Capital gains tax cuts raised US equity volatility 35 percent
A Bank of England working paper finds that US capital gains tax cuts since the 1970s increased stock price-dividend volatility by 35 percent. Lower tax rates strengthened the pass-through from subjective expectations to asset prices, fueling self-fulfilling market fluctuations.
Beliefs amplify market fluctuations
Estimating a general equilibrium model on US stock market data from 1975 to 2022 shows that cumulative capital gains tax cuts raised price-dividend volatility by 34.4 percent.
Return volatility increased by 29.5 percent over the same period.
The net destabilizing outcome reflects two competing mechanisms.
Lower tax rates strengthen the pass-through from subjective expectations to equity prices, which alone drives a 50.3 percent rise in valuation volatility.
In contrast, the reduction in realization-based lock-in frictions provides only a 15.9 percent offsetting dampening effect.
Consequently, the dynamic belief-price feedback loop clearly dominates trading friction channels.
Accrual rules outperform transaction taxes
Policy experiments demonstrate contrasting results across fiscal designs.
Replacing the realization regime with a revenue-neutral accrual tax of 7.2 percent reduces valuation volatility by 20 percent while eliminating lock-in distortions.
Similarly, introducing a small supplementary levy on unrealized gains dampens short-run valuation fluctuations monotonically.
By contrast, a financial transaction tax generates non-monotonic outcomes and becomes destabilizing at a 5 percent rate.
A potent macroprudential alternative
The findings dismantle the traditional assumption that cutting capital gains taxes stabilizes markets.
Targeting unrealized gains provides a superior macroprudential anchor by dampening self-fulfilling belief cycles.
Financial transaction taxes remain an unpredictable alternative that risks aggravating market instability.