, the model predicts that the rise in volatility would have been largely avoided if tax cuts had not been implemented. Finally, I show that optimal policy prescribes a CGT that lean against market expectations, preventing beliefdriven business cycles. Altogether, a CGT is identified as a unique macroprudential instrument that enhances the autonomy of monetary policy from financial stability considerations.

JEL Classification: D83, D84, E32, E44, E62, G12, G14
Keywords: Capital Taxation, Asset Pricing, Expectations, Macroprudential Policy, Equity Premium

Full Text: Capital Gains Taxation, Learning and Bubbles