On the destabilizing nature of capital gains taxes

Policymakers around the world impose some form of capital gains taxes to foster the stability of financial markets. Unfortunately, there is no clarity on the effects of capital gains taxes. Based on a stylized behavioral asset-pricing model highlighting the trading activity of extrapolating speculators, we show that policymakers may involuntary destabilize financial markets by imposing capital gains taxes. Most importantly, we find that the imposition of capital gains taxes may trigger endogenous cyclical asset price dynamics occurring around inflated price levels. A number of robustness checks in which we allow for interactions between speculators who use extrapolative and regressive expectation rules confirm our main results.